Management's discussion and analysis ("MD&A") should be read in conjunction with Part I of this Form 10-K as well as the consolidated financial statements and related notes included in Item 8 of this Form 10-K.
During the third quarter of 2013, we reorganized our business to better serve our customers, improve our organizational efficiency, increase sales and achieve future growth objectives. In order to attain these objectives, we separated our Hydrocarbons reportable segment into two separate reportable segments, Gas Monetization and Hydrocarbons, such that now we have a total of five reportable segments: Gas Monetization, Hydrocarbons, IGP, Services and Other. Each reportable segment, excluding Other, is led by a separate Segment President who reports directly to our CODM. We have revised our business segment reporting to represent how we currently manage our business and recast prior periods to conform to the current business segment presentation.
Overview of Financial Results
2013 compared to 2012
2013 net income attributable to KBR increased to
$229 millionfrom $144 millionin 2012. We generated $290 millionin operating cash flow in 2013 as compared to $142 millionin 2012. The 2013 operating cash flow amount includes the one-time payment of $108 millionin performance bonds relating to an ongoing dispute on a long completed project in Mexicothat we believe will be recoverable in the future. See Note 14 to our consolidated financial statements for further discussion of the performance bonds. 2013 financial performance was driven by our Gas Monetization business segment, which generated the highest revenue of $2.2 billionand gross profit of $324 millionduring the year. This segment is currently executing two multi-billion dollar LNG projects in Australiawhich are expected to continue throughout 2014. We are nearing completion of a major GTL project in Nigeriaand an LNG project in Algeria, which we expected to successfully close out. Although progress has been made in our negotiations, we have not signed any agreements and thus are not able to release certain remaining contingencies. Gas Monetization is actively pursuing new LNG prospects but is not expecting an EPC award on these prospects until 2015 or beyond. The Hydrocarbons business segment also had a strong year in 2013 with revenues increasing 18% from 2012 to approximately $1.5 billion, led by an increase in the number of downstream projects such as ammonia plants for clients taking advantage of a relatively abundant supply of natural gas throughout the world. However, the mix of projects has trended toward more construction activities and as such the total gross profit for this segment was relatively flat in 2013 when compared to 2012. We expect the global hydrocarbons markets to continue to improve in 2014 with energy demand driven by long-term global GDP growth. The overall volume of business in our IGP business segment declined in 2013 with revenue declining to approximately $1.5 billionfrom $1.8 billionin 2012 as government expenditures and investments in mining and infrastructure projects remain slow. However, IGP gross profit increased to $65 millionin 2013 from $20 millionin 2012 due to significant job losses on two projects in Indonesiain 2012 and an adverse ruling on a U.S. government contract, both of which were not repeated in 2013. We believe opportunities for our services are growing with non-U.S. governments and with electric power generating companies investing in new natural gas-fired power generation plants in the U.S. and/or projects to improve air emissions at existing coal-fired power plants. Our Services business segment had a strong year in 2013 with revenues increasing 28% to $2.1 billionprimarily driven by construction activities on oil sands-related projects in western Canada. Gross profit increased $106 millionfrom 2012 due to the higher volume of business and the impact in 2012 from profit reversals and project losses. We expect western Canadato remain a strong market for our construction services in 2014. As part of an effort to right size the company to match the expected workloads, we executed a reduction in force in the fourth quarter of 2013, and took an associated charge of approximately $10 millionacross the functions and businesses. This charge is included in cost of revenues and general and administrative expenses on the consolidated statement of income. We continue to examine our overhead and our expected revenue and workload and will continue to take measures in an effort to appropriately size the organization as workloads vary going forward. 26 --------------------------------------------------------------------------------
2012 compared to 2011
2012 net income attributable to KBR decreased to
$144 millionfrom $480 millionin 2011. This decline in performance was related to the December 2011decline in government operations in Iraq, project completions or near completions on three significant projects in the Gas Monetization segment, project losses in the IGP and Services business segments, and a $178 millioncharge in 2012 related to the impairment of a portion of the goodwill from our acquisition of R&S in 2010. Partially offsetting these items were new awards and increased activity in several market segments.
Gas Monetization revenue was flat in 2012 compared to 2011; however, gross profit increased
The Hydrocarbons business segment had a strong year in 2012 with revenues up slightly compared to 2011 and gross profit increasing 15% from
$161 millionto $185 milliondriven by an increase in the number of long-term technical service and engineering projects, recognition of license fee renewals, increased progress on existing projects primarily located in the U.S., the North Seaand Azerbaijan, as well as recognition of amounts related to the settlement of the Fina Antwerp Olefins ("FAO") claim. IGP business segment revenue declined by $1.4 billionin 2012, or 43%, compared to 2011 and gross profit decreased by $181 milliondue primarily to the completion of operations in Iraqwith the U.S. government, reduced activity due to a market slowdown and reduced investment in our Asia Pacific("APAC") region, additional project costs and liquidated damages related to two projects in Indonesiaassociated with our acquisition of R&S, and an unfavorable ruling from the U.S. Court of Federal Claims("COFC") regarding costs associated with dining facility services. Offsetting these declines were increases in activity from new awards in certain sectors, a shift from the LogCAP III contract to the LogCAP IV contract supporting the U.S. Department of Statein Iraq, new projects in the power sector related to air emissions controls systems, coal gasification projects and a waste-to-energy expansion project, and increased activity on certain projects in the Middle East. Our Services business segment revenues were almost flat in 2012 compared to 2011. However, gross profit was $80 millionlower in 2012 than in 2011 due to increased estimated costs to complete several U.S. construction fixed-price projects and the overall decline in our U.S. construction business. The higher costs on these fixed-price projects resulted in $75 millionin project loss provisions in 2012. Offsetting these losses was increased income from significant new awards in Canadadriven by construction activities on oil sands-related projects in western Canada.
For a more detailed discussion of the results of operations for each of our business segments, corporate general and administrative expense, income taxes and other items, see the "Results of Operations" section below.
Results of Operations by Business Segment
We analyze the financial results for each of our five business segments. The business segments presented are consistent with our reportable segments discussed in Note 2 to our consolidated financial statements. While certain business segments below do not meet the criteria for reportable segments in accordance with ASC 280 - Segment Reporting, we believe this supplemental information is relevant and meaningful to our investors.
For the year ended
December 31, 2013, we reclassified equity in earnings of unconsolidated affiliates from revenues to a separate component of operating income on our consolidated statement of income. We reclassified the 2012 and 2011 amounts to conform to our revised presentation. For purposes of reviewing the results of operations, "gross profit" is calculated as business segment revenue less cost of revenue, which includes business segment overhead costs directly attributable to the business segment but excludes equity in earnings of unconsolidated affiliates. 27 --------------------------------------------------------------------------------
December 31, 2013vs. 2012 2012 vs. 2011
Millions of dollars 2013 2012 $ % 2011 $ % Revenue Gas Monetization
$ 2,155 $ 3,006 $ (851 )(28 )% $ 3,017 $ (11 )- % Hydrocarbons 1,482 1,260 222 18 % 1,210 50 4 % Infrastructure, Government and Power 1,535 1,848 (313 ) (17 )% 3,261 (1,413 ) (43 )% Services 2,051 1,600 451 28 % 1,564 36 2 % Other 60 56 4 7 % 51 5 10 % Total $ 7,283 $ 7,770 $ (487 )(6 )% $ 9,103 $ (1,333 )(15 )% Gross profit Gas Monetization $ 324 $ 381 $ (57 )(15 )% $ 213 $ 16879 % Hydrocarbons 177 185 (8 ) (4 )% 161 24 15 % Infrastructure, Government and Power 65 20 45 225 % 201 (181 ) (90 )% Services 57 (49 ) 106 216 % 31 (80 ) (258 )% Other 15 16 (1 ) (6 )% 16 - - % Labor cost absorption not allocated to the business segments (57 ) (35 ) (22 ) (63 )% 18 (53 ) (294 )% Total $ 581 $ 518 $ 6312 % $ 640 $ (122 )(19 )% Equity in earnings of unconsolidated affiliates Gas Monetization $ 55 $ 33 $ 2267 % $ 27 $ 622 % Hydrocarbons - 1 (1 ) (100 )% 5 (4 ) (80 )% Infrastructure, Government and Power 47 56 (9 ) (16 )% 67 (11 ) (16 )% Services 13 33 (20 ) (61 )% 26 7 27 % Other 22 28 (6 ) (21 )% 33 (5 ) (15 )% Total $ 137 $ 151 $ (14 )(9 )% $ 158 $ (7 )(4 )% Impairment of goodwill and long-lived assets Infrastructure, Government and Power $ - $ (178 ) $ 178100 % $ - $ (178 )- % Other - (2 ) 2 100 % - (2 ) - % Total $ - $ (180 ) $ 180100 % $ - $ (180 )- %
Gain on disposition of assets
Amounts not allocated to the business segments Corporate general and administrative expense not allocated to the business segments
$ (249 ) $ (222 ) $ (27 )(12 )% $ (214 ) $ (8 )(4 )% Total operating income $ 471 $ 299 $ 17258 % $ 587 $ (288 )(49 )% n/m - not meaningful 28
Gas Monetization revenue decreased by
$851 millionin 2013 compared to 2012, as a result of reduced volume on a GTL project in Nigeriaand an LNG project in Algeriaas these projects completed or neared completion. This decrease was partially offset by revenue of $71 millionrecorded in the third quarter of 2013 resulting from a change order on an LNG project in Australia, higher activity and growth on a second LNG project in Australiaas a result of the project advancing to the EPC phase and increased activity on a number of FEED projects. Gas Monetization gross profit decreased by $57 millionin 2013 compared to 2012 primarily as a result of lower activity, cost savings realized in the prior period with no corresponding cost savings realized in the current period, as well as the correction of an error originating in periods prior to 2013 of approximately $25 million. The correction of this error combined with current year foreign currency effects resulted in a net unfavorable impact to gross profit of $22 millionfor the year ended December 31, 2013. The correction of the error was related to foreign currency accounting that resulted from activity over the course of the project. The decline in gross profit was also driven by $20 millionof other project charges due to delays in project start-up, tax assessments and project execution costs as well as a $7 millionproposed settlement with the African Development Bankon another project. The decrease in gross profit was partially offset by $71 millionof additional gross profit from the change order recorded in the third quarter of 2013 related to the Australian LNG project. Gas Monetization revenue decreased by $11 millionin 2012 compared to 2011, primarily driven by lower volume of work associated with near-completion on the GTL project in Nigeriaand the completion of another GTL project in Qatar, as well as the FEED phase of one of the Australian LNG projects. The decrease in 2012 revenues was offset by increased activity and schedule incentive awards on the LNG project in Australiaand the start of the EPC phase of the other LNG project in Australia. Gas Monetization gross profit increased by $168 millionin 2012 compared to 2011, as a result of increased activity on our three LNG projects. The increased activity was related to change orders which revised the estimated cost-to-complete for the Algerian LNG project, as well as schedule awards for the Australian LNG project. Partially offsetting these increases was a reduction in gross profit of $47 millionprimarily due to near-completion on the GTL project in Nigeriaand the completion of the GTL project in Qatarin 2011. Gas Monetization equity in earnings of unconsolidated affiliates, increased by $22 millionin 2013 compared to 2012, primarily due to increased activity and overall project growth on the other LNG project in Australia.
