The discussion and analysis that follows is organized to:
· provide an overview of our business; · describe selected key metrics evaluated by management; · explain the year-over-year trends in our results of operations; · describe our liquidity and capital resources; and · explain our critical accounting policies and estimates. Readers who are not familiar with our company or the financial statements of federal government information technology, or IT, service providers should closely review the "Description of Critical Accounting Estimates," and the "Description of Statement of Operations Items," sections included in our annual report on Form 10-K filed with the
Securities and Exchange Commissionon August 9, 2013. These sections provide background information that can help readers understand and analyze our financial information.
We are a leading provider of technology and strategic consulting services and solutions primarily to U.S. federal government organizations. Founded in 1978, we are dedicated to solving complex mission and efficiency challenges for our clients by providing IT solutions and professional services that enable mission performance, improve efficiency of operations or reduce operating costs. Our service offerings include IT lifecycle services; cloud and mobile computing; cyber security; solutions development and integration; and, strategy development and organizational change management. We also provide mission-specific domain expertise in areas such as intelligence analysis; energy and environmental consulting; and bioinformatics. We currently serve more than 250 federal government organizations, across National Security and Health and Civil markets, many of which we have served for over 20 years. Together, these organizations represented approximately 97% of our revenue for the three months ended
December 31, 2013and 98% for the three months ended December 31, 2012and the six months ended December 31, 2012and 2013. Our revenue and Adjusted EBITDA (as calculated in accordance with our credit agreement) was $333.7 millionand $39.0 millionfor the three months ended December 31, 2013, respectively, and $683.5 millionand $84.4 millionfor the six months ended December 31, 2013, respectively. For a reconciliation of Adjusted EBITDA to income from continuing operations, see the section entitled "Items Affecting the Comparability of our Operating Results." Our results were negatively impacted by the government shutdown, see the section entitled "Business Environment and Outlook" for a further discussion. On March 31, 2011, we entered into an Agreement and Plan of Merger with affiliates of Providence Equity Partners L.L.C., or Providence, and on July 20, 2011we became an indirect wholly-owned subsidiary of Sterling Holdco Inc., or Sterling Holdco, which is controlled by the PEP Funds, which we refer to as the Transaction. The PEP Funds refer collectively to Providence Equity Partners VI LPand Providence Equity Partners VI-A LPeach an affiliate of Providence.
Some of the statements under "Management's Discussion and Analysis of Financial Condition and Results of Operations" and elsewhere in this quarterly report on Form 10-Q constitute forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify these statements by forward-looking words such as "anticipate," "believe," "could," "estimate," "expect," "intend," "may," "plan," "potential," "should," "will," and "would" or similar words. You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or of our financial position, or state other forward-looking information. We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able to predict accurately or control. The factors listed in the "Risk Factors" section of our annual report on Form 10-K filed with the
Securities and Exchange Commission, or SEC, on August 9, 2013, as well as any cautionary language in Part II. Item 1A. in the quarterly report on Form 10-Q filed with the SECon November 8, 2013and this quarterly report on Form 10-Q, provide some, but not all possible examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we describe in our forward-looking
Factors or risks that could cause our actual results to differ materially from the results we anticipate include, but are not limited to:
· reduced spending levels including impacts of any government shut down and
changing budget priorities of our largest customer,
government, which accounts for approximately 97% of our revenue;
· failure of our customer to fund a contract or exercise options to extend
contracts, or our inability to successfully execute awarded contracts;
· limitations as a result of our substantial indebtedness which could adversely
affect our financial health, operational flexibility and strategic plans;
· failure to generate cash sufficient to pay the principal of, interest on, or
other amounts due on our debt;
· failure to comply with complex laws and regulations, including but not limited
to, the False Claims Act, the Federal Acquisition Regulation, the Defense
Federal Acquisition Regulation Supplement and the U.S. Government Cost
· possible delays or overturning of our government contract awards due to bid
protests, loss of contract revenue or diminished opportunities based on the
existence of organizational conflicts of interest or failure to perform by
other companies on which we depend to deliver products and services;
· security threats, attacks or other disruptions on our information
infrastructure, and failure to comply with complex network security and data
privacy legal and contractual obligations or to protect sensitive information;
· inability or failure to adequately protect our proprietary information or
intellectual property rights or violation of third party intellectual rights;
· potential for significant economic or personal liabilities resulting from
failures, errors, delays or defects associated with products, services and
systems we supply; · adverse changes in federal government practices;
· pricing pressure on new work, reduced profitability or loss of market share
due to intense competition and commoditization of services we offer;
· adverse results of audits and investigations conducted by the Defense Contract
various agencies with which we contract, including, without limitation, any
determination that our purchasing, property, estimating, cost accounting,
labor, billing, compensation, management information systems or contractor
internal control systems are deficient;
· difficulties accurately estimating contract costs and contract performance
· possible further impairment of goodwill, trade names and other assets as a
result of customer budget pressures and reduced U.S. federal government
· challenges attracting and retaining key personnel or high-quality employees,
particularly those with security clearances;
· failure to manage acquisitions or divestitures successfully, including
identifying, evaluating, and valuing acquisition targets, integrating acquired
companies, losses associated with divestitures, and the inability to effect
divestitures at attractive prices and on a desired timeline; · possible future losses that exceed our insurance coverage; · pending litigation and any resulting expenses, payments or sanctions,
including but not limited to penalties, compensatory damages or suspension or
debarment from future government contracting; and
· the effect of our acquisition by entities affiliated with
business relationships, operating results and business generally.
Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this quarterly report on Form 10-Q. Subsequent events and developments may cause our views to change. While we may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do
so. 16 Non-GAAP Financial Measures Adjusted EBITDA and gross contribution presented in this section are supplemental measures that are not required by, nor presented in accordance with generally accepted accounting principles, or GAAP. These non-GAAP measures are not measurements of our financial performance under GAAP and should not be considered as alternatives to net income, operating income, or any other performance measure derived in accordance with GAAP. In addition, our calculations of these non-GAAP measures may not be comparable to that of other companies. We believe these measure are frequently used by securities analysts, investors, and other interested parties in the evaluation of high-yield issuers, as well as management to assess operating performance.
Business Environment and Outlook
We generate approximately 97% of our revenue from services provided as a prime contractor or subcontractor on engagements with various agencies of the U.S. federal government. Accordingly, our business performance is affected by the overall level of U.S. federal government spending. The U.S. federal government continues to face fiscal and economic challenges, which have created increasing pressure to examine and reduce spending across all federal agencies in recent years. On
October 1, 2013, the government entered a shutdown period after Congressfailed to enact fiscal year 2014 appropriations. Government functions deemed non-essential were discontinued, many federal employees were furloughed, and certain contracts received "Stop Work" orders temporarily halting their execution. On October 16, Congresspassed and the President signed into law a bill that ended the shutdown and funded the federal government through mid-January. The total revenue impact of execution interruptions related to the shutdown was a reduction of approximately $12 million. The gross contribution lost from these projects was offset slightly by reductions in selling, general and administrative expenses, or SG&A, as indirect staff took more leave than usual and provided only critical support functions during the shutdown. The Adjusted EBITDA impact was a reduction of approximately $4 million. On December 26, the President signed the Bipartisan Budget Act of 2013, which revised the limits on discretionary appropriations for government fiscal years 2014 and 2015, allowing for higher levels of funding in those years than were allowed under the prior caps and budget enforcement procedures. On January 17, 2014, the President signed a $1.1 trillionomnibus budget bill that finalized federal funding through September 30. The government shutdown dynamics this fiscal year have added to the combination of sequester spending cuts and overall budget uncertainty that have adversely affected our financial performance for the last few years. The lack of budget visibility has led many federal procurement officials to delay contract awards, increasing competition and pricing pressure for new business opportunities in our market. These factors have led to lower win rates, erosion in gross margins, and an increase in bid protests, which have further delayed many contract awards. Other issues such as the increasing volume of contracts set-aside for small businesses and a greater prevalence of "low price technically acceptable" evaluation criteria have further challenged growth of companies in our market and ability to sustain historical gross margins. The replacement of automatic sequester cuts with improved funding levels in fiscal 2014 should offset a portion of this uncertainty, but we anticipate that heightened competition and margin pressure will continue. Despite these uncertainties affecting our industry, we expect the federal government to make continued investments in areas such as cyber security, operating efficiency, C4ISR, and health care system modernization, and to continue supporting the intelligence community and special-forces capabilities. Since fiscal 2011 we have increased our annual investments in business development, capture and proposal activities, while reducing our overall SG&A costs through reductions in our indirect labor force, consolidation and reconfiguration of underutilized office space, and reduction of fringe benefits. In December 2013, we created additional efficiencies by reorganizing our business, and we initiated a planning process to exit additional underutilized facilities later in fiscal 2014. No financial impacts of those planned facility exits have been incurred to date. We continue to believe we are well positioned to gain market share and achieve long-term growth, and this belief has been validated by a series of recent contract awards in the health IT and homeland security markets, in particular. With less than two percent market share in federal IT services, we feel unconstrained by new business opportunities and continue to invest in our capacity to address them. 17
Recent Contract Developments
October 2012, we were informed that we had not won the re-compete of our contract with the Federal Deposit Insurance Corporation, or FDIC. Shortly thereafter we protested to the Government Accountability Office(GAO) the award to a competitor and the government took corrective action. We submitted a new proposal to the government in March 2013and were notified in August 2013that we had not been awarded the contract. We filed a GAO protest of that award, which was denied. We then filed a separate challenge at the U.S. Court of Federal Claimsin December 2013. It was dismissed on February 3, 2014. On February 4, 2014, we filed an appeal with the Court of Appeals for the Federal Circuit. We have sought an injunction, but transition activities are expected to commence. Our work is funded through February 2014. The FDICcontract accounted for approximately $98 million, or 7%, of revenue and approximately $14 million, or 4%, of gross contribution, or revenue less cost of services, in fiscal 2013. The FDICcontract accounted for approximately $42 million, or 6%, of revenue and approximately $5 million, or 3%, of gross contribution in the six months ended December 31, 2013.
