UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2006

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                               to

Commission file number 1-8533


GRAPHIC

DRS Technologies, Inc.

(Exact name of registrant as specified in its charter)

Delaware

 

13-2632319

(State or other jurisdiction of
incorporation or organization)

 

(IRS Employer Identification No.)

 

5 Sylvan Way, Parsippany, New Jersey 07054

(Address of principal executive offices)

(973) 898-1500

(Registrant’s telephone number, including area code)

 


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 and 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 o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated filer   x

 

Accelerated Filer   o

 

Non-accelerated filer   o

 

Indicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o   No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class

 

Outstanding at February 5, 2007

Common Stock - $0.01 par value

 

40,524,491

 

 




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES

Index to Quarterly Report on Form 10-Q
For the Quarter Ended December 31, 2006

 

 

 

Page

 

 

 

 

PART I—FINANCIAL INFORMATION

 

 

 

 

 

Item 1.

 

Financial Statements (unaudited)

 

 

 

 

 

 

 

Consolidated Balance Sheets—December 31, 2006 and March 31, 2006

 

 

1

 

 

 

 

Consolidated Statements of Earnings—Three and Nine Months Ended December 31, 2006 and 2005

 

 

2

 

 

 

 

Consolidated Statements of Cash Flows—Nine Months Ended December 31, 2006 and 2005

 

 

3

 

 

 

 

Notes to the Consolidated Financial Statements

 

 

4

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

35

 

 

Item 3.

 

Quantitative and Qualitative Disclosure about Market Risk

 

 

49

 

 

Item 4.

 

Controls and Procedures

 

 

49

 

 

 

 

PART II—OTHER INFORMATION

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

49

 

 

Item 1A.

 

Risk Factors

 

 

52

 

 

Item 6.

 

Exhibits

 

 

52

 

 

Signatures

 

 

53

 

 

 




PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(in thousands, except share and per-share data)

(Unaudited)

 

 

December 31,

 

March 31,

 

 

 

2006

 

2006

 

Assets

 

Current assets

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

$

49,551

 

 

$

1,293

 

Accounts receivable, net of allowance for doubtful accounts of $1,780

 

 

 

 

 

 

 

and $1,668 as of December 31, 2006 and March 31, 2006, respectively

 

 

503,097

 

 

432,678

 

Inventories, net

 

 

363,980

 

 

331,206

 

Prepaid expenses, deferred income taxes and other current assets

 

 

126,615

 

 

135,613

 

Total current assets

 

 

1,043,243

 

 

900,790

 

Property, plant and equipment, less accumulated depreciation of $170,377 and $138,324 at December 31, 2006 and March 31, 2006, respectively

 

 

225,091

 

 

220,506

 

Acquired intangible assets, net

 

 

205,099

 

 

231,139

 

Goodwill

 

 

2,633,965

 

 

2,608,068

 

Deferred income taxes and other noncurrent assets

 

 

57,243

 

 

58,616

 

Total assets

 

 

$

4,164,641

 

 

$

4,019,119

 

Liabilities and Stockholders’ Equity

 

Current liabilities

 

 

 

 

 

 

 

Current installments of long-term debt

 

 

$

5,150

 

 

$

4,622

 

Accounts payable

 

 

230,315

 

 

224,673

 

Accrued expenses and other current liabilities

 

 

478,978

 

 

471,068

 

Total current liabilities

 

 

714,443

 

 

700,363

 

Long-term debt, excluding current installments

 

 

1,854,509

 

 

1,828,771

 

Other liabilities

 

 

144,704

 

 

138,405

 

Total liabilities

 

 

2,713,656

 

 

2,667,539

 

Commitments and contingencies

 

 

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

 

 

Preferred stock, $10 par value per share. Authorized 2,000,000 shares; none issued at December 31, 2006 and March 31, 2006

 

 

 

 

 

Common Stock, $.01 par value per share. Authorized 100,000,000 shares; issued 40,471,698 and 39,912,541 shares at December 31, 2006 and March 31, 2006, respectively

 

 

405

 

 

399

 

Additional paid-in capital

 

 

1,090,420

 

 

1,076,786

 

Retained earnings

 

 

355,669

 

 

277,706

 

Accumulated other comprehensive earnings

 

 

4,491

 

 

3,885

 

Unamortized stock compensation

 

 

 

 

(7,196

)

Total stockholders’ equity

 

 

1,450,985

 

 

1,351,580

 

Total liabilities and stockholders’ equity

 

 

$

4,164,641

 

 

$

4,019,119

 

 

See Accompanying Notes to Consolidated Financial Statements.

