SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
Quarterly Report under Section 13 or 15 (d)
of the Securities Exchange Act of 1934
For the six months ended April 30, 2004 Commission file number 0-13880
ENGINEERED SUPPORT SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
Missouri 43-1313242
(State of Incorporation) (IRS Employer Identification Number)
201 Evans Lane, St. Louis, Missouri 63121
(Address of principal executive offices) (Zip Code)
Registrant's telephone number including area code: (314) 553-4000
Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15 (d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the Registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. Yes X No
----- -----
Indicate by check mark whether the Registrant is an accelerated filer
(as defined by Rule 12b-2 of the Exchange Act). Yes X No
----- -----
The number of shares of the Registrant's common stock, $.01 par value,
outstanding at May 31, 2004 was 26,045,915.
1
ENGINEERED SUPPORT SYSTEMS, INC.
INDEX
Page
----
Part I - Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of April 30, 2004 and
October 31, 2003............................................... 3
Condensed Consolidated Statements of Income for the three and
six months ended April 30, 2004 and 2003....................... 4
Condensed Consolidated Statements of Cash Flows for the three
and six months ended April 30, 2004 and 2003................... 5
Notes to Condensed Consolidated Financial Statements............. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations............................ 16
Item 3. Quantitative and Qualitative Disclosures About Market Risk.. 21
Item 4. Controls and Procedures..................................... 22
Part II - Other Information
Items 1-6........................................................... 23
Signatures................................................................ 24
Exhibits ................................................................. 25
2
ENGINEERED SUPPORT SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
April 30 October 31
2004 2003
---------------------------
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents $ 21,745 $ 2,880
Accounts receivable 107,582 90,805
Contracts in process and inventories 65,847 50,959
Deferred income taxes 5,939 5,939
Other current assets 4,735 4,668
-------- --------
Total Current Assets 205,848 155,251
Property, plant and equipment, less accumulated
depreciation of $28,187 and $28,800 52,541 50,366
Goodwill 172,200 191,332
Acquired customer-related intangibles 37,328 11,049
Deferred income taxes 3,897 2,942
Other assets 12,708 11,303
-------- --------
Total Assets $484,522 $422,243
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current Liabilities
Notes payable $ 56,000 $ 73,100
Current maturities of long-term debt 411 90
Accounts payable 66,678 48,609
Other current liabilities 49,704 63,565
-------- --------
Total Current Liabilities 172,793 185,364
Long-term debt 754
Additional minimum pension liability 25,751 25,751
Other liabilities 13,622 13,961
Shareholders' Equity
Common stock, par value $.01 per share; 30,000
shares authorized; 25,944 and 25,263 shares issued 259 253
Additional paid-in capital 126,342 106,512
Retained earnings 161,365 127,753
Accumulated other comprehensive loss (16,364) (16,142)
-------- --------
271,602 218,376
Less treasury stock at cost, 0 and 561 shares 21,209
-------- --------
271,602 197,167
-------- --------
Total Liabilities and Shareholders' Equity $484,522 $422,243
======== ========
See notes to condensed consolidated financial statements.
3
ENGINEERED SUPPORT SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(UNAUDITED)
Three Months Ended Six Months Ended
April 30 April 30
------------------------- ------------------------
2004 2003 2004 2003
------------ ------------ ------------ -----------
Net revenues:
Products $137,612 $113,639 $263,199 $225,586
Services 72,524 11,418 142,067 21,134
-------- -------- -------- --------
210,136 125,057 405,266 246,720
-------- -------- -------- --------
Cost of revenues:
Products 91,755 86,431 179,597 173,111
Services 64,956 8,843 125,973 16,680
-------- -------- -------- --------
156,711 95,274 305,570 189,791
-------- -------- -------- --------
Gross profit 53,425 29,783 99,696 56,929
Selling, general and administrative expense 23,389 14,467 43,386 27,374
Restructuring expense 39 1,193 66 1,193
-------- -------- -------- --------
Operating income from continuing operations 29,997 14,123 56,244 28,362
Interest expense (305) (271) (1,003) (727)
Interest income 102 48 156 97
Gain (loss) on sale of assets (1) (5) 6
-------- -------- -------- --------
Income from continuing operations 29,793 13,900 55,392 27,738
Income tax provision 11,470 5,421 21,326 10,818
-------- -------- -------- --------
Net income from continuing operations 18,323 8,479 34,066 16,920
Income from discontinued operations,
net of income tax 157 294
-------- -------- -------- --------
Net income $ 18,323 $ 8,636 $ 34,066 $ 17,214
======== ======== ======== ========
Basic earnings per share:
Continuing operations $ 0.71 $ 0.35 $ 1.34 $ 0.71
Discontinued operations 0.01 0.01
-------- -------- -------- --------
Total $ 0.71 $ 0.36 $ 1.34 $ 0.72
======== ======== ======== ========
Diluted earnings per share:
Continuing operations $ 0.66 $ 0.33 $ 1.23 $ 0.67
Discontinued operations 0.01 0.01
-------- -------- -------- --------
Total $ 0.66 $ 0.34 $ 1.23 $ 0.68
======== ======== ======== ========
See notes to condensed consolidated financial statements.