We manage and assess the performance of our business by evaluating a variety of metrics. Selected key metrics are discussed below.
We define backlog as our estimate of the remaining future revenues from existing signed contracts. Our backlog includes funded and unfunded orders for services under existing signed contracts, assuming the exercise of all option years relating to those contracts, less the amount of revenue we have previously recognized under those contracts and de-obligations. Backlog includes all contract options that have been priced but not yet funded. Backlog also includes an estimate of the contract value under single award indefinite delivery/indefinite quantity, or ID/IQ, contracts against which we expect future task orders to be issued without competition. Backlog does not take contract ceiling value into consideration under multiple award contracts, nor does it include any estimate of future potential delivery orders that might be awarded under multiple award ID/IQ vehicles, government-wide acquisition contracts, or GWACs, or
General Services Administration, or GSA, schedule contracts. We define funded backlog to be the portion of backlog for which funding currently is appropriated and obligated to us under a contract or other authorization for payment signed by an authorized purchasing authority. Our future growth is dependent upon the strength of our target markets, our ability to identify opportunities, and our ability to successfully bid and win new contracts. New contract awards or orders generally represent the amount of revenue expected to be earned in the future from funded and unfunded contract awards received during the period. Ceiling increases are as a result of upward contract adjustments under existing contracts and increases in scope. "De-obligation" refers to the removal from backlog of amounts previously awarded by a customer resulting from either (i) a formal contract modification issued by the customer reducing, or de-obligating, the total contract value, or (ii) the expiration of the period of performance without an extension issued by the customer which would be necessary for us to continue working under the contract. In the latter case we remove the remaining contract value from backlog even though the contract value is not formally de-obligated by the customer. Three months Six months ended ended (in millions) December 31, 2013 December 31, 2013 Beginning backlog $ 3,686.4 $ 3,284.5 New contact awards 287.1 917.1 Ceiling increases 108.0 300.9 Total contract awards 395.1 1,218.0 De-obligations and removals (68.8) (140.0) Net orders 326.3 1,078.0 Revenue recognized (333.7) (683.5) Ending backlog $ 3,679.0 $ 3,679.0 Funded $ 791.7 $ 791.7 Unfunded 2,887.3 2,887.3 Total backlog $ 3,679.0 $ 3,679.0 A key measure of our business growth is the ratio of gross contracts awarded compared to the revenue recorded in the same period, or book-to-bill ratio. Our goal is for the level of business awards to exceed the revenue booked in order to drive future revenue growth. Our book-to-bill ratio, calculated using gross contract orders, was 1.18:1, 1.78:1 and 1.12:1 in the three, six and twelve months ended December 31, 2013, respectively. Despite the environment, we do not believe we are opportunity constrained and have grown our pipeline. The total value of proposals submitted in the six months ended December 31, 2013was $1.8 billion. Submittals include the total value of bids submitted for prime funded opportunities, including both new and re-compete contracts. Submittals do not include values of bids submitted for ID/IQ contracts or bids submitted as a subcontractor. We had approximately $2.0 billionof proposals awaiting award decision at December 31, 2013. 18
Our backlog includes orders under contracts that, in some cases, extend for several years, with the latest expiring during calendar year 2021.
Congressoften appropriates funds for our clients on a yearly basis, even though the corresponding contract with us may call for performance that is expected to take a number of years. As a result, contracts typically are only partially funded at any point during their term with further funding dependent on Congressmaking subsequent appropriations and the procuring agency allocating funding to the contract. The U.S. government may cancel any contract at any time. Most of our contracts have cancellation terms that would permit us to recover all or a portion of our incurred costs, termination costs, and potentially fees for work performed.
When contracting with our clients, we typically enter into one of three basic types of contracts: cost-plus-fee, time-and-materials, and fixed-price.
· Cost-plus-fee contracts. Cost-plus-fee contracts provide for reimbursement of
allowable costs and the payment of a fee, which is our profit. In addition,
some cost-plus-fee contracts provide for an award fee or incentive fee for
meeting the requirements of the contract.
· Time-and-materials contracts. Time-and-materials contracts provide for a fixed
hourly rate for each direct labor hour expended plus reimbursement of
allowable material costs and out-of-pocket expenses.
· Fixed-price contracts. Fixed-price contracts provide for a pre-determined
fixed price for specified products and/or services.