1




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
(in thousands, except per-share data)

(Unaudited)

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

December 31,

 

December 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

Revenue:

 

 

 

 

 

 

 

 

 

Products sales

 

$

511,692

 

$

361,213

 

$

1,500,180

 

$

998,036

 

Services

 

168,669

 

28,277

 

521,984

 

91,843

 

Total revenues

 

680,361

 

389,490

 

2,022,164

 

1,089,879

 

Costs and expenses

 

603,734

 

344,663

 

1,808,664

 

971,417

 

Operating income

 

76,627

 

44,827

 

213,500

 

118,462

 

Interest income

 

370

 

2,283

 

868

 

6,228

 

Interest and related expenses

 

30,268

 

12,458

 

90,789

 

36,959

 

Other (income) expense, net

 

(71

)

134

 

1

 

446

 

Earnings before non-controlling interests and income taxes

 

46,800

 

34,518

 

123,578

 

87,285

 

Non-controlling interests

 

131

 

477

 

1,089

 

1,559

 

Earnings before income taxes

 

46,669

 

34,041

 

122,489

 

85,726

 

Income taxes

 

11,575

 

14,297

 

40,906

 

33,010

 

Net earnings

 

$

35,094

 

$

19,744

 

$

81,583

 

$

52,716

 

Net earnings per share of common stock:

 

 

 

 

 

 

 

 

 

Basic earnings per share:

 

$

0.88

 

$

0.71

 

$

2.05

 

$

1.91

 

Diluted earnings per share:

 

$

0.86

 

$

0.69

 

$

2.01

 

$

1.84

 

Dividends per common share

 

$

0.03

 

$

0.03

 

$

0.09

 

$

0.09

 

 

See Accompanying Notes to Consolidated Financial Statements.

2




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(in thousands)

(Unaudited)

 

 

Nine Months Ended

 

 

 

December 31,

 

 

 

2006

 

2005

 

Cash Flows from Operating Activities

 

 

 

 

 

Net Earnings

 

$

81,583

 

$

52,716

 

Adjustments to reconcile net earnings to cash flows from operating activities:

 

 

 

 

 

Depreciation and amortization

 

57,122

 

31,719

 

Share-based compensation

 

8,224

 

1,895

 

Deferred income taxes

 

2,959

 

(500

)

Inventory reserve and provision for doubtful accounts

 

963

 

766

 

Amortization and write-off of deferred financing fees

 

4,419

 

2,846

 

Other, net

 

(150

)

(439

)

Changes in assets and liabilities, net of effects from business combinations:

 

 

 

 

 

(Increase) decrease in accounts receivable

 

(69,498

)

22,844

 

Increase in inventories

 

(44,252

)

(37,053

)

Decrease (increase) in prepaid expenses and other current assets

 

13,863

 

(3,453

)

Increase in accounts payable

 

3,254

 

27,365

 

Decrease in accrued expenses and other current liabilities

 

(6,806

)

(30,876

)

Increase (decrease) in customer advances

 

7,619

 

(7,981

)

Decrease in pension and postretirement benefit liabilities

 

973

 

347

 

Other, net

 

1,381

 

(742

)

Net cash provided by operating activities

 

61,654

 

59,454

 

Cash Flows from Investing Activities

 

 

 

 

 

Capital expenditures

 

(38,113

)

(26,311

)

Payments pursuant to business combinations, net of cash acquired

 

(9,761

)

(54,489

)

Dispositions of property, plant and equipment

 

348

 

946

 

Other, net

 

60

 

22

 

Net cash used in investing activities

 

(47,466

)

(79,832

)

Cash Flows from Financing Activities

 

 

 

 

 

Return of advanced interest on senior subordinated notes

 

 

(1,986

)

Debt issuance costs

 

 

(681

)

Borrowings of long-term debt

 

30,459

 

 

Repayment of long-term debt

 

(3,423

)

(32,037

)

Excess tax benefit realized from share-based payment arrangements

 

2,258

 

 

Proceeds from stock option exercises

 

8,517

 

9,750

 

Dividends paid

 

(3,619

)

(2,508

)

Other

 

245

 

 

Net cash provided by (used in) financing activities

 

34,437

 

(27,462

)

Effect of exchange rates on cash and cash equivalents

 

(367

)

654

 

Net increase (decrease) in cash and cash equivalents

 

48,258

 

(47,186

)

Cash and cash equivalents, beginning of period

 

1,293

 

306,852

 

Cash and cash equivalents, end of period

 

$

49,551

 

$

259,666

 

 

See Accompanying Notes to the Consolidated Financial Statements.

