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NCI, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations
[October 30, 2014]

NCI, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations


(Edgar Glimpses Via Acquire Media NewsEdge) Forward-Looking Statements This Quarterly Report on Form 10-Q, including the section titled "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains forward-looking statements regarding our business, financial condition, results of operations, and prospects. There are statements made herein, which may not address historical facts and, therefore, could be interpreted to be forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such statements are subject to factors that could cause actual results to differ materially from anticipated results. The factors that could cause actual results to differ materially from those anticipated include, but are not limited to, the following: • Our dependence on our contracts with U.S. Federal Government agencies, particularly within the U.S. Department of Defense, for the majority our revenue; a change in funding of our contracts due to bid protests; changes in U.S. Federal Government spending priorities; changes in contract type, particularly changes from cost-plus fee or time-and-material type contracts to firm fixed-price type contracts • A reduction in the overall U.S. Defense budget, volatility in spending authorizations for Defense and Intelligence-related programs by the U.S.



Federal Government or a shift in spending to programs in areas where we do not currently provide services • Delays in the U.S. Federal Government appropriations process, or budgetary cuts resulting from Congressional committee recommendations or automatic sequestration under the Budget Control Act of 2011; U.S. Federal Governmental shutdowns (such as the shutdown that occurred during the U.S.

Federal Government's 1996 and 2013 fiscal years); and other potential delays in the U.S. Federal Government appropriations process • Changes in U.S. Federal Government programs or requirements, including the increased use of small business providers • Failure to achieve contract awards in connection with recompetes for present business and/or competition for new business • U.S. Federal Government agencies more frequently awarding contracts on a technically acceptable/lowest cost basis in order to reduce expenditures • Adverse results of U.S. Federal Government audits of our government contracts • Competitive factors, such as pricing pressures and competition to hire and retain employees (particularly those with security clearances) • Failure to identify and successfully integrate future acquired companies or businesses into our operations or to realize any accretive or synergistic effects from such acquisitions, or effectively integrate acquisitions appropriate to the achievement of our strategic plans • Economic conditions in the United States, including conditions that result from terrorist activities or war • Material changes in policies, laws, or regulations applicable to our businesses, particularly legislation affecting (i) U.S. Federal Government contracts for services, (ii) outsourcing of activities that have been performed by the U.S. Federal Government, (iii) U.S. Federal Government contracts containing organizational conflict of interest clauses, (iv) delays related to agency specific funding freezes, and (v) competition for task orders under Government Wide Acquisition Contracts, agency-specific Indefinite Delivery/Indefinite Quantity contracts and/or schedule contracts with the General Services Administration • U.S. Federal Government's "insourcing" of previously contracted support services and the realignment of funds to non-defense related programs • Our ability to achieve the objectives of near-term or long-range business plans, particularly revenue growth, and the ability to realize future deferred tax assets benefits • Risk of contract non-performance or termination Some of these important factors are outlined under Item 1A. Risk Factors and elsewhere in our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC, and from time to time in other filings with the SEC, such as our Forms 8-K and 10-Q. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee our future results, level of activity, or performance. We undertake no obligation to update publicly or revise any forward-looking statements. You should not place undue reliance on any forward-looking statements.


In this document, unless the context indicates otherwise, the terms "Company," "NCI," "we," "us," and "our" refer to NCI, Inc., a Delaware corporation, and, where appropriate, its subsidiaries.

9-------------------------------------------------------------------------------- Table of Contents OVERVIEW We are a provider of information technology (IT) and professional engineering services and solutions to U.S. Federal Government Agencies. Our technology and industry expertise enables us to provide a wide spectrum of services and solutions that assist our customers in achieving their program goals. We deliver these complex services and solutions by leveraging our skills across eight core competencies: • Cloud Computing and IT infrastructure optimization • Enterprise information management and advanced analytics • Cybersecurity and information assurance • IT service management • Engineering and logistics support • Software and systems development/integration • Health IT and medical support • Modeling, simulation, and training Our team of highly skilled professionals is committed to service excellence and delivers innovative, cost-effective enterprise services and solutions on time and within budget. We are focused on reshaping the way services and solutions are delivered to our customers in order to proactively understand and meet their mission needs and enable them to rapidly adapt to dynamic environments.

Headquartered in Reston, Virginia, NCI currently operates in more than 100 locations around the globe. We report operating results and financial data as one reportable segment.