Fixed-price-level-of-effort contracts are similar to time-and-materials
contracts except they require a specified level of effort over a stated period
of time. To the extent our actual costs vary from the estimates upon which the
price of the fixed-price contract was negotiated, we will generate more or less than the anticipated amount of profit or could incur a loss. Each of these contract types has unique characteristics. From time to time, contracts may be issued that are a combination or hybrid of contract types. Cost-plus-fee contracts generally subject us to lower risk. They also can include award fees or incentive fees under which the customer may make additional payments based on our performance. However, not all costs are reimbursed under these types of contracts, and the government carefully reviews the costs we charge. In addition, negotiated base fees are generally lower than projected profits on fixed-price or time-and-materials contracts, consistent with our lower risk. Under time-and-materials contracts, including our fixed-price-level-of effort contracts, we are also generally subject to lower risk; however, our profit may vary if actual labor hour costs vary significantly from the negotiated rates. Fixed-price contracts typically involve the highest risk and, as a result, typically have higher fee levels. However, fixed-price contracts require that we absorb cost overruns, should they occur.
The following table summarizes our historical contract mix, measured as a percentage of total revenue, for the periods indicated.
Three months ended December 31, 2012 2013 Cost-plus-fee 32 % 32 % Time-and-materials 34 % 34 % Fixed-price (a) 34 % 34 % Six months ended December 31, 2012 2013 Cost-plus-fee 31 % 31 % Time-and-materials 36 % 34 % Fixed-price (a) 33 % 35 %
(a) Includes approximately 4% and 3% of the revenue earned on fixed-price-level-of-effort contracts in the fiscal 2013 periods and the fiscal 2014 periods, respectively.
19 Labor Utilization Because most of our revenue and profit is derived from services delivered by our employees, our ability to hire new employees and retain and deploy them is critical to our success. We define direct labor utilization as the ratio of labor expense recorded on customer engagements to total labor expense. We include every working employee in the computation and exclude leave taken, such as vacation time. As of
December 31, 2013, we had approximately 5,400 employees. Direct labor utilization was 82.0% and 81.1% for the three and six months ended December 31, 2013, respectively, compared to 79.9% and 79.8% in the same periods of the prior year. Labor incurred in the performance of our contracts is included in cost of services and all other labor costs incurred are included in selling, general and administrative expenses.
Days Sales Outstanding
Days sales outstanding, or DSO, is a measure of how efficiently we manage the billing and collection of accounts receivable, our most significant working capital requirement. From time to time we may offer discounts to our customers for early payment. We calculate DSO by dividing accounts receivable at the end of each quarter, net of billings in excess of revenue, by revenue per day for the period. Revenue per day for a quarter is determined by dividing total revenue by 90 days, adjusted for partial periods related to any acquisitions and divestitures. DSO was 66 days as of
December 31, 2013compared to 63 days as of December 31, 2012. Seasonality Certain aspects of our operations are influenced by the federal government's October-to-September fiscal year. The timing of contract awards, the availability of funding from the customer and the incurrence of contract costs are the primary drivers of our revenue recognition and may all be affected by the government's fiscal year. Additionally, our quarterly results are impacted by the number of working days in a given quarter. There are generally fewer working days for our employees to generate revenue in the first and second quarters of our fiscal year because our employees usually take relatively more leave for vacations and holidays, which lead to lower revenue and profitability in those quarters. Additionally, we typically give annual raises to our employees in the first half of our fiscal year, while the billing rates on our time-and-materials contracts typically escalate gradually, causing the profitability on these contracts to increase over the course of our fiscal
year. Summary of Financial Results Three months ended
Six months ended
2012 2013 2012 2013 Revenue $ 376,699 $ 333,713
$ 766,548 $ 683,536Operating costs and expenses: Cost of services 285,421 260,050 582,402 524,187 Selling, general and administrative 50,194 40,207 103,527 85,748 Depreciation and amortization of property and equipment 3,171 2,323 6,370 4,908 Amortization of intangible assets 21,577 18,064 43,723 36,584 Gain on the sale of a portion of the Health & Civil business - - - (1,564) Total operating costs and expenses 360,363 320,644 736,022 649,863 Operating income 16,336 13,069 30,526 33,673 Interest expense (25,241) (26,356) (50,722) (52,527) Interest income 9 24 21 34 Loss before income taxes (8,896) (13,263) (20,175) (18,820) Benefit from income taxes (3,345) (5,095) (7,241) (7,111) Net loss $ (5,551) $ (8,168) $ (12,934) $ (11,709)Six months ended December 31, 2012 2013 Net cash provided by operating activities $ 39,991 $ 48,105Net cash (used in) provided by investing activities (40,022) 731 Net cash used in financing activities - - Net (decrease) increase in cash and cash equivalents $ (31) $ 48,83620
Items Affecting the Comparability of Our Operating Results