4
ENGINEERED SUPPORT SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(UUAUDITED)
Six Months Ended
April 30
----------------------------
2004 2003
-------- --------
From operating activities:
Net income from continuing operations $ 34,066 $ 16,920
Depreciation and amortization 6,701 4,371
(Gain) loss on sale of assets 5 (6)
-------- --------
Cash provided before changes in operating
assets and liabilities 40,772 21,285
Net (increase) decrease in non-cash current assets (31,732) 17,571
Net increase (decrease) in non-cash current liabilities 7,915 8,253
Decrease in other assets 3,713 1,205
-------- --------
Net cash provided by (used in) continuing operations 20,668 48,314
Net cash provided by discontinued operations 1,885
-------- --------
Net cash provided by (used in) operating activities 20,668 50,199
-------- --------
From investing activities:
Purchase of TAMSCO, net of cash acquired (7,440)
Purchase of Pivotal, net of cash acquired (10,064)
Purchase of UPSI, net of cash acquired (2,026) (5,008)
Purchase of EEI, net of cash acquired (99)
Additions to property, plant and equipment (4,124) (5,314)
Proceeds from sale of property, plant and equipment 128 22
-------- --------
Net cash used in continuing operations (23,625) (10,300)
Net cash used in discontinued operations 3,696
-------- --------
Net cash used in investing activities (23,625) (6,604)
-------- --------
From financing activities:
Net borrowings (payments) under line-of-credit agreement (17,100) 2,000
Payments of long-term debt (103) (42,000)
Proceeds of long-term debt 381
Purchase of treasury stock (557)
Exercise of stock options 37,826 6,508
Issuance of common stock to employee stock purchase plan 1,282 892
Cash dividends (453) (288)
-------- --------
Net cash provided by (used in) continuing operations 21,833 (33,445)
Net cash used in discontinued operations
Net cash provided by (used in) financing activities 21,833 (33,445)
-------- --------
Effect of exchange rate changes on cash (11)
-------- --------
Net increase in cash and cash equivalents 18,865 10,150
Cash and cash equivalents at beginning of period 2,880 4,793
-------- --------
Cash and cash equivalents at end of period $ 21,745 $ 14,943
======== ========
See notes to condensed consolidated financial statements.
5
ENGINEERED SUPPORT SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS (UNAUDITED)
(in thousands, except per share amounts)
APRIL 30, 2004
NOTE A - BASIS OF PRESENTATION
The accompanying condensed consolidated financial statements have
been prepared by Engineered Support Systems, Inc. (the Company) without
audit and include the accounts of the Company and its wholly-owned
subsidiaries. These subsidiaries are organized within the Company's two
business segments: Support Systems and Support Services. The Support Systems
segment includes the operations of Systems & Electronics Inc. (SEI), Keco
Industries, Inc. (Keco), Engineered Air Systems, Inc. (Engineered Air),
Engineered Coil Company, d/b/a Marlo Coil (Marlo Coil), Engineered Electric
Company d/b/a Fermont (Fermont), Universal Power Systems, Inc. (UPSI),
Engineered Environments, Inc. (EEI), and Pivotal Power Inc. (Pivotal Power).
The Support Services segment includes the operations of Technical and
Management Services Corporation (TAMSCO), Radian, Inc. (Radian) and
ESSIbuy.com, Inc. (ESSIbuy). In the opinion of management, all adjustments
(including normal recurring accruals) considered necessary for a fair
presentation have been included. Operating results for the three and six
month periods ended April 30, 2004 are not necessarily indicative of the
results to be expected for the entire fiscal year.
The accompanying unaudited condensed consolidated financial
statements have been prepared in accordance with generally accepted
accounting principles for interim financial statements and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements.
For further information, refer to the consolidated financial statements and
footnotes thereto included in the Company's annual report to shareholders
for the year ended October 31, 2003.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2003, the FASB issued a revision to Interpretation 46
(FIN 46R) to clarify some of the provisions of FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities," and to exempt certain
entities from its requirements. The adoption of FIN 46R will not have a
material impact on the Company's financial statements as it does not
maintain any of the interests governed by this pronouncement.
In December 2003, the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the Act) became law in the U.S. The act
introduces a prescription drug benefit under Medicare, as well as a federal
subsidy to sponsors of retiree health care benefit plans that provide
retiree benefits in certain circumstances. It is not yet clear what impact,
if any, the new legislation will have on the Company's postretirement health
care plans. The accumulated postretirement benefit obligation
6
(APBO) reflected in the other liabilities section of the accompanying
consolidated balance sheet, and the net periodic postretirement benefit cost
(NPPBC) reflected in the accompanying consolidated statement of earnings do
not reflect the effects, if any, of the Act.
NOTE B - EARNINGS PER SHARE
Average diluted common shares outstanding include common stock
equivalents, which represent common stock options as computed based on the
treasury stock method. Average basic and diluted common shares outstanding
have been restated to reflect a three-for-two stock split effected by the
Company on October 31, 2003 in the form of a stock dividend.
Basic earnings per share for the three months ended April 30, 2004
and 2003 is based on average basic common shares outstanding of 25,922 and
24,117, respectively. Diluted earnings per share for the three months ended
April 30, 2004 and 2003 is based on average diluted common shares
outstanding of 27,858 and 25,515, respectively.
Basic earnings per share for the six months ended April 30, 2004 and
2003 is based on average basic common shares outstanding of 25,489 and
23,993, respectively. Diluted earnings per share for the six months ended
April 30, 2004 and 2003 is based on average diluted common shares
outstanding of 27,704 and 25,389, respectively.
NOTE C - STOCK-BASED COMPENSATION
The Company applies Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees," and related interpretations in
accounting for all stock option plans. Accordingly, no compensation expense
has been recognized for stock option awards. The following table illustrates
the effect on net income from continuing operations and earnings per share
had the Company applied the fair value recognition provisions of Statement
of Financial Accounting Standards (SFAS) No. 123, "Accounting for
Stock-Based Compensation," to stock option awards.