Hydrocarbons revenue increased
$222 millionand gross profit decreased $8 millionin 2013 compared to 2012. The increase in revenue was primarily due to an increase in large EPC contracts for downstream ammonia, urea and ethylene projects utilizing natural gas feedstock in North America, progress on an ethylene project in Uzbekistanand a services project in Azerbaijan. The mix of revenue between EPC projects with generally lower margins as a percentage of revenue compared with services projects contributed to the decline in gross profit, as well as the recognition of a $14 millionincrease in gross profit in 2012 from the FAO settlement. The higher revenue in 2013 was partially offset by completion of a floating production storage and offloading ("FPSO") project in the North Seaand several engineering and technical services projects. Hydrocarbons revenue increased $50 millionand gross profit increased by $24 millionin 2012 compared to 2011. These increases were primarily due to the progress achieved on license and engineering projects in various geographic locations. We also recognized an additional $20 millionin revenue related to the FAO claim settlement which resulted in a $14 millionincrease in gross profit. These increases were partially offset by the completion or near-completion of several long-term projects in late 2012.
Infrastructure, Government and Power
IGP revenue decreased
$313 millionin 2013 compared to 2012 driven by base closures and headcount reductions under the contract supporting the U.S. Military and the U.S. Department of Statein Iraq. As the U.S. government continues its withdrawal from Iraq, the volume of support services also continues to decline. There was also reduced activity related to commercial support services in Africa, reduced activity on a major contract for the U.K. Ministry of Defence("MoD"), and completion of a portion of U.K.MoD contracts in Afghanistan. Our infrastructure and minerals market offerings were affected by the continuing slow market conditions in the APAC region, and also from reduced government and private sector investments. These decreases were partially offset by new awards and activity on waste-to-energy expansion projects and on an air-quality project in the U.S. 29 -------------------------------------------------------------------------------- IGP gross profit increased $45 millionin 2013 compared to 2012, as a result of provisions taken in 2012 of $72 millionfrom cost overruns and liquidated damages mainly on two projects in Indonesia. Additionally, project charges of $28 millionrelated to the unfavorable U.S. government ruling associated with dining facility services in Iraqand $8 millionof liquidated damages recorded for a project in Indonesiain 2012 that did not recur in 2013. Gross profit in 2013 includes the reversal of $25 millionof reserves due to the progress of audits, offset by declines related to the continuing challenging market conditions in the APAC region, reduced activity in the Middle Eastunder the LogCAP IV contract, the completion and ramp down of existing projects in Africaand Afghanistan, and cost overruns on a large fixed-price power project in the U.S. IGP revenue decreased $1.4 billionin 2012 compared to 2011. This decline was primarily driven by the $1.5 billiondecline related to the completion of operations in Iraqunder the U.S. Armycontract in December 2011. In 2012, our services in the region shifted to our contract supporting the U.S. Department of Statein Iraq. These decreases were partially offset by $130 millionof new projects awarded in 2012 and increased progress on existing projects awarded during late 2011 in our power and industrial sector. New projects included air emissions controls systems in Illinoisand Kentucky, and we saw existing project growth from a coal-gasification project in Mississippiand a waste-to-energy expansion project in Florida. There was also increased activity related to support services in Africaand a NATOcontract in Afghanistanand increased activity in the Middle Eastassociated with the expansion of the Doha Expresswayprogram. IGP gross profit decreased by $181 millionin 2012 compared to 2011, primarily due to the completion of services under the U.S. Armycontract for work in Iraq. The decrease also includes the unfavorable ruling from the U.S. COFC which resulted in a noncash, pre-tax charge of $28 million, lower minerals sector gross profit of $54 milliondue to increased operating costs, funding of liquidated damages and other items on various projects legacy charges related to R&S acquisition related projects in Indonesia. Our industrial sector experienced a $15 milliondecline in gross profit, driven by lower activity on a U.K.MoD project in the U.K.and reduced margins on a U.K.MoD contract in Afghanistan. Gross profit related to the two Indonesian projects declined $38 millionas a result of additional project costs and liquidated damages. Gross profit in 2012 was further reduced due to increased costs, liquidated damages and technical delays mainly on the legacy R&S projects and due to a decline in market conditions in the APAC region.
The change in equity in earnings in unconsolidated affiliates, for IGP is primarily due to the
In the third quarter of 2012, during the course of our annual strategic planning process, we identified a deterioration in the economic conditions of the minerals markets as well as less than expected actual and projected income and cash flows due to lower project bookings and losses from ongoing projects that were acquired as part of KBR's acquisition of R&S. As a result of our interim goodwill impairment test, we recorded a non-cash goodwill impairment charge of
$178 millionin the third quarter of 2012. In the fourth quarter of 2013, during the course of our annual goodwill impairment test, we determined that expected income and cash flows for one reporting unit in our IGP business segment was substantially lower than previous forecasts due to the continuing decline in market conditions in the APAC region in the minerals sector, which has resulted in delays in award of certain expected projects. However, the results of our annual goodwill impairment test indicated no impairment of the goodwill related to the reporting unit in our IGP business. To arrive at the reporting unit's future cash flows, we used estimates of economic and market assumptions, including growth rates in revenues, costs and estimates of future expected changes in operating margins, tax rates and cash expenditures. Other significant estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. We will continue to monitor conditions in the market and its potential effects on the recoverability of the reporting unit assets. However, if market conditions materially change compared to our expectations, or if actual future new project awards fall below our projections, the goodwill could become impaired in the future. In our intangible assets discussion in Note 8, we disclosed that we performed an undiscounted cash flow analysis due to the annual goodwill impairment test and did not identify any impairment of intangible assets. In addition, we evaluated the other long-term assets consisting mainly of property, plant and equipment and did not identify an impairment of those assets. 30 --------------------------------------------------------------------------------
Services revenue increased by
$451 millionto $2.1 billionand gross profit increased by $106 millionto $57 millionin 2013 as compared to 2012. These increases were broad-based, driven primarily by increases in the construction, fabrication and turnaround services in Canada, building and construction projects in the U.S. and global maintenance and specialty services projects. Gross profit was also higher due to project loss provisions of $75 millionrecorded on certain U.S. construction projects during 2012 that did not recur in 2013. Services revenue increased by $36 millionin 2012 compared to 2011. This increase was driven by a number of projects, including construction services for gas plants in Northern British Colombia, fabrication modules for oil sands-related projects in Canada, as well as building and construction projects in the U.S. such as a base oil facility and turnaround upgrades and rebuilds. These increases were partially offset by lower revenue on other projects, including the completion of several large hospital projects and a major turnaround project that were finished in 2011. Services gross profit decreased by $80 millionin 2012 compared to 2011, primarily related to project loss provisions of $75 millionrecorded on certain U.S. construction projects in 2012. The provisions taken were primarily related to lower productivity and higher wage rates, which gave rise to higher direct labor costs, indirect costs and other extension-of-time-related costs. Services equity in earnings in unconsolidated affiliates, decreased from $33 millionin 2012 to $13 millionin 2013 due to extended dry dock and out of contract periods for MMM. Services equity in earnings in unconsolidated affiliates increased from $26 millionin 2011 to $33 millionin 2012 primarily due to the dry dock of Semi 2 in 2011 for MMM.