We define Adjusted EBITDA as GAAP net loss plus (i) benefit from income taxes, (ii) net interest (income) expense, (iii) depreciation and amortization of property and equipment, and (iv) amortization of intangible assets, or EBITDA, adjusted to exclude certain items that do not relate directly to our ongoing operations or which are non-cash in nature. Adjusted EBITDA, or Consolidated EBITDA as is defined in the credit agreement, as presented in the table below is used to determine our compliance with certain covenants contained in our credit agreement. We also use Adjusted EBITDA as a supplemental measure in the evaluation of our business because it provides a meaningful measure of operational performance by eliminating the effects of period-to-period changes in taxes and interest expense, among other things. Adjusted EBITDA decreased in the three, six and twelve months ended
December 31, 2013compared to the same periods in the prior year due primarily to a decline in direct labor services caused by the federal budget pressures, increasingly competitive market environment and the federal government shutdown. Operating income was negatively impacted by the shutdown by approximately $4 millionfor the second quarter of fiscal 2014. This decline was partially offset by reductions in SG&A expenses as a result of actions taken to align our indirect costs with our volume of business and during the federal government shutdown. Adjusted EBITDA margin for the three and six months ended December 31, 2013, excluding the impact of any acquisitions, was 11.7% and 12.3%, respectively, compared to 12.4% and 12.1% in the comparable prior year periods. Three months ended December 31,
Six months ended
2012 2013 2012 2013 Loss from continuing operations
$ (5,551) $ (8,168) $ (12,934) $ (11,709)Benefit from income taxes (3,345) (5,095) (7,241) (7,111) Interest expense, net 25,232 26,332 50,701 52,493 Depreciation and amortization of property and equipment 3,508 2,711 7,038 5,619 Amortization of intangible assets 21,577 18,064
43,723 36,584 Stock compensation 825 796 2,034 2,130 Severance 950 1,196 1,235 1,151 Facility exit charge 1,018 392 1,281 503 Other, net 2,049 704 3,940 1,500 Gain on the sale of a portion of our Health & Civil business - - - (1,564)
Subtotal - Adjusted EBITDA before
certain items 46,263 36,932 89,777 79,596 EBITDA impact of acquisitions 2,025 - 4,344 - EBITDA impact of cost savings 444 2,103
972 4,794 Adjusted EBITDA $ 48,732 $ 39,035 $ 95,093 $ 84,390 Twelve months ended December 31, 2012 2013
Loss from continuing operations
(16,331) (60,039) Interest expense, net 103,444 102,526 Depreciation and amortization of property and equipment 15,287 12,065 Amortization of intangible assets 92,120 81,008
Stock compensation 3,841 2,932 Severance 4,159 1,639 Facility exit charge 5,698 3,033 Other, net 9,644 3,914 Transaction costs 471 - Impairment of goodwill and other assets - 345,753 Gain on the sale of a portion of our Health & Civil business - (1,564) Subtotal - Adjusted EBITDA before certain items 191,763 175,198 EBITDA impact of acquisitions 8,177 - EBITDA impact of cost savings 3,117 11,785 Adjusted EBITDA
$ 203,057$ 186,983 21 · Stock compensation expense related to the stock incentive plans. The
charges are included in SG&A expenses in the condensed consolidated
statement of operations.
· Severance charges incurred to primarily reduce our indirect labor force.
The gross charges are included in SG&A expenses in the condensed consolidated statement of operations. · Facility exit charges related to the exit of underutilized space in certain of our leased facilities. The charges are included in SG&A expenses in the condensed consolidated statement of operations. · Certain other non-recurring items including the following: Three months ended December 31, Six months ended December 31, 2012 2013 2012 2013 Signing and retention bonuses of certain executive officers $ 64 $ - $ 1,057 $ - PEP management fees 438 438 876 875
Merger and acquisition costs 1,018 230
1,211 477 Other 529 36 796 148 Other, net $ 2,049 $ 704 $ 3,940 $ 1,500 Twelve months ended December 31, 2012 2013
Signing and retention bonuses of certain
executive officers $ 4,967 $
PEP management fees 1,752
Merger and acquisition costs 1,319 1,480 Other 1,606 600 Other, net $ 9,644 $ 3,914 · Transaction costs for accelerated stock compensation expense, accounting, investment banking, legal, severance, and other services related to the Transaction; · Impairment of goodwill and trade names as a result of the annual impairment analysis during fiscal 2013; · Gain on the sale of a portion of our Health and Civil business in the first quarter of fiscal 2014; · The acquisition of
MorganFranklin Corporation'sNational Security Solutions division, or NSS, in December 2012. In calculating Adjusted EBITDA, we add the estimated EBITDA impact of acquisitions as if the businesses had been acquired on the first day of the respective period in which an adjustment is recorded. · As defined in our credit agreement, cost savings represents the EBITDA impact of quantifiable run-rate cost savings for actions taken or expected to be taken within 12 months of the reporting date as if they
had been realized on the first day of the relevant period. Specifically,
for the periods presented, the cost savings adjustment represents the estimated EBITDA impact of actions taken to exit underutilized space in
certain of our leased facilities, the run-rate cost savings associated
with indirect labor reductions, and savings associated with certain fringe benefit changes. The impact of these items on our net loss is shown in the table above. We present Adjusted EBITDA as an additional measure of our core business performance period over period. Adjustments to loss from continuing operations result in a non-GAAP measure; however, we believe adjustment of the items above is useful as they are considered outside the normal course of our operations and obscure the comparability of performance period-over-period.