Key Financial Metrics Prime Contractor Revenue The following table shows our revenue derived from contracts on which we serve as a prime contractor.

Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Revenue derived from prime contracts 92 % 90 % 92 % 90 % Customer Group Revenue The following table shows our revenue from the customer groups listed as a percentage of total revenue for the period shown.

Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Department of Defense and intelligence agencies 73 % 74 % 75 % 75 % U.S. Federal civilian agencies 27 % 26 % 25 % 25 % Contract Type Revenue Our services and solutions are provided under three types of contracts: time-and-materials; cost-plus fee; and firm fixed-price. Our contract mix varies from year to year due to numerous factors including our business strategies and U.S. Federal Government procurement objectives.

The following table shows our revenue from each of these types of contracts as a percentage of our total revenue for the periods shown.

Three months ended September 30, Nine months ended September 30, 2014 2013 2014 2013 Time-and-materials 16 % 16 % 16 % 20 % Cost-plus fee 51 % 54 % 52 % 51 % Firm fixed-price 33 % 30 % 32 % 29 % 10 -------------------------------------------------------------------------------- Table of Contents The amount of risk and potential reward varies under each type of contract.

Under time-and-materials contracts, we are paid a fixed hourly rate by labor category. To the extent that our actual labor costs vary significantly from the negotiated hourly rates, we may generate more or less than the targeted amount of profit. We are typically reimbursed for other contract direct costs and expenses at our cost, and typically receive no fee on those costs. For cost-plus fee contracts, there is limited financial risk, because we are reimbursed all our allowable costs, therefore the profit margins tend to be lower on cost-plus fee contracts. Under firm fixed-price contracts, we perform specific tasks or provide specified goods for a predetermined price. Compared to time-and-materials and cost-plus fee contracts, firm fixed-price service contracts generally offer higher profit margin opportunities but involve greater financial risk because we would bear the impact of potential cost overruns in return for the full benefit of any cost savings.

Contract Backlog As of Funded Backlog Total Backlog (in millions) September 30, 2014 $ 165 $ 435 December 31, 2013 195 488 We define backlog as our estimate of the remaining future revenue from existing signed contracts over the remaining base contract performance period and from the option periods of those contracts that we believe have a more likely than not probability of being exercised. Our backlog does not include any estimate of future potential delivery orders that might be awarded under our GWAC, agency-specific IDIQ, or other multiple-award contract vehicles. We define funded backlog as the portion of backlog for which funding currently is appropriated and obligated to us under a contract or other authorization for payment signed by an authorized purchasing agency, less the amount of revenue we have previously recognized. Our funded backlog does not represent the full potential value of our contracts, as Congress often appropriates funds for a particular program or agency on a quarterly or yearly basis, even though the contract may provide for the provision of services over a number of years. We define unfunded backlog, not included above, as the total backlog less the funded backlog. Unfunded backlog includes values for contract options that have been priced but not yet funded. Additional information on how we determine backlog is included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC.

Results of Operations Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013 The following table sets forth certain items from our consolidated statements of income and expresses each item in dollars and as a percentage of revenue for the periods indicated: Three months ended September 30, 2014 2013 2014 2013 (in thousands) (as a percentage of revenue) Revenue $ 75,660 $ 77,918 100.0 % 100.0 % Operating expenses: Cost of revenue 64,102 67,832 84.7 87.1 General and administrative expenses 6,205 5,819 8.2 7.5 Depreciation and amortization 1,401 1,679 1.9 2.1 Purchase contingency gain - (864 ) - (1.1 ) Total operating expenses 71,708 74,466 94.8 95.6 Operating income 3,952 3,452 5.2 4.4 Interest expense, net 95 157 0.1 0.2 Income before income taxes 3,857 3,295 5.1 4.2 Provision for income taxes 1,495 1,344 2.0 1.7 Net income $ 2,362 $ 1,951 3.1 % 2.5 % 11 -------------------------------------------------------------------------------- Table of Contents Revenue For the three months ended September 30, 2014, revenue decreased by 2.9%, or $2.3 million, over the same period a year ago. The decrease was primarily due to approximately $2.7 million of lower revenue attributable to services provided on our PEO Soldier contract.

Cost of revenue Cost of revenue decreased 5.5%, or $3.7 million, for the three months ended September 30, 2014, as compared to the same period a year ago. This decrease was primarily the result of lower non-labor costs offset partially by an increase in direct labor and subcontractor costs. Cost of revenue represented 84.7% of revenue for the quarter ended September 30, 2014, as compared to 87.1% for the quarter ended September 30, 2013.