Other revenue increased by
$4 millionand gross profit decreased by $1 millionin 2013 compared to 2012. Included in Other is Ventures and other operations. Ventures operations consist of investments in joint ventures accounted for under the equity method of accounting, net of tax. Ventures revenue and gross profit decreased by $6 millionand $7 million, respectively, in 2013 compared to 2012. This decrease was primarily driven by declines related to the ammonia plant in Egyptresulting from interruptions in natural gas feedstock supply which we began experiencing in late 2012, partially offset by the timing of maintenance expenditures on a project in the U.K.in 2013 and charges associated with hedging activities incurred during 2012 for the ammonia plant in Egyptthat did not occur in 2013. Ventures revenue decreased by $5 millionwhile gross profit was unchanged in 2012 compared to 2011, due to a decline of $10 millionon the ammonia plant in Egyptrelated to noncash hedge accounting adjustments, write-off of deferred losses related to the refinancing of the investment's debt, reduced productivity as a result of low gas feedstock pressure and plant closure for turnaround maintenance. This decline was partially offset by higher revenue and gross profit of $6 millionachieved by other Ventures projects, primarily due to lower debt interest costs and lower maintenance costs.
Changes in Estimates
There are many factors, including, but not limited to, the ability to properly execute the engineering and designing phases consistent with our customers' expectations, the availability and costs of labor and resources, productivity and weather that can affect the accuracy of our cost estimates, and ultimately, our future profitability. In the past, we have realized both lower and higher than expected margins and have incurred losses as a result of unforeseen changes in our project costs; however, historically, our estimates have been reasonably dependable regarding the recognition of revenue and profit on percentage of completion contracts. During 2013, we recognized revisions in estimates on an LNG project in
Australiaas a result of an approved change order and increases in estimated project hours which impacted our 2013 gross profit by $190 million. 31 --------------------------------------------------------------------------------
Services Business Segment Revenue by Market Sector
The Services business segment provides construction management, direct-hire construction and maintenance services to clients in a number of markets. We believe customer focus, attention to delivery and a diverse market presence are the keys to our success in delivering construction and maintenance services. Accordingly, the Services business segment focuses on these key success factors. The analysis below is supplementally provided to present the revenue generated by Services business segment based on the markets served, some of which are the same sectors served by our other business segments. Year
Total Business Revenue by Segment Services Market Millions of dollars Revenue Revenue Sectors Gas Monetization
$ 2,155$ - $ 2,155Hydrocarbons 1,482 801 2,283 Infrastructure, Government and Power 1,535 1,250 2,785 Services 2,051 (2,051 ) - Other 60 - 60 Total KBR Revenue $ 7,283$ - $ 7,283Year Ending December 31, 2012 Total Business Revenue by Segment Services Market Millions of dollars Revenue Revenue Sectors Gas Monetization $ 3,006$ - $ 3,006Hydrocarbons 1,260 739 1,999 Infrastructure, Government and Power 1,848 861 2,709 Services 1,600 (1,600 ) - Other 56 - 56 Total KBR Revenue $ 7,770$ - $ 7,770Year Ending December 31, 2011 Total Business Revenue by Segment Services Market Millions of dollars Revenue Revenue Sectors Gas Monetization $ 3,017$ - $ 3,017Hydrocarbons 1,210 652 1,862 Infrastructure, Government and Power 3,261 912 4,173 Services 1,564 (1,564 ) - Other 51 - 51 Total KBR Revenue $ 9,103$ - $ 9,10332
Corporate, tax and other matters
Labor cost absorption not allocated to our business segments represents costs incurred by our central labor and resource departments net of the amounts charged to the business segments. Labor cost under-absorption was
$57 millionin 2013 compared to under-absorption of $35 millionin 2012 and an over-absorption of $18 millionin 2011. The increase in labor cost absorption not allocated to our business segments of $22 millionin 2013 compared to 2012 was primarily due to reduced volumes of contract hours and resource utilization in several of our engineering offices as a result of delays in awards of certain expected projects as well as $5 millionrelated to closure costs in one of our non-core offices. The 2012 labor cost absorption difference of $53 millioncompared to an over-absorption in 2011 was primarily due to lower chargeable hours and utilization in several of our engineering offices as a result of delays in awards of certain expected projects. General and administrative expense was $249 millionin 2013, $222 millionin 2012 and $214 millionin 2011. The increase in 2013 was primarily due to higher ERP project expenses of $21 million, consulting and legal expenses related to tax items, including arbitration with our former parent and charges in our risk and benefit programs. These increases were partially offset by lower incentive compensation costs in 2013. The increase in general and administrative expense in 2012 was primarily due to ERP project expenses, higher pension costs driven by unfavorable changes in assumptions that impacted 2012 expense and charges in our risk and benefit programs. The increases were partially offset by lower information technology support costs, lower legal costs and reductions associated with other cost containment measures. Interest expense, net of interest income, was $5 million, $7 millionand $18 millionin 2013, 2012 and 2011, respectively. The 2013 reduction in interest expense, net of interest income, compared to 2012 is primarily due to higher interest income in 2013 on our treasury-managed time deposits. Interest expense was substantially the same in 2013 and 2012. The 2012 reduction in expense compared to 2011 was primarily associated with favorable terms of the new Credit Agreement. Interest income was substantially the same in 2012 and 2011. We had net foreign currency gains of less than $1 millionin 2013, losses of $2 millionin 2012 and gains of $3 millionin 2011. Foreign currency losses in 2012 were primarily due to the fluctuating Euro and currencies with limited hedge markets such as the Algerian Dinar. Foreign currency gains in 2011 were primarily due to the weakening U.S. Dollar against most major currencies. Some of these positions were not fully hedged. Our effective tax rate on pretax earnings was 29.4%, 29.9% and 5.6% for the years ended December 31, 2013, 2012 and 2011, respectively. The U.S. statutory tax rate for all years was 35%. Our effective tax rate includes a charge of $38 millionas a result of an unfavorable ruling with respect to our tax dispute with our former parent Halliburton. Our adjusted effective tax rate excluding discrete items was approximately 23% for the year ended December 31, 2013. Our adjusted effective tax rate was lower than the U.S. statutory tax rate due to favorable tax rate differentials on foreign earnings, lower tax expense on foreign income from unconsolidated joint ventures and tax benefits from unincorporated joint ventures. In 2013, we recognized discrete net tax expense of approximately $30 million, which included a charge of $38 millionas a result of the unfavorable ruling described above, partially offset by benefits related to the recognition of previously unrecognized tax benefits related to tax positions in prior years, primarily as a result of the resolution of transfer pricing issues involving our U.K.subsidiaries. Included in the discrete net tax expense is a charge for valuation allowances. We are relying on a forecast of future taxable income in making our determination regarding the need for a valuation allowance on the deferred tax assets related to net operating losses and foreign tax credits. In the event our future taxable income is less than the forecasted amount, an additional valuation allowance may need to be recorded in the future. Provision for income taxes was $136 millionfor the year ended December 31, 2013. Our effective tax rate, excluding discrete items was approximately 29.9% for the year ended December 31, 2012. In the third quarter of 2012, we recorded a noncash goodwill impairment charge of $178 millionin our IGP business segment, which is not deductible for U.S. taxes. Excluding the nondeductible goodwill impairment charge and discrete items, our adjusted effective tax rate was 29.1% for year ended December 31, 2012. The adjusted effective tax rate includes increases of 3.9% as a result of incremental income taxes on certain undistributed foreign earnings in Australiathat were previously deemed to be permanently reinvested. Our adjusted effective tax rate excluding discrete items for 2012 was lower than our statutory tax rate of 35% primarily due to favorable tax rate differentials on foreign earnings and lower tax expense on foreign income from unincorporated joint ventures. In 2012, we also recognized discrete net tax benefits of approximately $50 million, including benefits primarily related to the recognition of previously unrecognized tax benefits related to tax positions taken in prior years due to progress in resolving transfer pricing matters with certain taxing jurisdictions, statute expirations on certain domestic tax matters and other reductions to foreign tax exposures, tax benefits associated with the interest on an adverse arbitration award associated with the Barracuda-Caratinga project in Brazil, as well as discrete tax benefits related to deductions arising from an unconsolidated joint venture in Australia. Provision for income taxes was $86 millionfor the year ended December 31, 2012. 33 -------------------------------------------------------------------------------- Our effective tax rate excluding discrete items was approximately 29.3% for the year ended December 31, 2011. The effective tax rate was lower than the U.S. statutory tax rate due to favorable tax rate differentials on foreign earnings and lower tax expense on foreign income from unincorporated joint ventures. In 2011, we recognized discrete tax benefits including a $69 milliontax benefit related to the arbitration award related to the Barracuda-Caratinga project as well as $32 millionin tax benefits due to the reduction of deferred tax liabilities associated with the pending liquidation of an unconsolidated joint venture in Australia, resulting in a net effective tax rate of approximately 5.6%. In September 2011, an arbitration panel in the Barracuda-Caratinga arbitration awarded Petrobras $193 million, which will be deductible for tax purposes, and for which we are indemnified by our former parent, Halliburton. The indemnification payment from Halliburton to KBR will be treated by KBR for tax purposes as a contribution to capital and accordingly is not taxable income. Consequently, the arbitration ruling resulted in a tax benefit during 2011. In addition, we recognized other discrete tax benefits in 2011 totaling $34 millionprimarily from favorable return to accrual adjustments, I.R.S. audit adjustments and the execution of tax planning strategies. Provision for income taxes was $32 millionfor the year ended December 31, 2011. Net income attributable to noncontrolling interests was $98 million, $58 millionand $60 millionin 2013, 2012 and 2011, respectively. The increase in 2013 from 2012 primarily resulted from additional income of $50 millionattributable to noncontrolling interests as a result of the change order executed on an LNG project on Barrow Islandin Australia. The slight decrease in 2012 from 2011 resulted from lower earnings on projects that were completed or nearing completion on our consolidated joint ventures.