Results of Operations
Revenue decreased 11.4% to
$333.7 millionin the three months ended December 31, 2013from $376.7 millionin the three months ended December 31, 2012. Revenue decreased 10.8% to $683.5 millionin the six months ended December 31, 2013from $766.5 millionin the six months ended December 31, 2012. We experienced a decline in revenue from SRA direct labor and overhead, subcontractors and materials and other reimbursable costs as shown in the components of costs of services below. The most significant percentage decline in revenue was due to lower materials and other reimbursable costs. The decline in labor services was primarily due to the competitive market environment, funding reductions on some of our existing programs, the continued delay of contract awards and the federal government shutdown. Revenue was negatively impacted by the shutdown by approximately $12 millionfor the second quarter of fiscal 2014. 22
Operating Costs and Expenses
Operating costs and expenses consisted of the following for the periods presented (dollars in thousands):
Three months ended December 31, 2012 2013 % Change Cost of services $ 285,421 $ 260,050 (8.9) % Selling, general and administrative 50,194 40,207 (19.9) % Depreciation and amortization of property and equipment 3,171 2,323 (26.7) % Amortization of intangible assets 21,577 18,064 (16.3) % (as a percentage of revenue) Cost of services 75.8 % 77.9 %
Selling, general and administrative 13.3 % 12.0 % Depreciation and amortization of property and equipment 0.8 % 0.7 % Amortization of intangible assets 5.7 % 5.4
% Six months ended December 31, 2012 2013 % Change Cost of services
$ 582,402 $ 524,187(10.0) % Selling, general and administrative 103,527 85,748 (17.2) % Depreciation and amortization of property and equipment 6,370 4,908 (23.0) % Amortization of intangible assets 43,723 36,584 (16.3) % Gain on the sale of a portion of the Health & Civil business - (1,564) NMF (as a percentage of revenue) Cost of services 76.0 % 76.7 % Selling, general and administrative 13.5 % 12.5 % Depreciation and amortization of property and equipment 0.8 % 0.7 % Amortization of intangible assets 5.7 % 5.4 % Gain on the sale of a portion of the Health & Civil business 0.0 % (0.2) % NMF = Not meaningful Cost of services consisted of the following for the periods presented (dollars in thousands): Three months Three months ended ended December 31, 2012 % of total December 31, 2013 % of total
Direct labor and related overhead $ 137,840 48.3 % $ 128,742 49.5 % Subcontractor labor 88,713 31.1 % 80,320 30.9 % Materials and other reimbursable costs 58,868 20.6 %
50,988 19.6 % Total cost of services $ 285,421 $ 260,050 Six months Six months ended ended December 31, 2012 % of total December 31, 2013 % of total
Direct labor and related overhead $ 287,850 49.4 % $ 263,018 50.2 % Subcontractor labor 184,189 31.6 % 166,891 31.8 % Materials and other reimbursable costs 110,363 19.0 %
94,278 18.0 % Total cost of services $ 582,402 $ 524,187 Cost of services decreased in the three and six months ended
December 31, 2013compared to the three and six months ended December 31, 2012. This decrease is due to lower business volume resulting from federal budget pressures, contract award delays and the government shutdown. As a percentage of revenue, cost of services increased in the three and six months ended December 31, 2013compared to the three and six months ended December 31, 2012. This increase is partially attributable to the loss of revenue due to the shutdown of the U.S. federal government in October 2013, which reduced labor services costs and revenue but did not reduce the fixed portions of overhead or fringe costs. The increase was also driven by ongoing heightened competition and pricing pressures, both for new business opportunities and recompetes of our existing programs. 23 Cost of services as a percentage of revenue varies from period to period depending on the mix of direct labor, subcontractor labor, and materials and other reimbursable costs. In periods where we have more materials and other reimbursable content, our costs of services as a percentage of revenue will be higher. We seek to optimize our labor content in performance of our contracts since we typically generate greater gross margin from our labor services, particularly from services that our employees provide, compared with other reimbursable items. SG&A expenses decreased $10.0 millionin the three months ended December 31, 2013compared to the three months ended December 31, 2012and $17.8 millionin the six months ended December 31, 2013compared to the same period of the prior year. Excluding stock compensation expense, severance charges to reduce our indirect labor force, officer compensation and other non-recurring costs, which are all discussed in greater detail in the section listed "Items Affecting the Comparability of Our Operating Results," SG&A expenses decreased approximately $8.3 millionand $14.5 millionin the three and six months ended December 31, 2013, respectively, compared to the comparable periods of the prior year. The decrease is primarily a result of actions taken to align our indirect costs with our volume of business and maintain competitive cost position. Additionally, the impact of the federal government shutdown reduced SG&A costs for the second quarter of fiscal 2014 by approximately $1 million.