General and administrative expenses General and administrative expense increased 6.6%, or $0.4 million, for the three months ended September 30, 2014, as compared to the same period a year ago. The increase was primarily due to increased costs supporting business development and our bid and proposal efforts.

Depreciation and amortization Depreciation and amortization expense was approximately $1.4 million and $1.7 million for the quarters ended September 30, 2014 and 2013, respectively.

Interest expense, net Net interest expense was $0.1 million and $0.2 million for the quarters ended September 30, 2014 and 2013, respectively. This decrease was primarily due to a lower average loan balance in the quarter ended September 30, 2014. During the third quarter of 2014, we had a weighted average outstanding loan balance of zero. During the third quarter of 2013, we had a weighted average outstanding loan balance of $7.2 million which accrued interest at a weighted average borrowing rate of 2.5%.

Income taxes Income tax expense increased by $0.2 million in the three months ended September 30, 2014, as compared to the three months ended September 30, 2013.

This increase was due to higher operating income for the period ended September 30, 2014, offset by a decrease in our effective tax rate. The effective income tax rate for the quarter ended September 30, 2014 was approximately 38.8% compared with 40.8% for the quarter ended September 30, 2013. The decrease in effective tax rate resulted from changes in the blended state tax rate.

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013 The following table sets forth certain items from our consolidated statements of income and expresses each item in dollars and as a percentage of revenue for the periods indicated: Nine months ended September 30, 2014 2013 2014 2013 (in thousands) (as a percentage of revenue) Revenue $ 242,588 $ 252,430 100.0 % 100.0 % Operating expenses: Cost of revenue 208,033 220,300 85.8 87.3 General and administrative expenses 19,967 17,809 8.2 7.1 Depreciation and amortization 4,302 4,824 1.8 1.9 Purchase contingency gain - (864 ) - (0.3 ) Total operating expenses 232,302 242,069 95.8 95.9 Operating income 10,286 10,361 4.2 4.1 Interest expense, net 302 656 0.1 0.2 Income before income taxes 9,984 9,705 4.1 3.8 Provision for income taxes 3,956 3,967 1.6 1.6 Net income $ 6,028 $ 5,738 2.5 % 2.3 % 12 -------------------------------------------------------------------------------- Table of Contents Revenue For the nine months ended September 30, 2014, total revenue decreased 3.9%, or $9.8 million, compared with the same period a year ago. The decrease was primarily due to approximately $6.5 million of lower revenue attributable to services provided on our PEO Soldier contract, and $3.3 million as a result of reductions of scope of work, and the expiration of task orders and contracts.

Cost of revenue Cost of revenue decreased 5.6%, or $12.3 million, for the nine months ended September 30, 2014, as compared to the same period a year ago. This decrease was primarily the result of lower non-labor costs. Cost of revenue represented 85.8% of revenue for the quarter ended September 30, 2014, as compared to 87.3% for the quarter ended September 30, 2013. This decrease was primarily the result of the factors affecting revenue and the associated indirect costs.

General and administrative expenses General and administrative expenses increased 12.1%, or $2.2 million, for the nine months ended September 30, 2014, as compared to the same period a year ago.

The increase was primarily due to $1.1 million in accelerated stock compensation expense, and increased business development and bid and proposal costs.

Depreciation and amortization Depreciation and amortization expense was approximately $4.3 and $4.8 million for the nine months ended September 30, 2014 and 2013, respectively. The decrease was primarily due to the reduction in the amortization expense of intangible assets.

Interest expense, net Net interest expense was approximately $0.3 million for the nine months ended September 30, 2014 and approximately $0.7 million for the nine months ended September 30, 2013. The decrease was primarily attributed to a lower weighted average loan balance and a slightly lower weighted average borrowing rate.

Income taxes For the nine months ended September 30, 2014 and 2013, income taxes were approximately $4.0 million on slightly increased pretax income and a slightly lower effective tax rate. The effective income tax rate for the nine months ended September 30, 2014 was approximately 39.6% as compared to an effective income tax rate of 40.9% for the nine months ended September 30, 2013. The lower effective income tax rate for the nine months ended September 30, 2014 was the result of a decrease in the blended state rate from our current state revenue allocation.