3




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements
(Unaudited)

1.   Description of Business

DRS Technologies, Inc., its wholly-owned subsidiaries and its controlling interests (hereinafter, DRS or the Company) is a supplier of defense electronic products, systems and military support services. The Company provides high-technology products and services to all branches of the U.S. military, major aerospace and defense prime contractors, government intelligence agencies, international military forces and industrial markets. The Company focuses on several key areas of importance for the U.S. Department of Defense (DoD), such as intelligence, surveillance, reconnaissance, power management, advanced communications and network systems. DRS is a provider of thermal imaging devices, combat display workstations, electronic sensor systems, power systems, battlefield digitization systems, air combat training systems, mission recorders, deployable flight incident recorders, environmental and telecommunication systems, aircraft loaders, military trailers and shelters. The Company also provides support services to the military, including security and asset protection system services, telecommunication and information technology services, training and logistics support services for all branches of the U.S. armed forces, and certain foreign militaries, homeland security forces and selected government and intelligence agencies.

On October 2, 2006, the Company implemented a new organizational operating structure that realigned its three operating groups the Command, Control, Communications, Computer and Intelligence Group, the Surveillance & Recconnaisance (SR) Group and the Sustainment Systems & Services (S3) Group, into four operating segments. The four operating segments are the Command, Control, Communications, Computers and Intelligence (C4I) Segment, the Reconnaissance, Surveillance and Target Acquisition (RSTA) Segment, the Sustainment Systems (SS) Segment and the Technical Services (TS) Segment. All other operations, primarily our Corporate Headquarters, are grouped in Other. See Note 12 for a description of each segment. All prior-year amounts presented by segment have been reclassified to reflect the new operating segment structure.

2.   Basis of Presentation

The accompanying unaudited consolidated financial statements include all wholly-owned and majority-owned subsidiaries and a controlling interests of DRS. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of the Company, the interim consolidated financial information provided herein reflects all adjustments (consisting of normal and recurring adjustments) necessary for a fair presentation of the Company’s consolidated financial position as of December 31, 2006, the results of its operations for the three- and nine-month periods ended December 31, 2006 and 2005, and its cash flows for the nine-month periods ended December 31, 2006 and 2005. The results of operations and cash flows for the interim periods ended December 31, 2006 are not necessarily indicative of the results to be expected for the full year. Certain fiscal 2006 amounts have been reclassified to conform to the fiscal 2007 presentation. These interim Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements of the Company for the fiscal year ended March 31, 2006, included in the Company’s filing on Form 10-K for the year ended March 31, 2006.

The fiscal year-end consolidated balance sheet data was derived from the Company’s audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America.

4




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

3.   ESSI Acquisition

On January 31, 2006, DRS completed its acquisition of Engineered Support Systems, Inc. (ESSI) for $1.93 billion in cash and DRS common stock. ESSI, formerly headquartered in St. Louis, Missouri, is a supplier of integrated military electronics, support equipment and technical services focused on advanced sustainment and logistics support solutions for all branches of the U.S. armed services, major prime defense contractors, certain international militaries, homeland security forces and selected government and intelligence agencies. ESSI also produces specialized equipment and systems for commercial and industrial applications. The results of ESSI have been included in our financial statements since the date of acquisition.

In accordance with EITF 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”, the Company recorded a $5.7 million liability in the preliminary purchase price allocation in connection with a plan to involuntarily terminate approximately 190 employees of ESSI, as well as exit certain leased facilities. The Company expects payments to be substantially complete by the fourth quarter of fiscal 2007.

 

 

Balance at
March 31,

 

Nine Months Ended
December 31, 2006

 

Balance at
December 31,

 

 

 

2006

 

Additions

 

Payments

 

2006

 

 

 

 

 

(in thousands)

 

 

 

Employee severance and termination benefits

 

 

$

5,129

 

 

 

$

 

 

 

$

(4,363

)

 

 

$

766

 

 

Facility and other exit costs

 

 

 

 

 

554

 

 

 

(521

)

 

 

33

 

 

Total

 

 

$

5,129

 

 

 

$

554

 

 

 

$

(4,884

)

 

 

$

799

 

 

 

The Company finalized its valuation of certain tangible and acquired intangible assets and is in the process of finalizing certain other discrete purchase price allocation matters; thus the the preliminary allocation of purchase price will change, however, such change will not be material to the consolidated balance sheet. Our preliminary purchase price allocation as of December 31, 2006 has not changed materially from the allocation included in Note 2 to the Company’s consolidated financial statements for the fiscal year ended March 31, 2006 (see Note 6). The Company will complete the purchase price allocation in conjunction with its January 2007 accounting close.