Three Months Ended Six Months Ended
April 30 April 30
------------------ -------------------
2004 2003 2004 2003
------- ------ ------- -------
Reported net income from continuing operations $18,323 $8,479 $34,066 $16,920
Total stock-based employee compensation expense
determined under the fair value method for all stock
option awards, net of income tax 517 648 558 653
------- ------ ------- -------
Pro forma net income from continuing operations $17,806 $7,831 $33,508 $16,267
======= ====== ======= =======
Earnings per share from continuing operations:
Basic - as reported $ 0.71 $ 0.35 $ 1.34 $ 0.71
======= ====== ======= =======
Basic - pro forma $ 0.69 $ 0.32 $ 1.31 $ 0.68
======= ====== ======= =======
Diluted - as reported $ 0.66 $ 0.33 $ 1.23 $ 0.67
======= ====== ======= =======
Diluted - pro forma $ 0.64 $ 0.31 $ 1.21 $ 0.64
======= ====== ======= =======
Historically, options granted have been fully vested at grant date.
The fair value of
7
options at the grant date was estimated using the Black-Scholes model with
the following weighted average assumptions for the three and six months
ended April 30, 2004 and 2003: an expected life of 1.5 years, volatility of
36% and 51%, a dividend yield of 0.12% and 0.16% and a risk-free interest
rate of 3.25% and 3.74%, respectively. The weighted average fair value of
options granted in the three and six months ended April 30, 2004 and 2003
was $7.55 and $5.11, respectively.
NOTE D - ACQUISITIONS
On May 1, 2003, the Company acquired all of the outstanding common
stock of TAMSCO, a provider of information technology logistics and
digitization services and a designer and integrator of telecommunication
systems primarily for the U.S. Department of Defense (DoD). The purchase
price was approximately $71.1 million, which is net of $0.1 million of cash
acquired. Approximately $1.1 million of the purchase price has not yet been
paid subject to final collection of accounts receivable. In connection with
this transaction, the Company also assumed and paid $14.9 million of TAMSCO
indebtedness. The purchase of TAMSCO, net of cash acquired, totals $84.9
million, which represents the $71.1 million purchase price plus assumed
indebtedness of $14.9 million and less $1.1 million of purchase price not
yet paid. ($84.9 million of purchase price paid through April 30, 2004
represents $77.4 million paid during the Company's year ended October 31,
2003 plus an additional $7.5 million, related to tax adjustments and
accounts receivable collection, paid during the six months ended April 30,
2004).
The initial purchase price allocation for TAMSCO was based on
preliminary information, which was subject to adjustment upon obtaining
complete valuation information. During the second quarter of 2004, the
Company obtained the final valuation report from an independent third party
valuation firm of the assets acquired and liabilities assumed. As a result,
the Company reclassified $29.9 million from goodwill, as recorded in the
preliminary allocation, to acquired customer-related intangibles and
recorded a $2.2 million non-cash charge in the quarter ended April 30, 2004
to reflect the related amortization expense from acquisition date. The fair
value of assets acquired, including goodwill of $36.1 million and acquired
customer-related intangibles of $29.9 million, was $103.9 million and
liabilities assumed totaled $32.8 million.
The following unaudited pro forma summary presents the combined
historical results of operations for the three and six month periods ended
April 30, 2003 as adjusted to reflect the TAMSCO purchase transaction
assuming the acquisition had occurred at November 1, 2002. These pro forma
results are not necessarily indicative of the combined results that would
have occurred had the acquisition actually taken place on November 1, 2002,
nor are they necessarily indicative of the combined results that may occur
in the future.
8
Three Months Ended Six Months Ended
April 30, 2003 April 30, 2003
------------------ ----------------
Net revenues $166,150 $326,674
======== ========
Net income from continuing operations $ 8,765 $ 19,125
======== ========
Basic earnings per share from continuing
operations $ 0.36 $ 0.80
======== ========
Diluted earnings per share from continuing
operations $ 0.34 $ 0.75
======== ========
On December 5, 2003, the Company acquired all of the outstanding
stock of Pivotal Power, a supplier of high-performance static power
conversion equipment primarily to military customers. The purchase price was
approximately $10.1 million, net of cash acquired. The purchase price was
financed with short-term borrowings under the Company's revolving credit
facility. The fair value of assets acquired, including goodwill of $6.0
million, was $11.6 million and liabilities assumed totaled $1.5 million.
This allocation is preliminary and subject to final valuation and
adjustment.
On September 24, 2003, the Company acquired all of the outstanding
common stock of EEI, a designer and manufacturer of specialized
environmental control units and heat transfer systems for defense and
industrial markets. The purchase price was approximately $15.6 million. The
purchase price was financed with short-term borrowings under the Company's
revolving credit facility. The purchase of EEI, net of cash acquired,
totaled $16.7 million, which represents the $15.6 million purchase price
plus assumed indebtedness of $1.1 million. The fair value of assets
acquired, including goodwill of $14.4 million, was $19.8 million and
liabilities assumed totaled $4.3 million. This allocation is preliminary and
subject to final valuation and adjustment.
On June 27, 2002, the Company acquired all of the outstanding
common stock of UPSI, a provider of uninterruptible power supply systems for
the DoD, intelligence agencies and commercial customers. The purchase price
was approximately $5.5 million plus certain contingent cash consideration
based upon UPSI's net revenue levels through two measurement dates, December
31, 2002 and October 31, 2003. Based upon UPSI's net revenue through the
December 31, 2002 measurement date, $5.0 million of cash consideration was
added to purchase price and paid during the year ended October 31, 2003.
Based upon UPSI's net revenue through the October 31, 2003 measurement date,
$2.0 million of cash consideration was added to purchase price and paid in
December 2003. The fair value of the assets acquired, including goodwill of
$12.5 million, was $13.6 million and liabilities assumed totaled $1.1
million. The purchase price was financed with short-term borrowings under
the Company's revolving credit facility.
TAMSCO is included in the Support Services segment. Pivotal Power,
EEI and UPSI are included in the Support Systems segment. The operating
results of each are included in consolidated operations since their
respective dates of acquisition.