Liquidity and Capital Resources Our primary liquidity needs are for financing working capital, capital expenditures, stock repurchases, and making selective strategic acquisitions.

Historically, we have relied primarily on our cash flow from operations and borrowings under our credit facility to provide the capital for our liquidity needs. As part of our growth strategy, we may pursue acquisitions that could require us to incur additional debt or issue new equity. We expect the combination of our current cash, cash flow from operations, and the available borrowing capacity under our credit facility to continue to meet our normal working capital, capital expenditures and other cash requirements.

During the third quarter of 2014, the balance of accounts receivable decreased by $9.2 million to $54.8 million at the end of the quarter. Days sales outstanding of accounts receivable (DSO) decreased 7 days to 67 days at September 30, 2014 as compared to 74 days at December 31, 2013. As of September 30, 2014, no amounts were due under the credit facility, as compared to $1.0 million outstanding as of December 31, 2013, reflecting $1.0 million of net repayments during the first nine months of 2014. Net cash provided by operating activities was $21.0 million at September 30, 2014.

Our Board of Directors authorized management to repurchase up to $25.0 million of our Class A common stock pursuant to a stock repurchase program. If shares are repurchased, the shares will be repurchased pursuant to open market purchases, privately negotiated transactions, or block transactions. We have no obligation to repurchase shares under the authorization, and the timing, actual number and value of the shares which are repurchased (and the manner of any such repurchase) will be at the discretion of management and will depend on a number of factors, including the price of our common stock, our Company's cash needs, borrowing capacity under our credit facility, interest rates, and our financial performance and position. We may suspend or discontinue repurchases at any time.

13 -------------------------------------------------------------------------------- Table of Contents During 2013 and the three and nine months ended September 30, 2014, we did not purchase any shares. At September 30, 2014, we had $16.7 million remaining under the Board of Directors' authorization for share repurchases.

Credit Facility: Our amended and restated senior credit facility consists of a revolving line of credit with a borrowing capacity of up to an $80.0 million principal amount, and a $45.0 million accordion feature allowing us to increase our borrowing capacity to up to a $125.0 million principal amount, subject to obtaining commitments for the incremental capacity from existing or new lenders.

The outstanding borrowings are collateralized by a security interest in substantially all the Company's assets. The lenders also require a direct assignment of all contracts at the lenders' discretion. The outstanding balance under the credit facility accrues interest based on one-month LIBOR plus an applicable margin, ranging from 210 to 310 basis points, based on the ratio of our outstanding senior funded debt to Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) as defined in the credit facility agreement.

The credit facility allows us to use borrowings thereunder of up to $17.5 million to repurchase shares of our common stock. Funds borrowed under the credit facility may be used to finance possible future acquisitions, for working capital requirements, for stock repurchases, for cash dividends or for general corporate uses.

The loan interest accrual rate is set monthly at one-month LIBOR plus a set amount per the credit facility, amended in December 2013.

The credit facility contains various restrictive covenants that, among other provisions, restrict our ability to incur or guarantee additional debt; make certain distributions, investments and other restricted payments such as dividends; enter into transactions with certain affiliates; create or permit certain liens; and consolidate, merge, or sell assets. In addition, the credit facility contains certain financial covenants that require us to maintain a minimum tangible net worth; maintain a minimum fixed-charge coverage ratio and a minimum funded debt-to-earnings ratio; and limit capital expenditures below certain thresholds. There are no restrictions on our retained earnings in the credit facility.

As of September 30, 2014, we were in compliance with all our loan covenants.

Off-Balance Sheet Arrangements We do not have any material off-balance sheet arrangements.

Critical Accounting Policies There have been no significant changes to our Critical Accounting Policies during the third quarter of 2014. Refer to our Critical Accounting Policies section in our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC.

In May of 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which will replace most of the current revenue recognition guidance under U.S. GAAP when it becomes effective for annual periods beginning after December 15, 2016, and interim periods therein. While this new accounting standard will not affect the Company until the Company's 2017 fiscal year, it does require either a full retrospective approach reflecting the application of the standard in each prior reporting period, or a retrospective approach with the cumulative effect of initially adopting the ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures).

The main principle of ASU 2014-09 is that revenue should be recognized when contracted goods or services are transferred to customers in an amount that reflects the consideration that the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 defines a five step process to achieve this new principle which will require entities to apply significantly more management judgment and may require the use of more estimates than are required under existing U.S. GAAP. We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2017.

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