4.   Share-Based Compensation

Adoption of SFAS 123R   In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation” (SFAS No. 123), and supercedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). SFAS 123R addresses the accounting for transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s

equity instruments or that may be settled by the issuance of such equity instruments. SFAS 123R requires companies to recognize compensation cost in an amount equal to the fair value of share-based awards expected to vest.

On April 1, 2006, DRS adopted SFAS 123R, as interpreted by SEC Staff Accounting Bulletin No. 107, using the modified prospective method. Under this method, the Company is required to record

5




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

compensation cost for the unvested portion of previously granted awards that were outstanding as of April 1, 2006. Results for prior periods have not been restated. The Company previously accounted for share-based compensation under the recognition and measurement principle of APB No. 25 and related interpretations. Prior to adopting SFAS 123R, no share-based compensation cost was reflected in net income for stock options, as stock options granted had an exercise price equal to the market value of the underlying common stock on the date of the grant. Also, prior to the SFAS 123R adoption, compensation cost for restricted stock and restricted stock units (collectively “non-vested stock”) was recorded based on the closing market value on the last trading day prior to the date of grant and forfeitures were accounted for as they occurred. Compensation cost for non-vested stock was charged to unamortized stock compensation in Stockholders’ equity and amortized to expense over the requisite vesting periods. With the adoption of SFAS 123R on April 1, 2006, unamortized stock compensation relating to previous grants of non-vested stock of $7.2 million was netted against additional paid-in capital and forfeitures of non-vested stock are estimated at the date of grant and adjusted as circumstances warrant. Additionally, prior to the adoption of SFAS 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as operating cash flows in the Consolidated Statement of Cash Flows. SFAS 123R requires excess tax benefits (i.e., the tax benefit recognized upon exercise of stock options in excess of the benefit recognized as compensation cost for those options) to be classified as financing cash flows in the Consolidated Statement of Cash Flows. Pursuant to SFAS 123R, tax benefits resulting from the exercise of stock options, which have been presented as operating cash flows prior to the adoption of SFAS 123R are not reclassified to financing activities, but rather continue to be presented as operating cash flows.

The adoption of SFAS 123R resulted in a non-cash credit to Other income (expense), net, for the cumulative effect of a change in accounting principle of $0.2 million related to the recognition of estimated forfeitures on non-vested stock, which was recorded in the three-month period ended June 30, 2006. The cumulative effect credit is immaterial for purposes of separate presentation on the Consolidated Statement of Earnings.

In the three- and nine-month periods ended December 31, 2006, we recorded total share-based costs related to stock options and non-vested stock of $2.8 million and $8.9 million, respectively. Such amounts were recognized in the consolidated financial statements as follows:

 

 

Three Months Ended
December 31,

 

Nine Months Ended
December 31,

 

 

 

    2006 

 

    2005    

 

   2006   

 

   2005   

 

 

 

(in thousands)

 

Total cost of share-based payment plans

 

$

2,833

 

 

$

791

 

 

 

$

8,883

 

 

 

$

1,895

 

 

Amounts capitalized in inventory

 

$

1,619

 

 

$

791

 

 

 

$

3,891

 

 

 

$1,895

 

 

Amounts charged against earnings for amounts previously capitalized in inventory

 

$

1,442

 

 

$

859

 

 

 

$

3,232

 

 

 

$

1,269

 

 

Amounts charged against earnings before income tax benefit

 

$

2,656

 

 

$

859

 

 

 

$

8,224

 

 

 

$

1,269

 

 

 

As a result of applying SFAS 123R to the Company’s stock options, DRS’s earnings before income taxes and net earnings for the three months ended December 31, 2006 were $1.2 million and $0.7 million lower, respectively, and for the nine months ended December 31, 2006 were $5.0 million and $3.0 million lower, respectively, than if the Company had continued to account for share-based compensation under APB No. 25. Basic and diluted earnings per share for the three months ended December 31, 2006 would

6




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

have been $0.90 per share and $0.88 per share, respectively, and for the nine months ended December 31, 2006 would have been $2.13 per share and $2.08 per share, respectively, if the Company had not adopted SFAS 123R. Reported amounts for the three months ended December 31, 2006 were $0.88 per basic share and $0.86 per diluted share, and for the nine months ended December 31, 2006 were $2.05 per basic share and $2.01 per diluted share.