9
NOTE E - OTHER COMPREHENSIVE INCOME (LOSS)
The Company's other comprehensive income (loss) for the three months
ended April 30, 2004 and 2003 was $(159) and $0, respectively. The Company's
other comprehensive income (loss) for the six months ended April 30, 2004
and 2003 was $(222) and $177, respectively. The components of other
comprehensive income (loss) include a minimum pension liability adjustment,
a currency translation adjustment and an adjustment to the fair value of
derivatives.
NOTE F - INTANGIBLE ASSETS
The following disclosure presents certain information on the
Company's acquired intangible assets as of April 30, 2004 and October 31,
2003. All acquired intangible assets are being amortized over their
estimated useful lives with no estimated residual values.
Weighted Average
Amortization Gross Accumulated Net
Period Amount Amortization Amount
------ ------ ------------ ------
Customer-related intangibles:
April 30, 2004 12.1 years $45,159 $7,831 $37,328
October 31, 2003 5.4 years 15,300 4,251 11,049
The amortization expense related to acquired intangible assets was
$2,870 for the three months ended April 30, 2004 and $3,580 for the six
months ended April 30, 2004. Amortization expense related to acquired
intangible assets totaled $710 for the three months ended April 30, 2003 and
$1,420 for the six months ended April 30, 2003. Related estimated
amortization expense is $5,982 for the year ending October 31, 2004, $4,821
for the years ending October 31, 2005 and 2006, $4,453 for the year ending
October 31, 2007 and approximately $1,800 for the years ending October 31,
2008 through October 31, 2018.
NOTE G - OPERATIONAL RESTRUCTURING
During the quarter ended April 30, 2003, the Company announced a
restructuring plan under which the electronics assembly work performed at
the Company's Sanford, Florida facility of its SEI subsidiary would be
relocated to alternate SEI facilities. Statement of Financial Accounting
Standards No. 146 (SFAS 146), "Accounting for Costs Associated with Exit or
Disposal Activities", applies to all disposal activities initiated after
December 31, 2002 and prospectively nullifies EITF 94-3. SFAS 146 requires
that a liability for employee termination costs associated with an exit or
disposal activity be recognized when the liability is incurred. (EITF 94-3
had previously required that a liability for such costs be recognized at the
date of the Company's commitment to
10
an exit or disposal plan). The Company recorded expense related to this plan
of $2.1 million during the year ended October 31, 2003, consisting of $1.2
million for severance and related benefits and $0.9 million for non-cash
costs. The Company anticipates that it will record no additional
restructuring expense related to this plan for periods ending after April
30, 2004. The plan involved the termination of 106 employees, all of which
were terminated as of April 30, 2004.
During the six months ended April 30, 2004, the Company recorded the
following costs in connection with this restructuring plan.
Accrued at Accrued at
October 31 April 30
2003 Expensed Utilized 2004
---- -------- -------- ----
Severance and related benefits $983 $66 $995 $54
==== === ==== ===
NOTE H - DISCONTINUED OPERATIONS
During the second quarter of 2002, the Company formally adopted a
plan to dispose of Engineered Specialty Plastics, Inc. (ESP), a wholly-owned
subsidiary representing the entirety of the Plastic Products business
segment. The Company completed the sale of ESP in the quarter ended April
30, 2003 to a private equity group. Consideration received by the Company
included $4.1 million of cash, a $3.3 million two-year note from the buyers
secured by the real property of ESP, and contingent consideration based upon
ESP's future revenues, net of a $0.8 million working capital adjustment paid
by the Company. In conjunction with the intended disposition of ESP, the
Company had previously recorded an estimated loss on disposal of
discontinued operations of $4.2 million during the year ended October 31,
2002 to reduce the carrying value of ESP's net assets to their estimated
fair value less estimated selling costs. The completion of the sale resulted
in an additional $0.2 million loss on disposal during the year ended October
31, 2003. The Company has reported the results of operations of ESP as
discontinued operations for the three and six month periods ended April 30,
2003 in the Condensed Consolidated Statements of Income.
Certain information with respect to the discontinued operations of
ESP is as follows:
Three Months Ended Six Months Ended
April 30, 2003 April 30, 2003
------------------ ----------------
Net revenues $4,010 $9,136
====== ======
Income (loss) on discontinued operations,
net of income tax $ 157 $ 294
====== ======
11
NOTE I - NOTES PAYABLE
Effective April 23, 2003, the Company retired all borrowings under
its existing credit facility and entered into a new bank agreement which
provided a $125 million unsecured, revolving credit facility. Borrowings
under the new agreement, which expires April 23, 2007, are subject to
interest, at the Company's option, at either the Eurodollar rate plus an
applicable margin or at the prime rate plus an applicable margin. The margin
applicable to the Eurodollar rate varies from 0.875% to 1.625% and the
margin applicable to the prime rate varies from 0.0% to 0.25% depending upon
the Company's ratio of total indebtedness to earnings before interest,
taxes, depreciation and amortization (leverage ratio). As of April 30, 2004,
the Company had borrowings of $56.0 million against the new revolving credit
facility.