Acquisitions and Other Transactions
Information relating to various acquisitions and other transactions is described in "Item 1. Business" and in Note 20 to our consolidated financial statements and the information discussed therein is incorporated by reference into this Item 7. Backlog of Unfilled Orders Backlog generally represents the dollar amount of revenue and our pro-rata share of work to be performed by unconsolidated joint ventures we expect to realize in the future as a result of performing work on contracts. We generally include total expected revenue in backlog when a contract is awarded under a legally binding commitment. In many instances, arrangements included in backlog are complex, nonrepetitive in nature and may fluctuate depending on estimated revenue and contract duration. Where contract duration is indefinite, projects included in backlog are limited to the estimated amount of expected revenue within the following twelve months. Certain contracts provide maximum dollar limits, with actual authorization to perform work under the contract agreed upon on a periodic basis with the customer. In these arrangements, only the amounts authorized are included in backlog. For projects where we act solely in a project management capacity, we only include the value of our services of each project in backlog. For certain long-term service contracts with a defined contract term, such as those associated with privately financed projects, the amount included in backlog is limited to five years. We have included in the table below our proportionate share of unconsolidated joint ventures estimated revenue in backlog. However, because these projects are accounted for under the equity method, only our share of future earnings from these projects will be recorded in our results of operations. Our backlog for projects related to unconsolidated joint ventures totaled
$5.5 billionat December 31, 2013and $5.8 billionat December 31, 2012. We consolidate joint ventures which are majority-owned and controlled or are variable interest entities in which we are the primary beneficiary. Our backlog included in the table below for projects related to consolidated joint ventures with noncontrolling interests includes 100% of the backlog associated with those joint ventures and totaled $1.4 billionat December 31, 2013and $2.1 billionat December 31, 2012. All backlog is attributable to firm orders as of December 31, 2013and 2012. Backlog attributable to unfunded government orders was $166 millionat December 31, 2013and $236 millionat December 31, 2012. The following table summarizes our backlog by business segment. December 31, Millions of dollars 2013 2012 Gas Monetization $ 6,158 $ 7,745Hydrocarbons 2,619 1,354 Infrastructure, Government and Power 2,097 2,824 Services 2,544 2,025 Other 996 983 Total backlog $ 14,414 $ 14,93134
-------------------------------------------------------------------------------- We estimate that as of
December 31, 2013, 49% of our backlog will be executed within one year. As of December 31, 2013, 43% of our backlog was attributable to fixed-price contracts and 57% of our backlog was attributable to cost-reimbursable contracts. For contracts that contain both fixed-price and cost-reimbursable components, we classify the components as either fixed-price or cost-reimbursable according to the composition of the contract; however, except for smaller contracts, we characterize the entire contract based on the predominant component. Gas Monetization backlog decreased $1.6 billionprimarily due to work performed on existing projects, specifically the large GTL and LNG projects in Nigeriaand Algeria. We expect Gas Monetization backlog to continue to decline in 2014 as no major EPC awards are forecasted until 2015. Hydrocarbons backlog increased $1.3 billionprimarily due to new awards for downstream projects such as ammonia plants. IGP backlog decreased by $727 millionprimarily as a result of work performed on existing projects and the continued level of reduced U.S. government spending and investments in mining projects. Services backlog increased $519 milliondue to new awards of $2.6 billionprimarily in maintenance and specialty services, partially offset by work performed of $2.1 billionon various construction projects in the U.S. and Canada.
Liquidity and Capital Resources
Cash and equivalents totaled
December 31, Millions of dollars 2013 2012 Domestic U.S. cash
$ 355 $ 242International cash 675 610 Joint venture cash 69 201 Total $ 1,099 $ 1,053Domestic cash relates to cash balances held by U.S. entities and is largely used to support obligations of those businesses as well as general corporate needs such as implementation of our new ERP systems, the payment of dividends to shareholders and potential repurchases of our outstanding common stock. Joint venture cash balances reflect the amounts held by joint venture entities that we consolidate for financial reporting purposes. Such amounts are limited to joint venture activities and are not readily available for general corporate purposes but portions of such amounts may become available to us in the future should there be distribution of dividends to the joint venture partners. We expect that the majority of the joint venture cash balances will be utilized for the corresponding joint venture projects. The international cash balances may be available for general corporate purposes but are subject to local restrictions such as capital adequacy requirements and local obligations such as the funding of our underfunded U.K.pension plan and other obligations incurred in the normal course of business by those foreign entities. Additionally, repatriated foreign cash may become subject to U.S. income taxes. Cash generated from operations is our primary source of operating liquidity. Our cash balances are held in numerous locations throughout the world. We believe that existing cash balances and internally generated cash flows are sufficient to support our day-to-day domestic and foreign business operations for at least the next 12 months. We generally do not provide U.S. federal and state income taxes on the accumulated but undistributed earnings of non-U.S. subsidiaries except for certain entities in Mexicoand certain other joint ventures, as well as for approximately 50% of our earnings from our operations in Australia. Taxes are provided as necessary with respect to earnings that are considered not permanently reinvested. We will continue to provide for U.S. federal and state taxes on 50% of the earnings of our Australian operations as we no longer intend to permanently reinvest these amounts. In determining whether earnings would be considered permanently invested, we considered future non-U.S. cash needs such as, 1) our anticipated foreign working capital requirements, including funding of our U.K.pension plan; 2) the expected growth opportunities across all geographical markets and; 3) our plans to invest in strategic growth opportunities that may include acquisitions around the world. For all other non-U.S. subsidiaries, no U.S. taxes are provided because such earnings are intended to be reinvested indefinitely to finance foreign activities. As of December 31, 2013, foreign cash and equivalents on which U.S. income taxes have not been recognized, excluding cash held by consolidated joint ventures, is estimated to be approximately $554 millionof the $675 millionof the total international cash referenced in the table above. We have estimated the amount of unrecognized deferred U.S. tax liability to be approximately $91 million, which includes the effects of foreign tax credits associated with the deferred income to reduce the U.S. tax liabilities. 35 -------------------------------------------------------------------------------- Our operating cash flow can vary significantly from year to year and is affected by the mix, terms and percentage of completion of our engineering and construction projects. We sometimes receive cash through billings to our customers on our larger engineering and construction projects and those of our consolidated joint ventures in advance of incurring the related costs. In other projects our net investment in the project costs may be greater than available project cash and we may utilize other cash on hand or availability under our Credit Agreement to satisfy any periodic operating cash requirements. Engineering and construction projects generally require us to provide credit support to our customers in the form of letters of credit, surety bonds or guarantees. Our ability to obtain new project awards in the future may be dependent on our ability to maintain or increase our letter of credit and surety bonding capacity, which may be further dependent on the timely release of existing letters of credit and surety bonds. As the need for credit support arises, letters of credit will be issued under our Credit Agreement or arranged with our banks on a bilateral, syndicated or other basis. We believe we have adequate letter of credit capacity under our existing Credit Agreement and bilateral lines, as well as adequate surety bond capacity under our existing lines to support our operations and current backlog for the next twelve months. Our excess cash is generally invested in either time deposits with commercial banks or money market funds governed under rule 2a-7 of the U.S. Investment Company Act of 1940 and rated AAA by Standard & Poor's or Aaa by Moody's Investors Service. As of December 31, 2013, substantially all of our excess cash was held in commercial bank time deposits with the primary objectives of preserving capital and maintaining liquidity.