Prior Period Pro Forma Information   Prior to April 1, 2006, the Company applied the
intrinsic-value-based method of accounting prescribed by APB 25, and its related interpretations. Compensation expense for stock options granted to an employee or director was recognized in earnings based on the excess, if any, of the quoted market price of DRS common stock at the date of grant, or other measurement date, over the amount an employee or director must pay to acquire the common stock. When the exercise price of the option granted to an employee or director equaled or exceeded the quoted market price of DRS common stock at the date of grant, the Company did not recognize compensation expense. Compensation cost for nonvested stock was recorded based on the market value of DRS common stock on the date of grant.

The table below compares the “as reported” net earnings and earnings per share to the “pro forma” net earnings and earnings per share for the three- and nine-month periods ended December 31, 2005, that the Company would have reported if it had elected to recognize compensation expense in accordance with the fair-value-based method of accounting of SFAS No. 123. For purposes of determining the pro forma effects of SFAS No. 123, the estimated fair value of options granted was calculated using the Black-Scholes option pricing valuation model. Forfeitures were accounted for as they occurred and no amount of stock option expense was capitalized into inventory or other assets, but instead were considered period expenses.

 

 

Three Months
Ended
December 31,

 

Nine Months
Ended
December 31,

 

 

 

2005

 

2005

 

 

 

(in thousands,
except per-share data)

 

Net earnings, as reported

 

 

$

19,744

 

 

 

$

52,716

 

 

Add: Stock-based compensation expense included in reported net earnings, net of taxes

 

 

478

 

 

 

1,145

 

 

Less: Total stock-based compensation expense determined under
fair-value-based method for all awards, net of taxes

 

 

(2,601

)

 

 

(6,860

)

 

Pro forma net earnings

 

 

$

17,621

 

 

 

$

47,001

 

 

Earnings per share:

 

 

 

 

 

 

 

 

 

Basic - as reported

 

 

$

0.71

 

 

 

$

1.91

 

 

Basic - pro forma

 

 

$

0.63

 

 

 

$

1.70

 

 

Diluted - as reported

 

 

$

0.69

 

 

 

$

1.84

 

 

Diluted - pro forma

 

 

$

0.61

 

 

 

$

1.65

 

 

 

Share-based Compensation Plans   On August 7, 1996, the stockholders approved the 1996 Omnibus Plan (1996 Plan). Under the terms of the Omnibus Plan, which expired on June 16, 2006, options could be granted to key employees, directors and consultants of the Company. The 1996 Plan initially was limited to 500,000 shares of DRS common stock and was ultimately increased, with stockholder approval, to

7




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

5,875,000 shares of DRS common stock. Awards under the 1996 Plan were at the discretion of the Executive Compensation Committee and could be made in the form of incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock and restricted stock units, phantom stock, stock bonuses and other awards. The Company has historically utilized newly issued shares of DRS common stock to satisfy its equity-based compensation awards.

On August 3, 2006, the stockholders approved the 2006 Omnibus Plan (2006 Plan) which has similar terms to that of the 1996 Omnibus Plan. The 2006 Omnibus Plan provides for the issuance of up to 4.0 million shares of DRS common stock.

Stock Options   Unless the Executive Compensation Committee expressly provides otherwise, options granted under the Omnibus Plan have a contractual term of ten years and generally are not exercisable prior to one year after the date of grant, with 25% of the options granted exercisable on each of the first four anniversaries of the date of grant. On July 6, 2005, the Company granted 209,500 stock options that

fully vested on March 31, 2006. In accordance with the July 6, 2005 stock option grant, recipients are required to hold any shares acquired upon exercise of the options prior to March 31, 2008 (net of any shares sold or withheld to pay the exercise price and any applicable statutory minimum federal, state and local tax requirements) for a period of one year following the date of exercise. The Company’s decision to modify its traditional vesting terms for the July 6, 2005 stock option grant was made pursuant to management’s evaluation of the Company’s overall incentive compensation strategy. As a part of the evaluation, management considered the amount of compensation expense that would otherwise have been recognized in the Company’s results of operations in future periods under SFAS 123R. The July 6, 2005 stock option grant had a $4.8 million impact on the Company’s fiscal 2006 pro forma pre-tax compensation expense.

During fiscal 1999, the Compensation Committee of the Board of Directors issued options to purchase 250,000 shares of DRS common stock with vesting terms similar to awards issued under the 1996 Plan at exercise prices in excess of the market price on the date of grant. During the quarter ended December 31, 2006, 70,000 of these options were exercised, the remaining options expire in fiscal 2009.

The stock options exercised during fiscal 2000 included 50,000 shares, which are being held by the Company in “book entry” form. Book entry shares are not considered issued or outstanding and are excluded from the tables below. However, these shares are included in the Company’s diluted earnings per share calculations for the three- and nine-month periods ended December 31, 2006 and 2005.