NOTE J - CONTRACTS IN PROCESS AND INVENTORIES
Contracts in process and inventories of certain of the Company's
operating subsidiaries (SEI, Engineered Air, Keco, Fermont, Radian, TAMSCO
and Pivotal Power) represent accumulated contract costs, estimated earnings
thereon based upon the percentage of completion method and contract
inventories reduced by the contract value of delivered items. Inventories of
Marlo Coil, UPSI and EEI are valued at the lower of cost or market using the
first-in, first-out method. Contracts in process and inventories are
comprised of the following:
April 30, 2004 October 31, 2003
-------------- ----------------
Raw materials $ 2,407 $ 2,669
Work-in-process 3,999 2,332
Finished goods 497 185
Inventories substantially applicable to
government contracts in process, less
progress payments of $72,779 and
$55,010 58,944 45,773
------- -------
$65,847 $50,959
======= =======
NOTE K - SEGMENT INFORMATION
The Company operates in two business segments: Support Systems and
Support Services. The Support Systems segment designs, engineers and
manufactures integrated military electronics and other military support
equipment primarily for the DoD, as well as related heat transfer and air
handling equipment for domestic commercial and industrial users, and
material handling equipment primarily for the U.S. Postal Service. Segment
products include environmental control systems, load management and
transport systems, power generation, distribution and conditioning systems,
airborne radar systems, reconnaissance, surveillance and target acquisition
systems, chemical and biological protection systems, petroleum and water
distribution systems and other
12
multipurpose military support equipment. The Support Services group provides
engineering services, logistics and training services, advanced technology
services, asset protection systems and services, telecommunication systems
integration and information technology services primarily for the DoD. The
Support Services segment also provides certain power generation and
distribution equipment to the DoD.
The Company previously defined its business segments as Light
Military Support Equipment, Heavy Military Support Equipment and Electronics
and Automation Systems. With the Company's entry into the services area
through the acquisitions of Radian on May 10, 2002 and TAMSCO on May 1,
2003, the growth of the Company's logistics support capabilities and the
continuing rationalization of its operations, the Company has reorganized
into the Support Systems and Support Services segments from the previous
three segments. The new reporting structure reflects how the Company manages
operations, reports results and allocates resources.
Total assets at April 30, 2004, by segment were $289,988 for Support
Systems and $194,534 for Support Services. Goodwill by segment as of April
30, 2004 totaled $104,374 for Support Systems and $67,826 for Support
Services.
The differences in net revenues between the accompanying condensed
consolidated statements of income and the reporting segment information as
presented below are due to certain reclassifications made to categorize net
revenues by their functional nature, as required, on the face of the
financial statements.
Three Months Ended Six Months Ended
April 30 April 30
----------------------- ------------------------
2004 2003 2004 2003
---- ---- ---- ----
Net Revenues:
Support Systems $130,034 $101,050 $241,828 $197,800
Support Services 86,515 24,758 175,657 50,240
Intersegment Revenues (6,413) (751) (12,219) (1,320)
-------- -------- -------- --------
Total $210,136 $125,057 $405,266 $246,720
======== ======== ======== ========
Operating Income from Continuing Operations:
Support Systems $ 28,340 $ 11,163 $ 47,322 $ 23,261
Support Services 1,657 2,960 8,922 5,101
-------- -------- -------- --------
29,997 14,123 56,244 28,362
Interest expense, net (203) (223) (847) (630)
Gain (loss) on sale of assets (1) (5) 6
-------- -------- -------- --------
Income from continuing operations
before income taxes $ 29,793 $ 13,900 $ 55,392 $ 27,738
======== ======== ======== ========
13
NOTE L - SHAREHOLDERS' EQUITY
The following summary presents a reconciliation of total
shareholders' equity from October 31, 2003 to April 30, 2004:
Balance at October 31, 2003 $197,167
Comprehensive income:
Net income 34,066
Currency translation adjustments (222)
--------
Total comprehensive income 33,844
--------
Cash dividends (453)
Exercise of stock options 37,826
Issuance of common stock 1,280
Issuance of treasury stock 1,938
--------
Balance at April 30, 2004 $271,602
========
NOTE M - PENSION AND OTHER POSTRETIREMENT BENEFITS
The following tables detail the amount of net periodic benefit cost
recognized related to the Company's pension and other postretirement
benefits for the three and six month periods ended April 30, 2004 and 2003.
Three Months Ended
April 30
----------------------------------------------------
Other
Pension Benefits Postretirement Benefits
---------------------- -----------------------
2004 2003 2004 2003
---- ---- ---- ----
Service cost $ 706 $ 546 $ 71 $ 59
Interest cost 1,743 1,255 169 155
Expected return on plan assets (1,823) (1,257)
Amortization of prior service cost 148 92
Actuarial loss (gain) 641 268 110 74
Other 7
------- ------- ---- ----
$ 1,415 $ 911 $350 $288
======= ======= ==== ====
14
Six Months Ended
April 30
------------------------------------------------------
Other
Pension Benefits Postretirement Benefits
---------------------- -----------------------
2004 2003 2004 2003
---- ---- ---- ----
Service cost $ 1,412 $ 1,089 $142 $118
Interest cost 3,486 2,509 337 309
Expected return on plan assets (3,646) (2,515)
Amortization of prior service cost 297 176
Actuarial loss (gain) 1,282 536 221 148
Other 14
------- ------- ---- ----
$ 2,831 $ 1,809 $700 $575
======= ======= ==== ====
As of April 30, 2004, $3,850 of contributions have been made to
pension and other postretirement benefit plans. The Company anticipates
contributing an additional $4,179 to fund the pension and other postretirement
benefit plans in 2004 for a total of $8,029.
15
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
CRITICAL ACCOUNTING POLICIES
Refer to Management's Discussion and Analysis of Financial
Condition and Results of Operations from the Company's 2003 Annual Report to
Shareholders into the Company's Annual Report on Form 10-K for the period
ended October 31, 2003 for a discussion of the critical accounting policies
which we believe are most difficult, subjective or complex.
The following analysis should be read in this context.
RESULTS OF OPERATIONS
Consolidated net revenues from continuing operations increased
$85.1 million, or 68.0%, to $210.1 million in the second quarter of 2004
compared to $125.0 million in the second quarter of 2003. The increase was
primarily due to the inclusion of the results of the Company's most recent
acquisitions combined with solid organic revenue growth. Technical and
Management Services Corporation (TAMSCO), Engineered Environments, Inc.