Cash flows activities summary
December 31, Millions of dollars 2013 2012
Cash flows provided by operating activities
$ 290 $ 142 $ 650Cash flows provided by (used in) investing activities (62 ) 52 (88 ) Cash flows used in financing activities (148 ) (116 ) (377 ) Effect of exchange rate changes on cash (34 ) 9 (5 ) Increase in cash and equivalents $ 46 $ 87
Operating activities. Cash provided by operations totaled
$290 millionin 2013 and resulted from our earnings, working capital and distributions of earnings received from unconsolidated affiliates of $180 million, partially offset by our payment of $108 millionin outstanding performance bonds to PEMEX Exploration and Production ("PEP"), other uses driven by taxes and contributions of approximately $54 millionto our pension funds. See Note 14 to our consolidated financial statements for further discussion of the performance bonds. Cash provided by operations totaled $142 millionin 2012 and resulted from our earnings, adjusted for items to reconcile to net income, of $317 millionand distributions of earnings received from unconsolidated affiliates, including repayment of advances to unconsolidated affiliates of $102 million, partially offset by working capital uses related to our business with the U.S. government and the Gas Monetization and Services business segments. Cash provided by operations totaled $650 millionin 2011, driven primarily by strong earnings and collections of advances and distributions from unconsolidated affiliates of $196 million. Operating cash flow was primarily driven by the timing of working capital requirements on several large projects. Cash remitted for income taxes, net of refunds, was $201 million. In addition, we contributed $74 millionto our pension plans, including a lump sum contribution of $40 millionwhich had been previously agreed with the trustees of our international U.K.plans. Cash held by consolidated joint ventures increased by $99 million.
Investing activities. Cash used in investing activities totaled
Cash provided by investing activities totaled
$52 millionin 2012 which was primarily due to proceeds of $127 millionfrom the sale of our interest in the 601 Jefferson building and the Clinton Drivecampus facility. These proceeds were offset by capital expenditures of $75 millionassociated with information technology projects and leasehold and facility improvements. Cash used in investing activities totaled $88 millionfor 2011 which was primarily due to capital expenditures of $83 millionlargely related to information technology projects and leasehold improvements. Additionally, we made investments totaling $11 millionin an equity method joint venture associated with the lease of our corporate headquarters and received proceeds of $6 millionfrom the sale of an investment. 36 -------------------------------------------------------------------------------- Financing activities. Cash used in financing activities totaled $148 millionin 2013 and included $7 millionfor the purchase of treasury stock, $36 millionfor dividend payments to common shareholders, $108 millionfor distributions to noncontrolling interests and $14 millionfor principal payments on short- and long-term borrowings consisting primarily of nonrecourse debt of our Fasttrax variable interest entity ("VIE") and computer software purchases financed in 2010. The uses of cash were partially offset by $9 millionof investments from noncontrolling interests and $6 millionof proceeds from the exercise of stock options. Cash used in financing activities totaled $116 millionin 2012 and included $40 millionfor the purchase of treasury stock, $37 millionfor dividend payments to common shareholders, $36 millionfor distributions to noncontrolling interests and $14 millionfor principal payments on short- and long-term borrowings consisting primarily of nonrecourse debt of our Fasttrax VIE and computer software purchases financed in 2010. The uses of cash were partially offset by $11 millionof tax benefits associated with stock exercises and proceeds from the exercise of stock options. Cash used in financing activities totaled $377 millionin 2011 and included $178 millionof payments to acquire the noncontrolling interest in MWKL, $118 millionof payments to purchase 4 million shares of treasury stock, $63 millionfor distributions to noncontrolling interests, $30 millionfor dividend payments to common shareholders and $15 millionfor principal payments on short- and long-term borrowings consisting primarily of nonrecourse debt of our Fasttrax VIE and computer software purchases financed in 2010. These payments were partially offset by a return of cash of $17 millionused to collateralize standby letters of credit. Future sources of cash. Future sources of cash include cash flows from operations, including cash advances from our clients, cash derived from working capital management and cash borrowings under our Credit Agreement as well as potential litigation proceeds. Future uses of cash. Future uses of cash will primarily relate to working capital requirements, including any payments on the Halliburton award, capital expenditures, dividends, share repurchases and strategic investments. In addition, we will use cash to fund pension obligations, payments under operating leases and various other obligations, including potential litigation payments, as they arise. Our capital expenditures will be focused primarily on information technology, real estate, facilities and equipment. See "Off-Balance Sheet Arrangements" below for a schedule of contractual obligations and other long-term liabilities that will require the use of cash.
December 2, 2011, we entered into a $1 billion, five-year unsecured revolving credit agreement (the "Credit Agreement") with a syndicate of international banks. The Credit Agreement is available for cash borrowings and the issuance of letters of credit related to general corporate needs. The Credit Agreement expires in December 2016; however, given that projects generally require letters of credit that extend beyond one year in length, we will likely need to enter into a new or amended credit agreement no later than 2015. Amounts drawn under the Credit Agreement will bear interest at variable rates, per annum, based either on (1) the Londoninterbank offered rate ("LIBOR") plus an applicable margin of 1.50% to 1.75%, or (2) a base rate plus an applicable margin of 0.50% to 0.75%, with the base rate equal to the highest of (a) reference bank's publicly announced base rate, (b) the Federal Funds Rate plus 0.5%, or (c) LIBORplus 1%. The amount of the applicable margin to be applied will be determined by our ratio of consolidated debt to consolidated EBITDA for the prior four fiscal quarters, as defined in the Credit Agreement. The Credit Agreement provides for fees on letters of credit issued under the Credit Agreement at a rate equal to the applicable margin for LIBOR-based loans, except for performance letters of credit, which are priced at 50% of such applicable margin. We pay an issuance fee of 0.15% of the face amount of a letter of credit. We also pay a commitment fee of 0.25% per annum on any unused portion of the commitment under the Credit Agreement. As of December 31, 2013, there were $226 millionin letters of credit and no cash borrowings outstanding. The Credit Agreement contains customary covenants, including financial covenants requiring maintenance of a ratio of consolidated debt to consolidated EBITDA not greater than 3.5 to 1 and a minimum consolidated net worth of $2 billionplus 50% of consolidated net income for each quarter beginning December 31, 2011and 100% of any increase in shareholders' equity attributable to the sale of equity interests. At December 31, 2013, we were in compliance with our financial covenants. The Credit Agreement contains a number of other covenants restricting, among other things, our ability to incur additional liens and indebtedness, enter into asset sales, repurchase our equity shares and make certain types of investments. Our subsidiaries are restricted from incurring indebtedness, except if such indebtedness relates to purchase money obligations, capitalized leases, refinancing or renewals secured by liens upon or in property acquired, constructed or improved in an aggregate principal amount not to exceed $200 millionat any time outstanding. Additionally, our subsidiaries may incur unsecured indebtedness not to exceed $200 millionin aggregate outstanding principal amount at any time. We are also permitted to repurchase our equity shares, 37 -------------------------------------------------------------------------------- provided that no such repurchases shall be made from proceeds borrowed under the Credit Agreement, and that the aggregate purchase price and dividends paid after December 2, 2011, does not exceed the Distribution Cap (equal to the sum of $750 millionplus the lesser of (1) $400 millionand (2) the amount received by us in connection with the arbitration and subsequent litigation of the PEP contracts as discussed in Note 14 to our consolidated financial statements). At December 31, 2013, the remaining availability under the Distribution Cap was approximately $619 million.
Nonrecourse Project Finance Debt
Fasttrax Limited, a joint venture in which we indirectly own a 50% equity interest with an unrelated partner, was awarded a concession contract in 2001 with the U.K.MoD to provide a Heavy Equipment Transporter Service to the British Army. Under the terms of the arrangement, Fasttrax Limitedoperates and maintains 92 heavy equipment transporters ("HETs") for a term of 22 years. The purchase of the HETs by the joint venture was financed through a series of bonds secured by the assets of Fasttrax Limitedtotaling approximately £84.9 million (approximately $120 millionat the exchange rate on the date of the transaction) and a bridge loan totaling approximately £12.2 million (approximately $17 millionat the exchange rate on the date of the transaction) which are nonrecourse to KBR and its partner. The bridge loan was replaced when the shareholders funded combined equity and subordinated debt in 2005. The secured bonds are an obligation of Fasttrax Limitedand are not a debt obligation of KBR because they are nonrecourse to the joint venture partners. Accordingly, in the event of a default on the term loan, the lenders may only look to the resources of Fasttrax Limitedfor repayment. The guaranteed secured bonds were issued in two classes consisting of Class A 3.5% Index Linked Bonds in the amount of £56 million (approximately $79 millionat the exchange rate on the date of the transaction) and Class B 5.9% Fixed Rate Bonds in the amount of £16.7 million (approximately $24 millionat the exchange rate on the date of the transaction). Principal payments on both classes of bonds commenced in March 2005and are due in semi-annual installments over the term of the bonds, which mature in 2021. Subordinated notes payable to each of the 50% partners initially bear interest at 11.25% and increase to 16% over the term of the notes through 2025. For financial reporting purposes, only our partner's portion of the subordinated notes appears in the consolidated financial statements. Payments on the subordinated debt commenced in March 2006and are due in semi-annual installments over the term of the notes. The combined principal installments for both classes of bonds and subordinated notes, including inflation-adjusted bond indexation, over the next five years and beyond as of December 31, 2013are included in the commitments and contractual obligations table in the following section. See Note 9 for further discussion on equity method investments and variable interest entities and see Note 11 for further discussion on this debt.