8




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

The following table summarizes information regarding the Company’s stock option activity and amounts as of and for the nine-month period ended December 31, 2006.

 

 

Number of
Options

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
Contractual
Term (years)

 

Aggregate
Intrinsic
Value
(in thousands)

 

Outstanding at March 31, 2006

 

2,913,358

 

 

$

29.08

 

 

 

 

 

 

 

 

 

 

Granted

 

232,412

 

 

$

49.49

 

 

 

 

 

 

 

 

 

 

Exercised

 

(370,274

)

 

$

23.11

 

 

 

 

 

 

 

 

 

 

Forfeited/cancelled

 

(148,090

)

 

$

36.80

 

 

 

 

 

 

 

 

 

 

Outstanding at December 31, 2006

 

2,627,406

 

 

$

31.31

 

 

 

   6.2   

 

 

 

$

56,159

 

 

Vested and expected to vest at December 31, 2006(1)

 

2,604,346

 

 

$

31.25

 

 

 

   6.2   

 

 

 

$

55,823

 

 

Exercisable at December 31, 2006

 

1,921,949

 

 

$

28.96

 

 

 

   5.5   

 

 

 

$

45,615

 

 


(1)Represents outstanding options reduced by expected forfeitures.

The aggregate intrinsic values, disclosed in the table above, represent the difference between DRS’s closing stock price on the last trading day of the third quarter (December 29, 2006) and the exercise price, multiplied by the number of in-the-money stock options for each category.

The total intrinsic values of stock options exercised, based on the difference between DRS’s stock price at the time of exercise and the related exercise price, during the nine months ended December 31, 2006 and 2005, was $9.5 million and $12.7 million, respectively. Total compensation expense related to stock options was $1.2 million and $5.0 million, for the three- and nine-month periods ended December 31, 2006, respectively. At December 31, 2006, unrecognized compensation costs related to stock options was $9.5 million ($5.7 million after income taxes), which is expected to be recognized over a weighted average remaining period of 2.3 years.

The estimated weighted average grant date fair value of each stock option awarded was $16.41 and $21.44 for the three-and nine-month periods ended December 31, 2006, respectively, and $23.51 and $22.22 for the three-and nine-month periods ended December 31, 2005, respectively.

Stock Option Fair Value Estimation Assumptions   For purposes of estimating the fair value provisions of SFAS 123R, the Company estimates the fair value of its stock options at the date of grant using the Black-Scholes option-pricing valuation model. The Company’s valuation model is impacted by DRS’s stock price as well as weighted average assumptions for a number of subjective variables described below.

·       Expected Holding Period   The expected holding period of stock options granted represents the period of time that stock options granted are expected to be outstanding until they are exercised, cancelled or forfeited. The Company uses historical information to estimate stock option exercise data and employee terminations within the valuation model.

9




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

·       Expected Volatility   Expected volatility is based on historical daily volatility of DRS common stock over the expected holding period.

·       Expected Dividend Yield   Expected dividend yield is based on DRS’s expected payments relative to the current market price of DRS common stock.

·       Risk-Free Interest Rate   The risk-free interest rates for stock options are based on the U.S. Treasury yield curve in effect at the time of grant for maturities similar to the expected holding period of the stock options.

·       Forfeiture Rate   The forfeiture rate is based on the historical forfeiture experience and prospective analysis of different pools of employees. We monitor share option exercise and employee termination patterns of each pool to estimate forfeiture rates within the valuation model.

Changes in assumptions can materially impact the estimated fair value of stock options. The weighted average assumptions used in the valuation model are presented in the table below.

 

 

Nine Months
Ended
December 31,

 

 

 

2006

 

Expected holding period (in years)

 

 

5.6

 

 

Expected volatility

 

 

38.91

%

 

Expected dividend yield

 

 

0.24

%

 

Risk-free interest rate

 

 

4.94

%

 

Weighted-average fair value of options granted

 

 

$

21.44

 

 

 

Restricted Stock and Restricted Stock Units   Restricted stock awards are granted to certain employees, as permitted under the 2006 Plan in the name of the employee, who has all the rights of a stockholder, subject to certain restrictions. The restricted stock cliff vests three years from the date of grant. Restricted stock units are granted in the name of the employee; however, the participant has no rights as a stockholder. These restricted stock units are redeemed for DRS common stock once a three year cliff vesting period has been satisfied. The cost of the grants, as determined by the market prices of the common stock at the grant dates, net of expected forfeitures, is recognized over the vesting periods.