(EEI) and Pivotal Power Inc. (Pivotal Power), each acquired within the past
twelve months, generated net revenues (prior to the exclusion of
intersegment revenues) of $59.3 million, $2.7 million and $2.0 million,
respectively, during the second quarter of 2004. All other operating
subsidiaries contributed a combined 16.9% increase in net revenues during
the quarter. Gross profit from continuing operations for the three months
ended April 30, 2004 increased $23.6 million, or 79.3%, to $53.4 million
(25.4% of consolidated net revenues) from $29.8 million (23.8% of
consolidated net revenues) in the comparable 2003 period. Contributions from
the above recent acquisitions totaling $7.2 million, coupled with higher
revenues and overall improved gross margins at existing business units,
primarily within the Support Systems segment, drove the increase in gross
profit. Selling, general and administrative expense from continuing
operations increased $8.9 million, or 61.7%, in the second quarter of 2004
to $23.4 million (11.1% of consolidated net revenues) from $14.5 million
(11.6% of consolidated net revenues) in the second quarter of 2003. Selling,
general and administrative expense for TAMSCO, EEI and Pivotal Power
accounted for $7.4 million of the $8.9 million increase. During the second
quarter of 2003, the Company recorded a restructuring expense of $1.2
million related to its plan to relocate electronics assembly work performed
at the Company's Sanford, Florida facility of its Systems & Electronics Inc.
(SEI) subsidiary to alternate SEI facilities. As a result of the above,
operating income from continuing operations increased $15.9 million, or
112.4%, in the quarter ended April 30, 2004 to $30.0 million from $14.1
million in the second quarter of 2003.
Consolidated net revenues from continuing operations increased $158.5
million, or 64.3%, to $405.3 million in the six months ended April 30, 2004
compared to $246.7 million in the first half of 2003. This increase was
primarily due to the inclusion of the results of the Company's most recent
acquisitions combined with solid organic revenue growth. TAMSCO, EEI and
Pivotal Power generated net revenues (prior to the exclusion of intersegment
revenues) of $114.6 million, $7.1 million and $3.1 million, respectively,
during the six months ended April 30, 2004. All other operating subsidiaries
contributed a combined 13.7% increase in net revenues during the first half
of 2004. Gross profit from continuing operations for the six months ended
April 30, 2004 increased $42.8 million, or 75.1%, to $99.7 million (24.6% of
consolidated net revenues) from $56.9 million (23.1% of consolidated net
revenues) in the comparable 2004 period.
16
Again, contributions from the acquisitions of TAMSCO, EEI and Pivotal Power
totaling $15.9 million, along with higher revenues and overall improved
gross margins at existing business units, primarily within the Support
Systems segment, drove the increase in gross profit. Selling, general and
administrative expense from continuing operations increased $16.0 million,
or 58.5%, in the six months ended April 30, 2004 to $43.4 million (10.7% of
consolidated net revenues) from $27.4 million (11.1% of consolidated net
revenues) in the first half of 2003. Selling, general and administrative
expense for TAMSCO, EEI and Pivotal Power accounted for $11.8 million of the
$16.0 million increase. During the second quarter of 2003, the Company
recorded a restructuring expense of $1.2 million related to its plan to
relocate electronics assembly work performed at the Company's Sanford,
Florida facility of its Systems & Electronics Inc. (SEI) subsidiary to
alternate SEI facilities. As a result of the above, operating income from
continuing operations increased $27.9 million, or 98.3%, in the six months
ended April 30, 2004 to $55.4 million from $28.3 million in the first half
of 2003.
SUPPORT SYSTEMS. Net revenues in the second quarter of 2004 for the
Support Systems segment totaled $130.0 million compared to $101.0 million
(prior to the elimination of intersegment revenues in each period) for the
same period in the prior year, a 28.7% increase. The improved results
reflect the inclusion of a combined $4.7 million in net revenues from EEI
and Pivotal Power during the second quarter and overall higher revenues at
existing business units. Net organic revenue growth for the Support Systems
segment during the second quarter totaled $25.3 million, an increase of
25.0%. The programs with the largest revenue gains during the quarter
include $7.0 million from the Field Deployable Environmental Control Unit
(FDECU), which is deployed extensively in worldwide U.S. military
operations, and $18.2 million from the Manportable Surveillance and Target
Acquisition Radar (MSTAR), which is serving a wide range of defense
applications including base perimeter security. Comparatively lower revenue
levels on the Tunner 60K Aircraft Cargo Loader/Transporter of $9.5 million
partially offset these increases for the period. Gross profit for the
segment increased by $18.1 million, or 76.4%, in the three months ended
April 30, 2004 to $41.8 million (32.1% of segment revenues) from $23.7
million (23.4% of segment revenues) primarily on the strength of significant
revenue increases. Quarterly operating income for the segment climbed to
$28.3 million (21.8% of segment revenues) compared to $11.2 million (11.0%
of segment revenues) last year. Incremental gross profit contributions, cost
savings realized under the Company's facility rationalization initiatives
and the absorption of corporate overhead costs by the Support Services
business segment led to the improved results for the Support Systems
segment.
Net revenues in the six months ended April 30, 2004 for the Support
Systems segment totaled $241.8 million compared to $197.8 million (prior to
the elimination of intersegment revenues in each period) for the first six
months of 2003. The improved results reflect the inclusion of a combined
$10.2 million in net revenues from EEI and Pivotal Power during the six
months ended April 30, 2004 and overall higher revenues at existing business
units. Net organic revenue growth for the Support Systems segment during the
first half of 2004 totaled $33.8 million, an increase of 17.1%. Again,
significant revenue gains from the FDECU ($14.9 million) and MSTAR ($30.8
million) programs were prime contributors to this increase. Gross profit for
the segment increased by $28.1, or 61.4%, in the six months ended April 30,
2004 to $73.9 million (30.5% of segment revenues) compared to $45.8 million
(23.2% of segment revenues) last year primarily on the strength of
significant revenue increases. Quarterly operating
17
income for the segment increased to $47.3 million (19.6% of segment
revenues) compared to $23.3 million (11.8% of segment revenues) in the prior
year. Again, incremental gross profit contributions, cost savings realized
under the Company's facility rationalization initiatives and the absorption
of corporate overhead costs by the Support Services business segment led to
the improved results for the Support Systems segment.