Off-Balance Sheet Arrangements
Letters of credit, surety bonds and guarantees. In connection with certain projects, we are required to provide letters of credit, surety bonds or guarantees to our customers. Letters of credit are provided to certain customers and counterparties in the ordinary course of business as credit support for contractual performance guarantees, advanced payments received from customers and future funding commitments. We have approximately
$2.2 billionin committed and uncommitted lines of credit to support the issuance of letters of credit and, as of December 31, 2013, we have utilized $687 millionof our present capacity under lines of credit. Surety bonds are also posted under the terms of certain contracts to guarantee our performance. The letters of credit outstanding included $226 millionissued under our Credit Agreement and $461 millionissued under uncommitted bank lines at December 31, 2013. Of the total letters of credit outstanding, $249 millionrelate to our joint venture operations where the letters of credit are posted by our banks on our behalf using our capacity to support our agreed upon pro-rata share of obligations under various contracts executed by joint ventures of which we are a member. As the need arises, future projects will be supported by letters of credit issued under our Credit Agreement or other lines of credit arranged on a bilateral, syndicated or other basis. We believe we have adequate letter of credit capacity under our Credit Agreement and bilateral lines of credit to support our operations for the next twelve months. 38 -------------------------------------------------------------------------------- Commitments and other contractual obligations. The following table summarizes our significant contractual obligations and other long-term liabilities as of December 31, 2013: Payments Due Millions of dollars 2014 2015 2016 2017 2018 Thereafter Total Operating leases $ 100 $ 88 $ 80 $ 62 $ 55 $ 399 $ 784Purchase obligations (a) 18 4 1 1 1 3 28
Pension funding obligation (b) 46 46 46 46 46
Nonrecourse project finance debt 10 10 11 12 12
33 88 Total (c)
$ 174 $ 148 $ 138 $ 121 $ 114 $ 669 $ 1,364(a) In the ordinary course of business, we enter into commitments for the
purchase or lease of software, materials, supplies and similar items. The
purchase obligations can span several years depending on the duration of
the projects. In general, the costs associated with those purchase
obligations are expensed to correspond with the revenue earned on the
related projects. The purchase obligations disclosed above do not include
purchase obligations that we enter into with vendors in the normal course
of business that support existing contracting arrangements with our customers.
(b) Included in our pension obligations are payments related to our agreement
with the trustees of our international plan. The agreement calls for
minimum contributions of £28 million in 2014 through 2023. The foreign
funding obligations were converted to U.S. dollars using the conversion
rate as of
December 31, 2013. KBR, Inc.has provided a guarantee for up to £125 million in support of Kellogg Brown & Root (U.K.) Limited's obligation to make payments to the plan in respect of its liability under the Pensions Act 1995.
(c) Not included in the total are uncertain tax positions recorded pursuant to
ASC 740 - Income Taxes, which totaled
The ultimate timing of when these obligations will be settled cannot be
determined with reasonable assurance and have been excluded from the table
above. See Note 12 for further discussion on income taxes.
Other factors potentially affecting liquidity
Contract claims. As of
December 31, 2013, claims and unapproved change orders related to several projects. Included in the table above are claims included in project estimates-at-completion associated with the reimbursable portion of an EPC contract to construct an LNG facility for which we have recognized additional contract revenue totaling $46 million. The claims on this project represent incremental subcontractor costs that we are legally entitled to recover from the customer under the terms of the contract. We also have claims associated with one of our APAC projects for which we have recognized contract revenue of $10 million. These claims are recorded in "costs and estimated earnings in excess of billings on uncompleted contracts" on our accompanying consolidated balance sheets. Liquidated damages. Some of our engineering and construction contracts have schedule dates and performance obligations that if not met could subject us to penalties for liquidated damages in the event claims are asserted for which we were responsible for the delays. These generally relate to specified activities that must be completed within a project by a set contractual date or achievement of a specified level of output or throughput of a plant we construct. Each contract defines the conditions under which a customer may make a claim for liquidated damages. However, in some instances, liquidated damages are not asserted by the customer, but the potential to do so is used in negotiating or settling claims and closing out the contract. Based upon our evaluation of our performance and other legal analysis, we have not accrued for possible liquidated damages related to several projects totaling $10 millionat December 31, 2013and $2 millionat December 31, 2012, (including amounts related to our share of unconsolidated subsidiaries) that we could incur based upon completing the projects as currently forecasted.
Transactions with Former Parent
Information relating to our transactions with former parent commitments and contingencies is described in Note 15 to our consolidated financial statements and the information discussed therein is incorporated by reference into this Item 7. 39
Transactions with Joint Ventures
We perform many of our projects through incorporated and unincorporated joint ventures. In addition to participating as a joint venture partner, we often provide engineering, procurement, construction, operations or maintenance services to the joint venture as a subcontractor. Where we provide services to a joint venture that we control and therefore consolidate for financial reporting purposes, we eliminate intercompany revenues and expenses on such transactions. In situations where we account for our interest in the joint venture under the equity method of accounting, we do not eliminate any portion of our revenues or expenses. We recognize the profit on our services provided to joint ventures that we consolidate and joint ventures that we record under the equity method of accounting primarily using the percentage-of-completion method.
Recent Accounting Pronouncements
Information relating to recent accounting pronouncements is described in Note 22 to the consolidated financial statements and the information discussed therein is incorporated by reference into this Item 7.
U.S. Government Matters
Information relating to U.S. government matters commitments and contingencies is described in Note 13 to our consolidated financial statements and the information discussed therein is incorporated by reference into this Item 7.
Information relating to various commitments and contingencies is described in Note 14 to our consolidated financial statements and the information discussed therein is incorporated by reference into this Item 7.