Compensation cost for non-vested stock for the three months ended December 31, 2006 and 2005 was $1.6 million and $0.8 million, respectively, and $3.9 million and $1.9 million for the nine months ended December 31, 2006 and 2005, respectively. As of December 31, 2006, total unrecognized compensation costs related to non-vested stock awards was $13.4 million and that amount is expected to be recognized over a weighted average remaining period of 2.2 years.

10




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

The following table details the activity in non-vested stock awards for the nine months ended December 31, 2006.

 

 

Nine Months Ended
December 31, 2006

 

 

 

Number of
Shares

 

Weighted
Average Grant
Date Fair Value
per Share

 

Nonvested - Balance at March 31, 2006

 

 

281,590

 

 

 

$

40.81

 

 

Granted

 

 

247,208

 

 

 

$

49.86

 

 

Vested

 

 

(39,760

)

 

 

$

25.45

 

 

Forfeited / cancelled

 

 

(57,610

)

 

 

$

47.75

 

 

Nonvested - Balance at December 31, 2006

 

 

431,428

 

 

 

$

46.81

 

 

 

5.   Inventories

Inventories are summarized as follows:

 

 

December 31,

 

March 31,

 

 

 

2006

 

2006

 

 

 

(in thousands)

 

Work-in-process

 

 

$

442,384

 

 

$

368,991

 

General and administrative costs

 

 

66,290

 

 

63,836

 

Raw material and finished goods

 

 

51,089

 

 

66,706

 

 

 

 

559,763

 

 

499,533

 

Less: Progress payments and certain customer advances

 

 

186,100

 

 

158,967

 

  Inventory reserve

 

 

9,683

 

 

9,360

 

Total

 

 

$

363,980

 

 

$

331,206

 

 

Inventoried contract costs for the Company’s businesses that are primarily government contractors include certain general and administrative (G&A) costs, including internal research and development costs (IRAD) and bid and proposal costs (B&P). G&A, IRAD and B&P costs are allowable, indirect contract costs under U.S. government regulations. The Company allocates these costs to government contracts and accounts for them as product costs at the majority of the Company’s operating units, not as period expenses.

11




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

The table below presents a summary of G&A, IRAD and B&P costs included in inventoried contract costs and changes to them, including amounts used in the determination of costs and expenses. The cost data in the table below does not include the G&A, IRAD and B&P costs for the Company’s lines of businesses that are not primarily contracted with the U.S. government, such costs are expensed as incurred.

 

 

Three Months Ended
December 31,

 

Nine Months Ended
December 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

Balance in inventory at beginning of period

 

$

65,223

 

$

50,813

 

$

63,836

 

$

47,365

 

Add: Incurred costs

 

91,877

 

57,697

 

266,938

 

162,970

 

Less: Amounts included in costs and expenses

 

(90,810

)

(58,236

)

(264,484

)

(160,061

)

Balance in inventory at end of period

 

$

66,290

 

$

50,274

 

$

66,290

 

$

50,274

 

 

Total expenditures for IRAD amounted to approximately $12.6 million and $12.1 million for the three-month periods ended December 31, 2006 and 2005, respectively, and $37.9 million and $33.5 million, respectively, for the nine-month periods then ended.

6.   Goodwill and Intangible Assets

The following disclosure presents certain information regarding the Company’s acquired intangible assets as of December 31, 2006 and March 31, 2006. All acquired intangible assets are being amortized over their estimated useful lives, as indicated below, with no estimated residual values.

Acquired Intangible Assets

 

 

 

Weighted
Average
Amortization
Period

 

Gross Carrying
Amount

 

Accumulated
Amortization

 

Net Balance

 

 

 

 

 

 

 

(in thousands)

 

 

 

As of December 31, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Technology-based intangibles

 

 

18 years

 

 

 

$

47,861

 

 

 

$

(16,243

)

 

 

$

31,618

 

 

Customer and contract-related intangibles

 

 

11 years

 

 

 

214,428

 

 

 

(40,947

)

 

 

173,481

 

 

Total

 

 

 

 

 

 

$

262,289

 

 

 

$

(57,190

)

 

 

$

205,099

 

 

As of March 31, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Technology-based intangibles

 

 

18 years

 

 

 

$

47,861

 

 

 

$

(14,100

)

 

 

$

33,761

 

 

Customer and contract-related intangibles

 

 

11 years

 

 

 

217,190

 

 

 

(19,812

)

 

 

197,378

 

 

Total

 

 

 

 

 

 

$

265,051

 

 

 

$

(33,912

)

 

 

$

231,139

 

 

 

The aggregate acquired intangible asset amortization expense for the three-month periods ended December 31, 2006 and 2005 was $7.9 million and $2.2 million, respectively, and for the nine-month periods ended December 31, 2006 and 2005 was $23.3 million and $6.3 million, respectively. The acquired intangible amortization expense, based on gross carrying amounts at December 31, 2006, is estimated to be $31.4 million for fiscal 2007, $29.2 million per year for fiscal 2008, $29.2 million for fiscal 2009, $28.3 million for fiscal 2010 and $27.5 million for fiscal 2011.