Depreciation and amortization of property and equipment decreased in the three and six months ended
Amortization of intangible assets decreased in the three and six months ended
December 31, 2013as compared to the three and six months ended December 31, 2012as amortization is recorded on an accelerated basis based on the expected benefits of the assets. Interest Three months ended December 31, Six months ended December 31, 2012 2013 2012 2013 Interest expense $ (25,241) $ (26,356) $ (50,722) $ (52,527)Interest income 9 24 21 34 Interest, net $ (25,232) $ (26,332) $ (50,701) $ (52,493)
Interest expense increased in three and six months ended
December 31, 2013by $1.1 millionand $1.8 million, respectively, compared to the comparable prior year periods primarily due to an increase of the fixed rates on our interest rate swaps. Interest expense for the three and six months ended December 31, 2012and 2013 includes amortization of original issue discount and debt issuance costs of $1.8 millionand $3.7 million, respectively, compared to $1.8 millionand $3.7 millionin the comparable prior year periods. We manage our exposure to interest rate movements through the use of interest rate swap agreements. As of December 31, 2013, we had fixed the interest rate on all but $150.0 million
of our outstanding total debt. Income Taxes
The effective tax rate for the six months ended
December 31, 2012and 2013 was a tax benefit of 35.9% and 37.8%, respectively, which is lower than the statutory income tax rates primarily due to non-deductible permanent items. The increase in the tax benefit is due to the reinstatement of the federal research and development credit that was not in effect during the six months ended December 31, 2012.
Liquidity and Capital Resources
Our primary capital needs are to finance the costs of operations, pending the billing and collection of accounts receivable and to make acquisitions. Our working capital (current assets minus current liabilities) as of
December 31, 2013was $67.5 millioncompared to $96.8 millionas of June 30, 2013. As of December 31, 2013, our total unrestricted cash was $53.9 millionand our total outstanding debt was $1.1 billion, excluding unamortized discount. 24 Six months ended December 31, 20122013
Net cash provided by operating activities $ 39,991
$ 48,105Net cash (used in) provided by investing activities (40,022) 731 Net cash used in financing activities - - Net (decrease) increase in cash and cash equivalents $ (31) $ 48,836 Cash FlowAccounts receivable represent our largest working capital requirement. We bill the majority of our clients monthly after services are rendered. Our operating cash flow is primarily affected by the overall profitability of our contracts, our ability to invoice and collect from our clients in a timely manner, and the timing of vendor and tax payments. Net cash provided by operating activities was $40.0 millionand $48.1 millionin the six months ended December 31, 2012and 2013, respectively. In the six months ended December 31, 2013, the increase in cash provided by operating activities was primarily due to the timing of vendor payments, lower payments of accrued payroll and employee benefits, offset by the timing of billings and collections of our accounts receivable. Net cash used in investing activities was $40.0 millionin the six months ended December 31, 2012and the net cash provided by investing activities was $0.7 millionin the six months ended December 31, 2013. In the six months ended December 31, 2013, net cash provided by investing activities represented the sale of a portion of the Health & Civil business of $5.5 millionpartially offset by $4.8 millionof capital expenditures. In the six months ended December 31, 2012, net cash used in investing activities was driven by $34.2 millionused to acquire NSS and capital expenditures of $5.8 million. Net cash used in financing activities was zero in the six months ended December 31, 2012and 2013. Borrowings on our revolving credit facility during the six months ended December 31, 2013of $100.0 millionwere repaid during the six months.