SUPPORT SERVICES. Net revenues of the Support Services segment
increased to $86.5 million, an increase of $61.8 million, or 249.4%,
compared to $24.8 million (prior to the elimination of intersegment revenues
in each period) for the second quarter of 2003, principally due the
inclusion of results from TAMSCO ($59.3 million in revenues). TAMSCO's
revenues were above previous forecasts by the Company primarily due to
additional activity under the eight-year, $2.9 billion ceiling Rapid
Response (R2) contract. Net organic revenue growth for the Support Services
segment grew 10.1% during the second quarter. This growth was generated in
spite of comparatively lower revenues from the Company's Deployable Power
Generation and Distribution System (DPGDS) related to the timing of order
receipt and delivery requirements. DPGDS revenues are anticipated to be
significantly higher in the second half of 2004. Gross profit for the
segment increased by $5.5 million, or 90.2%, in the three months ended April
30, 2004 to $11.6 million (13.5% of segment revenues) from $6.1 million
(24.7% of segment revenues). Task orders awarded under the R2 contract for
goods and services typically carry a lower fee, or mark-up, than those
projects that contain a high level of labor content. The initial purchase
price allocation for TAMSCO was based on preliminary information, which was
subject to adjustment upon obtaining complete valuation information. During
the second quarter of 2004, the Company obtained the final valuation report
from an independent third party valuation firm of the assets acquired and
adjustments assumed. As a result, the Company reclassified $29.9 million
from goodwill, as recorded in the preliminary allocation, to acquired
customer-related intangibles and recorded a $2.2 million non-cash charge in
the quarter ended April 30, 2004 to reflect amortization expense from
acquisition date. Segment operating income for the first quarter of 2004
totaled $1.7 million (1.9% of segment revenues) compared to $3.0 million
(12.0% of segment revenues) in the same period last year.
Net revenues for the Support Services segment increased to $175.7
million, an increase of $125.4 million, or 249.6%, compared to $50.3 million
(prior to the elimination of intersegment revenues in each period) for the
first half of 2003, principally due to the inclusion of results from TAMSCO
($114.6 million in revenues). TAMSCO's revenues for the six months ended
April 30, 2004 were above Company forecasts primarily due to additional
activity under the R2 contract. Net organic revenue growth for the Support
Services segment grew 21.5% during the first six months of 2004, primarily
as a result of Radian's security and asset protection service offerings and
a significant increase in ESSIbuy revenues. Gross profit for the segment
increased by $14.7 million, or 132.3%, in the six months ended April 30,
2004 to $25.8 million (14.7% of segment revenues) from $11.1 million (22.1%
of segment revenues) in the prior year. Task orders awarded under the R2
contract typically carry a lower fee, or mark-up, than those projects that
contain a high level of labor content.
18
Segment operating income for the first six months of 2004 totaled $8.9
million (5.1% of segment revenues) compared to $5.1 million (10.2% of
segment revenues) in the same period last year.
Net interest expense was approximately the same in both the second
quarter of 2004 and of 2003, and increased by $0.2 million to $0.8 million
in the six months ended April 30, 2004, reflecting comparable average
borrowing levels during these periods as significant operating cash flows
offset the financing requirements of acquisition activities. The effective
income tax rate was 38.5% for the three and six month periods ended April
30, 2004 and was 39.0% for the three and six month periods ended April 30,
2003. As a result of the foregoing, net income from continuing operations
increased 116.1% to $18.3 million (8.7% of consolidated net revenues) in the
quarter ended April 30, 2004 as compared to $8.5 million (6.8% of
consolidated net revenues) in the second quarter of 2003. For the six months
ended April 30, 2004, net income from continuing operations increased 101.3%
to $34.1 million (8.4% of consolidated net revenues) from $16.9 million
(6.9% of consolidated net revenues) for the first half of 2003.
During the second quarter of 2002, the Company formally adopted a
plan to dispose of ESP. The Company completed the sale of ESP in the quarter
ended April 30, 2003 to a private equity group. In conjunction with this
plan, the Company has recorded an estimated loss, net of income tax, of $4.2
million during the year ended October 31, 2002. The completion of the sale
resulted in an additional $0.2 million loss on disposal during the year
ended October 31, 2003.
Based on second quarter results, existing backlog and anticipated
orders, the Company anticipates that 2004 revenues will approximate $840
million, and that earnings per share will approximate between $2.65 and
$2.70.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In December 2003, the FASB issued a revision to Interpretation 46
(FIN 46R) to clarify some of the provisions of FASB Interpretation No. 46,
"Consolidation of Variable
19
Interest Entities," and to exempt certain entities from its requirements.
The adoption of FIN 46R will not have a material impact on the Company's
financial statements as it does not maintain any of the interests governed
by this pronouncement.
In December 2003, the Medicare Prescription Drug, Improvement and
Modernization Act of 2003 (the Act) became law in the U.S. The act
introduces a prescription drug benefit under Medicare, as well as a federal
subsidy to sponsors of retiree health care benefit plans that provide
retiree benefits in certain circumstances. It is not yet clear what impact,
if any, the new legislation will have on the Company's postretirement health
care plans. The accumulated postretirement benefit obligation (APBO)
reflected in the other liabilities section of the accompanying consolidated
balance sheet, and the net periodic postretirement benefit cost (NPPBC)
reflected in the accompanying consolidated statement of earnings do not
reflect the effects, if any, of the Act.