Critical Accounting Policies
The preparation of financial statements in conformity with accounting principles generally accepted in
the United Statesrequires management to select appropriate accounting policies and to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses. Our critical accounting policies are described below to provide a better understanding of our assumptions and judgments about future events and related estimates and how they can impact our financial statements. A significant accounting estimate is one that requires difficult, subjective or complex estimates and assessments and is fundamental to our results of operations. We base our estimates on historical experience and on various other assumptions we believe to be reasonable according to the current facts and circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We believe the following are the critical accounting policies used in the preparation of our consolidated financial statements in accordance with accounting principles generally accepted in the United States, as well as the significant estimates and judgments affecting the application of these policies. This discussion and analysis should be read in conjunction with our consolidated financial statements and related notes. Engineering and Construction Contracts. Revenue from long-term contracts to provide construction, engineering, design or similar services is recognized as contract performance progresses using the percentage-of-completion method. We estimate the progress towards completion to determine the amount of revenue and profit to be recognized in each reporting period, based upon estimates of the total cost to complete the project; estimates of the project schedule and completion date; estimates of the extent of progress toward completion; and amounts of any probable claims and change orders included in revenue. Progress is generally based upon a cost incurred to total estimated costs at completion approach but we also use alternative methods including physical progress, labor hours incurred to total estimated labor hours at completion or others depending on the type of project. At the outset of each contract, we prepare a detailed analysis of our estimated cost to complete the project. Risks relating to service delivery, usage, productivity and other factors are considered in the estimation process. Our project personnel periodically evaluate the estimated costs, claims, change orders and percentage of completion at the project level. The recording of profits and losses on long-term contracts requires an estimate of the total profit or loss over the life of each contract. This estimate requires consideration of total contract value, change orders and claims, less costs incurred and estimated costs to complete. We also take into account liquidated damages when determining total contract profit or loss. Our contracts often require us to pay liquidated damages should we not meet certain performance requirements, including completion of the project in accordance with a scheduled timeline. We recognize accrued liquidated damages as a reduction in revenues. We generally include an estimate of liquidated damages in contract costs when it is deemed probable that they will be paid. Profits are recorded based upon the product of estimated contract profit at completion times the current percentage-complete for the contract. 40 -------------------------------------------------------------------------------- When estimating the amount of total gross profit or loss on a contract, we include unapproved change orders or claims to our clients as adjustments to revenues and claims to vendors, subcontractors and others as adjustments to total estimated costs. Claims against others are recorded up to the extent of the lesser of the amounts management expects to recover or to costs incurred and include no profit until such time as they are finalized and approved. See Note 5 for our discussion on unapproved change orders and claims. At least quarterly, significant projects are reviewed in detail by senior management. We have a long history of working with multiple types of projects and in preparing cost estimates. However, there are many factors that impact future costs, including but not limited to weather, inflation, labor and community disruptions, timely availability of materials, productivity and other factors as outlined in "Item 1A. Risk Factors". These factors can affect the accuracy of our estimates and materially impact our future reported earnings. For contracts containing multiple deliverables we analyze each activity within the contract to ensure that we adhere to the separation guidelines of ASC 605 - Revenue Recognition and ASC 605-25 - Multiple-Element Arrangements. Estimated Losses on Uncompleted Contracts and Changes in Contract Estimates. We record provisions for estimated losses on uncompleted contracts in the period in which such losses are identified. The cumulative effects of revisions to contract revenue and estimated completion costs are recorded in the accounting period in which the amounts become evident and can be reasonably estimated. These revisions can include such items as the effects of change orders and claims, warranty claims, liquidated damages or other contractual penalties, adjustments for audit findings on U.S. government contracts and contract closeout settlements. Accounting for government contracts. Frequently, services provided to the United States governmentare governed by cost-reimbursable contracts. Generally, these contracts may contain base fees (a fixed profit percentage applied to our actual costs to complete the work) and incentive/award fees. Revenue is recorded at the time services are performed, and such revenue includes base fees, actual direct project costs incurred and an allocation of indirect costs. Indirect costs are applied using rates approved by our government customers. The general, administrative and overhead cost reimbursement rates are estimated periodically in accordance with government contract accounting regulations and may change based on actual costs incurred or based upon the volume of work performed. Revenue is reduced for our estimate of costs that either are in dispute with our customer or have been identified as potentially unallowable pursuant to the terms of the contract or the federal acquisition regulations. For contracts containing multiple deliverables we analyze each activity within the contract to ensure that we adhere to the separation guidelines of ASC 605 - Revenue Recognition and ASC 605-25 - Multiple-Element Arrangements. Similar to many cost-reimbursable contracts, these government contracts are typically subject to audit and adjustment by our customer. Each contract is unique; therefore, the level of confidence in our estimates for audit adjustments varies depending on how much historical data we have with a particular contract. KBR excludes from billings to the U.S. government costs that are expressly unallowable, or mutually agreed to be unallowable, or not allocable to government contracts based on the applicable regulations. Revenue recorded for government contract work is reduced for our estimate of potentially unallowable costs related to issues that may be categorized as disputed or unallowable as a result of cost overruns or the audit process. Our estimates of potentially unallowable costs are based upon, among other things, our internal analysis of the facts and circumstances, terms of the contracts and the applicable provisions of the FAR, quality of supporting documentation for costs incurred and subcontract terms, as applicable. From time to time, we engage outside counsel to advise us in determining whether certain costs are allowable. We also review our analysis and findings with the administrative contracting officer ("ACO") as appropriate. In some cases, we may not reach agreement with the DCAA or the ACO regarding potentially unallowable costs which may result in our filing of claims in various courts such as the Armed Services Board of Contract Appeals ("ASBCA") or the COFC. We only include amounts in revenue related to disputed and potentially unallowable costs when we determine it is probable that such costs will result in revenue. We generally do not recognize additional revenue for disputed or potentially unallowable costs for which revenue has been previously reduced until we reach agreement with the DCAA and/or the ACO that such costs are allowable. Goodwill Impairment Testing. Goodwill represents the excess of cost over the fair market value of net assets acquired in business combinations and, in accordance with ASC 350 - Intangibles - Goodwill and Other, we are required to test goodwill for impairment on an annual basis, and more frequently when negative conditions or other triggering events arise. We test goodwill for impairment annually as of October 1. As of December 31, 2013, we had goodwill totaling $772 millionon our consolidated balance sheets. In accordance with ASC 350 - Intangibles - Goodwill and Other, we conduct our goodwill impairment testing at the reporting unit level. 41 -------------------------------------------------------------------------------- Our October 1, 2013, annual impairment test for goodwill was a quantitative analysis using a two-step process that involves comparing the estimated fair value of each reporting unit to its carrying value, including goodwill. If the fair value of a reporting unit exceeds its carrying value, the goodwill of the reporting unit is not considered impaired; therefore, the second step of the impairment test is unnecessary. If the carrying value of a reporting unit exceeds its fair value, we perform the second step of the goodwill impairment test to measure the amount of goodwill impairment loss to be recorded, as necessary. The second step compares the implied fair value of the reporting unit's goodwill to the carrying value, if any, of that goodwill. We determine the implied fair value of the goodwill in the same manner as determining the amount of goodwill to be recognized in a business combination. Consistent with prior years, the fair values of reporting units in 2013 were determined using a combination of two methods, one utilizing market earnings multiples (the market approach) and the other derived from discounted cash flow models with estimated cash flows based on internal forecasts of revenues and expenses over a ten year period plus a terminal value (the income approach). Under the market approach, we estimate fair value by applying earnings and revenue market multiples to a reporting unit's operating performance for the trailing twelve-month period. The earnings multiples for the market approach ranged from 7.6 to 10.9 times the earnings for each of our reporting units. The income approach estimates fair value by discounting each reporting unit's estimated future cash flows using a weighted-average cost of capital that reflects current market conditions and the risk profile of the reporting unit. To arrive at our future cash flows, we use estimates of economic and market assumptions, including growth rates in revenues, costs, estimates of future expected changes in operating margins, tax rates and cash expenditures. The risk-adjusted discount rates applied to our future cash flows under the income approach ranged from 12.5% to 17.8%. We believe these two approaches are appropriate valuation techniques and we generally weight the two resulting values equally as an estimate of a reporting unit's fair value for the purposes of our impairment testing. However, we may weigh one value more heavily than the other when conditions merit doing so. Other significant estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The fair value derived from the weighting of these two methods provides appropriate valuations that, in the aggregate, reasonably reconcile to our market capitalization, taking into account observable control premiums. In addition to the earnings multiples and the discount rates disclosed above, certain other judgments and estimates are used in our goodwill impairment test. Given this, if market conditions change compared to those used in our market approach, or if actual future results of operations fall below the projections used in the income approach, our goodwill could become impaired in the future. At the annual testing date of October 1, 2013, our market capitalization exceeded the carrying value of our consolidated net assets by $2.8 billionand, except for one reporting unit in our IGP business segment, the fair value of all our reporting units substantially exceeded their respective carrying amounts as of that date. The fair value for one reporting unit in our Hydrocarbons business segment and two reporting units in our IGP business segment exceeded their carrying values based on projected growth rates and other market inputs that are more sensitive to the risk of future variances due to competitive market conditions and reporting unit project execution. If future variances for these assumptions are negative and significant, the fair values of these reporting units may not substantially exceed their carrying values in future periods. The carrying value of the one reporting unit in our IGP business segment exceeded its fair value by approximately 30%, thus failing Step 1. This is the same reporting unit discussed below in relation to the goodwill impairment in 2012. We then performed Step 2 of the goodwill impairment test which compares the implied fair value of goodwill to the carrying value of that goodwill. The implied fair value of the reporting unit's goodwill exceeds its carrying value by approximately $5 millionor 6%. Therefore, no impairment was indicated, but changes in the actual performance versus the assumptions used in the Step 2 impairment test could result in a future impairment. On January 1, 2014, we reorganized four of the five reporting units in the IGP business segment into three geographic-based reporting units. This reorganization allows the IGP business segment to focus its full-scope engineering, procurement, construction and defense services on a regional level. We have concluded that each will be considered a separate reporting unit for goodwill impairment testing purposes. As a result, we performed an additional impairment test immediately before and after this change in reporting