Our Term Loan B Facility requires quarterly installment payments of approximately
$2.2 millionper quarter commencing on December 31, 2011. In addition, we are required to make annual payments equal to 75% of excess cash flow, or ECF (as defined in the credit agreement), with a reduction to 50% based upon achievement of a net senior secured leverage ratio, or NSSLR, of less than 3.5x, 25% if less than 2.75x and zero if less than 2.0x. Any required ECF payments are due on October 15each year. We repaid $140.0 millionof our Term Loan B Facility in fiscal 2012, which satisfied all of the required quarterly principal payments for the term of the loan and satisfied our required ECF principal payments for fiscal 2012. We repaid $20.0 millionof our Term Loan B Facility in fiscal 2013, which satisfied our required ECF principal payments for fiscal 2013. We estimate the fiscal 2014 ECF requirement to be $45.0 million, which is due October 15, 2014and is included in current liabilities on the condensed consolidated balance sheet. We are required to meet the NSSLR covenant quarterly if any revolving loan, swing-line loan or letter of credit is outstanding on the last day of the quarter. As of December 31, 2013, we had no outstanding letters of credit or borrowings under our Revolver. The ratio is calculated as the consolidated net secured indebtedness as of the last day of the quarter (defined as consolidated net secured debt less any cash and permitted investments) to the preceding four quarters' consolidated EBITDA (as defined in the Credit Agreement). The required ratio decreases over time from less than or equal to 5.25x as of December 31, 2013to less than or equal to 4.5x as of June 30, 2016. As of December 31, 2013, our net senior secured leverage ratio was 3.5x. We were in compliance with all of our covenants as of December 31, 2013. The $400.0 millionof Notes bear interest at a rate of 11% per annum and mature on October 19, 2019. Interest on the Notes is payable semi-annually. The Notes are redeemable in whole or in part, at our option, at varying redemption prices that generally include premiums. In addition, until October 1, 2014, we may, at our option, redeem up to 35% of the then outstanding aggregate principal amount of the Notes with the net cash proceeds from certain equity offerings at a redemption price equal to 111% of the aggregate principal amount thereof. The Senior Secured Credit Facilities and the Notes are guaranteed by all of our wholly-owned subsidiaries. The Senior Secured Credit Facilities are also guaranteed by Sterling Parent. The guarantees are full and unconditional and joint and several. Each of our subsidiary guarantors are 100% owned and have no independent assets or operations. 25 Capital Requirements
We believe the capital resources available to us under the Revolver portion of our Senior Secured Credit Facilities and cash from our operations are adequate to fund our normal working capital needs as well as our capital expenditure requirements, which are expected to be less than 1.0% of revenue, for at least the next twelve months. Income Taxes The Transaction accelerated the recognition of expense for stock options and restricted stock, creating a tax deduction of approximately
$80.0 millionin fiscal 2012. As a result of net operating loss carryforwards resulting primarily from this stock compensation deduction, as well as Transaction costs and tax-deductible interest expense, we do not expect to make any material U.S. federal income tax payments for the next twelve months.
Accounts Receivable Factoring
During the second quarter of fiscal 2014, we entered into an accounts receivable purchase facility that enables us to sell accounts receivable under certain contracts to a third party. The balance of the receivables may not exceed
$50.0 millionat any time. As of December 31, 2013, there was no activity under this facility.
Off-Balance Sheet Arrangements
December 31, 2013, other than operating leases, we had no material off-balance sheet arrangements, including retained or contingent interests in assets transferred to unconsolidated entities; derivative instruments indexed to our stock and classified in stockholder's equity on the condensed consolidated balance sheet; or variable interests in entities that provide us with financing, liquidity, market risk or credit risk support or engage with us in leasing, hedging or research and development services. We utilize interest rate derivatives to add stability to interest expense and to manage our exposure to interest rate movements. For further discussion of our derivative instruments and hedging activities see Item 3 below and Note 6 to our condensed consolidated financial statements as of and for the period ended December 31, 2013included in this quarterly report on Form 10-Q.
Description of Critical Accounting Policies and Estimates
The preparation of our financial statements in accordance with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, as well as the disclosure of contingent assets and liabilities. These estimates are based on our historical experience and various other factors that are deemed reasonable at the time the estimates are made. Actual results may differ significantly from these estimates under different assumptions or conditions. We re-evaluate these estimates quarterly and test goodwill and trade names for impairment at least annually during the fourth quarter as of
April 1. We believe the critical accounting policies requiring significant estimates and judgments are revenue recognition, accounting for acquisitions, including the identification of intangible assets and the ongoing impairment assessments of goodwill and intangible assets, accounting for stock compensation expense and income taxes. If any of these estimates or judgments proves to be inaccurate, our results could be materially affected in the future. For a full discussion of our critical accounting policies, refer to the "Description of Critical Accounting Estimates" section included in our annual report on Form 10-K filed with the Securities and Exchange Commissionon August 9, 2013.
Recent Accounting Pronouncements
February 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update 2013-02, or ASU 2013-02, an update to Comprehensive Income. This update requires the presentation and disclosure of reclassification adjustments out of Accumulated Other Comprehensive Income, or AOCI, in a single note or on the face of the financial statements. This update is effective for fiscal years and interim periods within those years beginning after December 15, 2012, or our fiscal 2014. The adoption of this ASU did not impact our financial position, results of operations or cash flows. In July 2013, the FASB issued ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which requires standard presentation of an unrecognized tax benefit when a carryforward related to net operating losses or tax credits exist. This update is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2013, or our fiscal 2015. The adoption of this ASU will not have an impact on our financial position, results of operations or cash flows.