LIQUIDITY AND CAPITAL RESOURCES
On April 16, 2003, the Company completed the sale of ESP to a private
equity group. Consideration received by the Company included $4.1 million of
cash, a $3.3 million two-year note from the buyers secured by the real
property of ESP, and contingent consideration based upon ESP's future
revenues, net of a $0.8 million working capital adjustment paid by the
Company.
Effective April 23, 2003, the Company retired all borrowings under
its existing credit facility and entered into a new bank agreement which
provided a $125 million unsecured, revolving credit facility. Borrowings
under the new agreement, which expires April 23, 2007, are subject to
interest, at the Company's option, at either the Eurodollar rate plus an
applicable margin or at the prime rate plus an applicable margin. The margin
applicable to the Eurodollar rate varies from 0.875% to 1.625% and the
margin applicable to the prime rate varies from 0.0% to 0.25% depending upon
the Company's ratio of total indebtedness to earnings before interest,
taxes, depreciation and amortization (leverage ratio). As of April 30, 2004,
the Company had borrowings of $56.0 million against the revolving credit
facility and a cash balance of $21.7 million.
Effective December 5, 2003, the Company acquired all of the
outstanding stock of Pivotal Power, Inc. (Pivotal Power), a supplier of high
performance static power conversion equipment primarily to military
customers. The purchase price of Pivotal Power, net of cash acquired,
required $10.1 million in cash which the Company financed with short-term
borrowings under its revolving credit facility.
At April 30, 2004, the Company's working capital and ratio of current
assets to current liabilities were $33.1 million and 1.19 to 1 as compared
with $(30.1) million and 0.84 to 1 at October 31, 2003. The Company
generated cash from continuing operations of $20.7 million in the six months
ended April 30, 2004 as compared to generating $48.3 million of cash flow
from continuing operations in the first six months of 2003. This decrease in
operating cash flows was a result of a significant growth in accounts
receivable and contract inventories relating to the Company's increasing
revenue base
20
and to the contractual requirements of certain programs. Investment in
property, plant and equipment totaled $4.1 million and $5.3 million for the
first six months of 2004 and 2003, respectively. The Company anticipates
that capital expenditures in 2004 should not exceed $10.0 million.
Management believes that cash flow generated from operations, together with
the available line of credit, will provide the necessary resources to meet
the needs of the Company in the foreseeable future.
There have been no material changes in the total contractual and
contingent obligations included in the Company's annual report to
shareholders for the year ended October 31, 2003.
BUSINESS AND MARKET CONSIDERATIONS
Approximately 97% of consolidated net revenues from continuing
operations for the six months ended April 30, 2004 were directly or
indirectly derived from defense orders by the U.S. government and its
agencies. As of April 30, 2004, the Company's funded backlog of orders
totaled $695.1 million, with related customer options of an additional
$775.3 million. These amounts compare to funded backlog of $533.4 million
and related customer options of an additional $922.7 million as of October
31, 2003.
Management continues to pursue potential acquisitions, primarily of
those companies providing strategic consolidation within the defense
industry.
FORWARD-LOOKING STATEMENTS
In addition to historical information, this report includes certain
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, which are intended to be covered by the
safe harbors created thereby. The forward-looking statements involve certain
risks and uncertainties, including, but not limited to acquisitions,
additional financing requirements, the decision of any of the Company's key
customers (including the U.S. government) to reduce or terminate orders with
the Company, cutbacks in defense spending by the U.S. government and
increased competition in the Company's markets, which could cause the
Company's actual results to differ materially from those projected in, or
inferred by, the forward-looking statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Market risks relating to the Company's operations result primarily
from changes in interest rates. In order to manage this risk, the Company
periodically converts its variable-rate debt to fixed rates via interest
rate swaps. In November 2002, Company interest rate swaps on $23.6 million
of variable-rate debt, matured. Given outstanding debt levels, significant
cash flows and anticipated expenditures during fiscal years 2003 and 2004,
Company management has not utilized interest rate swaps or other derivative
contracts to hedge this risk since November 2002. Management does not
believe its
21
exposure to interest rate fluctuations has had, or will have, a significant
impact on the Company's operations.
ITEM 4. CONTROLS AND PROCEDURES.
As of April 30, 2004, the Company carried out an evaluation, under
the supervision and with the participation of the Company's management,
including the Company's Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of the Company's disclosure
controls and procedures as defined in Rules 13a-14(c) and 15d-14(c) under
the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based
upon the evaluation, the Company's Chief Executive Officer and Chief
Financial Officer concluded that the Company's disclosure controls and
procedures are effective. Disclosure controls and procedures are controls
and procedures that are designed to ensure that information required to be
disclosed in Company reports filed or submitted under the Exchange Act is
recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commission's rules and forms.
There have been no significant changes in the Company's internal
controls or in other factors that could significantly affect those controls
subsequent to the date this evaluation was carried out, including any
corrective actions with regard to significant deficiencies and material
weakness.
22
PART II
OTHER INFORMATION
Items 1-5 Not applicable.
Item 6 Exhibits and Reports on Form 8-K.
(a) Exhibits
11. Statement Re: Computation of Earnings Per Share
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
(b) During the quarter ended April 30, 2004, the
Company filed the following reports on Form 8-K:
(1) Form 8-K dated March 1, 2004
regarding release of the Company's financial results for
the three months ended January 31, 2004
23
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ENGINEERED SUPPORT SYSTEMS, INC.
Date: June 14, 2004
-------------
By: /s/ Gerald E. Daniels
------------------------
Gerald E. Daniels
Vice Chairman and
Chief Executive Officer
Date: June 14, 2004
-------------
By: /s/ Gary C. Gerhardt
------------------------
Gary C. Gerhardt
Vice Chairman and Chief
Financial Officer
24