units, utilizing the same methodology as our October test and no indication of impairment was identified. In the third quarter of 2012, we recognized a noncash goodwill impairment charge of $178 millionrelated to the IGP business segment in connection with our interim impairment review. The charge was primarily the result of the determination that both the actual and expected income and cash flows for our IGP business segment were substantially lower than previous forecasts due to losses from ongoing projects acquired as part of the acquisition of Roberts & Schaefer Company. We also identified a deterioration 42 -------------------------------------------------------------------------------- in economic conditions in the minerals markets and less than expected actual and projected income and cash flows for the IGP business segment, which reduced forecasts of the sales, operating income and cash flows expected in 2013 and beyond. Deferred taxes and tax contingencies. Deferred tax assets and liabilities are recognized for the expected future tax consequences of events that have been recognized in the financial statements or tax returns. A deferred tax asset or liability is recognized for the estimated future tax effects attributable to temporary differences between the financial reporting basis and the income tax basis of assets and liabilities. A current tax asset or liability is recognized for the estimated taxes refundable or payable on tax returns for the current year. The measurement of current and deferred tax assets and liabilities is based on provisions of the enacted tax law, and the effects of potential future changes in tax laws or rates are not considered. In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. A valuation allowance is provided for deferred tax assets if it is more likely than not that these items will not be realized. We consider the scheduled reversal of deferred tax liabilities, projected future taxable income and available tax planning strategies in making this assessment. Additionally, we use forecasts of certain tax elements such as taxable income and foreign tax credit utilization and the evaluation of tax planning strategies in making an assessment of realization. The company is relying on a forecast of future taxable income in making its determination regarding the need for a valuation allowance on the deferred tax assets related to state net operating losses. In the event our future taxable income is less than the forecasted amount, an additional valuation allowance may need to be recorded in the future. As of December 31, 2013, we had net deferred tax assets of $390 million, which are net of deferred tax liabilities of $208 millionand a valuation allowance of $44 millionprimarily related to certain U.S. state and foreign branch net operating losses. We have operations in the United Statesand in numerous other countries. Consequently, we are subject to the jurisdictions of a significant number of taxing authorities. The income earned in these various jurisdictions is taxed on differing bases, including income actually earned, income deemed earned and revenue-based tax withholding. The final determination of our worldwide tax liabilities involves the interpretation of local tax laws, tax treaties and related authorities in each jurisdiction. Changes in the operating environment, including changes in tax law and currency/repatriation controls, could impact the determination of our tax liabilities for a tax year. Income tax positions must meet a more-likely-than-not recognition threshold to be recognized. Income tax positions that previously failed to meet the more-likely-than-not threshold are recognized in the first subsequent financial reporting period in which that threshold is met. Previously recognized tax positions that no longer meet the more-likely-than-not threshold are derecognized in the first subsequent financial reporting period in which that threshold is no longer met. The company recognizes potential interest and penalties related to unrecognized tax benefits in income tax expense. Tax filings of our subsidiaries, unconsolidated affiliates and related entities are routinely examined in the normal course of business by tax authorities. These examinations may result in assessments of additional taxes, which we work to resolve with the tax authorities and through the judicial process. Predicting the outcome of disputed assessments involves some uncertainty. Factors such as the availability of settlement procedures, willingness of tax authorities to negotiate and the operation and impartiality of judicial systems vary across the different tax jurisdictions and may significantly influence the ultimate outcome. We review the facts for each assessment, utilize assumptions and estimates to determine the most likely outcome and provide taxes, interest and penalties as needed based on this outcome. Legal and Investigation Matters. As discussed in Notes 13 and 14 of our consolidated financial statements, as of December 31, 2013and 2012, we have accrued an estimate of the probable and estimable costs for the resolution of some of our legal and investigation matters. For other matters for which the liability is not probable and reasonably estimable, we have not accrued any amounts. Attorneys in our legal department monitor and manage all claims filed against us and review all pending investigations. Generally, the estimate of probable costs related to these matters is developed in consultation with internal and external legal counsel representing us. Our estimates are based upon an analysis of potential results, assuming a combination of litigation and settlement strategies. The precision of these estimates and the likelihood of future changes depend on a number of underlying variables and a range of possible outcomes. We attempt to resolve these matters through settlements, mediation and arbitration proceedings when possible. If the actual settlement costs, final judgments or fines, differ from our estimates after appeals, our future financial results may be materially and adversely affected. We record adjustments to our initial estimates of these types of contingencies in the periods when the change in estimate is identified. Pensions. Our pension benefit obligations and expenses are calculated using actuarial models and methods, in accordance with ASC 715 - Compensation - Retirement Benefits. Two of the more critical assumptions and estimates used in the actuarial calculations are the discount rate for determining the current value of benefit obligations and the expected rate of return on plan 43 -------------------------------------------------------------------------------- assets. Other assumptions and estimates used in determining benefit obligations and plan expenses include inflation rates and demographic factors such as retirement age, mortality and turnover. These assumptions and estimates are evaluated periodically and updated accordingly to reflect our actual experience and expectations. The discount rate used to determine the benefit obligations was computed using a yield curve approach that matches plan specific cash flows to a spot rate yield curve based on high quality corporate bonds. The expected long-term rate of return on assets was determined by a stochastic projection that takes into account asset allocation strategies, historical long-term performance of individual asset classes, an analysis of additional return (net of fees) generated by active management, risks using standard deviations and correlations of returns among the asset classes that comprise the plans' asset mix. Plan assets are comprised primarily of equity securities, fixed income funds and securities, hedge funds, real estate and other funds. As we have both domestic and international plans, these assumptions differ based on varying factors specific to each particular country or economic environment. The discount rate utilized to calculate the projected benefit obligation at the measurement date for our U.S. pension plan increased to 3.38% at December 31, 2013from 3.09% at December 31, 2012. The discount rate utilized to determine the projected benefit obligation at the measurement date for our U.K.pension plan, which constitutes 96% of all plans, decreased to 4.45% at December 31, 2013from 4.50% at December 31, 2012. An additional future decrease in the discount rate of 25 basis points for our pension plans would increase our projected benefit obligation by an estimated $101 millionand $2 millionfor the U.K.and U.S. plans, respectively, while a similar increase in the discount rate would reduce our projected benefit obligation by an estimated $96 millionand $2 millionfor the U.K.and U.S. plans, respectively. Our expected long-term rates of return on plan assets utilized at the measurement date remained unchanged at 7.00% for our U.S. pension plans and increased to 6.45% from 6.15% for our U.K.pension plans. To calculate the expected return on pension plan assets, the market-related value of assets for our U.S. pension plans is actual fair value. For our international plan, a method is used that recognizes investment gains or losses, the difference between the expected and actual return based on market-related value of assets over a five-year period, which has the effect of reducing year-to-year volatility. Unrecognized actuarial gains and losses are generally recognized using the corridor method over a period of approximately 15 years, which represents a reasonable systematic method for amortizing gains and losses for the employee group. Our unrecognized actuarial gains and losses arise from several factors, including experience and assumption changes in the obligations and the difference between expected returns and actual returns on plan assets. The difference between actual and expected returns is deferred as an unrecognized actuarial gain or loss and is recognized as future pension expense. Our pretax unrecognized actuarial loss in accumulated other comprehensive income at December 31, 2013was $829 million, of which $42 millionis expected to be recognized as a component of our expected 2014 pension expense compared to $36 millionin 2013. During 2013, we made contributions to fund our defined benefit plans of $54 million. We currently expect to make contributions in 2014 of approximately $46 million. The actuarial assumptions used in determining our pension benefits may differ materially from actual results due to changing market and economic conditions, higher or lower withdrawal rates and longer or shorter life spans of participants. While we believe that the assumptions used are appropriate, differences in actual experience, expectations, or changes in assumptions may materially affect our financial position or results of operations. Our actuarial estimates of pension benefit expense and expected pension returns of plan assets are discussed in Note 10 in the accompanying financial statements. Variable Interest Entities. We account for VIEs in accordance with ASC 810 - Consolidation which requires the consolidation of VIEs in which a company has both the power to direct the activities of the VIE that most significantly impact the VIE's economic performance and the obligation to absorb losses or the right to receive the benefits from the VIE that could potentially be significant to the VIE. If a reporting enterprise meets these conditions then it has a controlling financial interest and is the primary beneficiary of the VIE. An unconsolidated VIE is accounted for under the equity method of accounting. We assess all newly created entities and those with which we become involved to determine whether such entities are VIEs and, if so, whether or not we are their primary beneficiary. Most of the entities we assess are incorporated or unincorporated joint ventures formed by us and our partner(s) for the purpose of executing a project or program for a customer, such as a governmental agency or a commercial enterprise, and are generally dissolved upon completion of the project or program. Many of our long-term energy-related construction projects in our Gas Monetization business segment are executed through such joint ventures. Typically, these joint ventures are funded by advances from the project owner, and accordingly, require little or no equity investment by the joint venture partners but may require other financial support from the joint venture partners such as letters of credit, performance and financial guarantees or obligations to fund losses incurred by the joint venture. Other joint ventures, such as privately financed initiatives in our Ventures business unit, generally require the partners to invest and take an ownership position in an entity that manages and operates an asset post construction. 44
As required by ASC 810 - Consolidation, we perform a qualitative assessment to determine whether we are the primary beneficiary once an entity is identified as a VIE. Thereafter, we continue to re-evaluate whether we are the primary beneficiary of the VIE in accordance with ASC 810 - Consolidation. A qualitative assessment begins with an understanding of the nature of the risks in the entity as well as the nature of the entity's activities. These include the terms of the contracts entered into by the entity, ownership interests issued by the entity and how they were marketed and the parties involved in the design of the entity. We then identify all of the variable interests held by parties involved with the VIE including, among other things, equity investments, subordinated debt financing, letters of credit, financial and performance guarantees and contracted service providers. Once we identify the variable interests, we determine those activities which are most significant to the economic performance of the entity and which variable interest holder has the power to direct those activities. Though infrequent, some of our assessments reveal no primary beneficiary because the power to direct the most significant activities that impact the economic performance is held equally by two or more variable interest holders who are required to provide their consent prior to the execution of their decisions. Most of the VIEs with which we are involved have relatively few variable interests and are primarily related to our equity investment, significant service contracts and other subordinated financial support.