12




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

As discussed in Note 1, the Company realigned its operating segments in the third quarter of fiscal 2007. The table below reconciles the change in the carrying amount of goodwill by operating segment for the period from March 31, 2006 to December 31, 2006.

 

 

C4I
Segment

 

RSTA
Segment

 

SS
Segment

 

TS
Segment

 

Total

 

 

 

(in thousands)

 

Balance as of March 31, 2006

 

$

658,453

 

$

168,586

 

$

1,045,502

 

$

735,527

 

$

2,608,068

 

ESSI acquisition

 

 

 

6,758

 

12,034

 

18,792

 

Codem acquisition earn-out

 

838

 

 

 

 

838

 

WalkAbout acquisition earn-out

 

253

 

 

 

 

253

 

Night Vision Equipment earn-out

 

 

6,627

 

 

 

6,627

 

Transfer of operating unit (A)

 

(4,929

)

 

 

4,929

 

 

Other adjustments

 

(1,895

)

 

 

 

(1,895

)

Foreign currency translation adjustment

 

1,108

 

 

174

 

 

1,282

 

Balance as of December 31, 2006

 

$

653,828

 

$

175,213

 

$

1,052,434

 

$

752,490

 

$

2,633,965

 


(A)       On April 1, 2006, DRS Technical Services, Inc. (TSI), an operating unit of the C4I Segment, was consolidated into an operating unit of the TS Segment to achieve certain operating synergies. For the three- and nine-month periods ended December 31, 2005, the TSI operating unit recorded $3.7 million and $14.0 million in revenues, respectively, and $0.3 million and $0.7 million of operating income, respectively, and had $9.3 million of assets at December 31, 2005, which was considered immaterial for purposes of restating prior year goodwill balances and segment information for both the C4I Segment and the TS Segment.

In connection with the new organizational operating structure implemented October 2, 2006 the Company tested its goodwill for impairment. The change in operating structure significantly changed the composition of certain reporting units, which under SFAS No. 142, “Goodwill and Other Intangible Assets,” requires the Company to test for impairment. The Company completed its impairment test with no adjustment to the carrying value of its goodwill for the three- and nine-month periods ended December 31, 2006.

13




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

7. Product Warranties

Product warranty costs generally are accrued when the covered products are delivered to the customer. Product warranty expense is recognized based on the terms of the product warranty and the related estimated costs, considering historical claims expense. Accrued warranty costs are reduced as these costs are incurred and as the warranty period expires, and may be otherwise modified as specific product performance issues are identified and resolved. The table below presents the changes in the Company’s accrual for product warranties for the nine months ended December 31, 2006 and 2005, which are included in accrued expenses and other current liabilities.

 

 

Nine Months Ended
December 31,

 

 

 

2006

 

2005

 

 

 

(in thousands)

 

Balance at beginning of period

 

$ 29,829

 

$ 21,839

 

Acquisitions during the period

 

(1,070

)

360

 

Accruals for product warranties issued during the period

 

17,035

 

6,853

 

Settlements made during the period

 

(14,501

)

(9,388

)

Other

 

68

 

31

 

Balance at end of the period

 

$ 31,361

 

$ 19,695

 

 

 

8.   Debt

 

 

December 31,
2006

 

March 31,
2006

 

 

 

(in thousands)

 

Credit Facility:

 

 

 

 

 

 

 

Revolving line of credit

 

 

$    70,000

 

 

$    40,000

 

Term Loan

 

 

272,938

 

 

275,000

 

Canadian Term Loan

 

 

8,881

 

 

9,853

 

65¤8% Senior Notes due 2016

 

 

350,000

 

 

350,000

 

2.00% Convertible Senior Notes due 2026

 

 

345,000

 

 

345,000

 

75¤8% Senior Subordinated Notes due 2018

 

 

250,000

 

 

250,000

 

67¤8% Senior Subordinated Notes due 2013

 

 

550,000

 

 

550,000

 

Unamortized bond premium on 6 7/8% Senior

 

 

 

 

 

 

 

Subordinated Notes

 

 

7,736

 

 

8,585

 

Other obligations

 

 

5,104

 

 

4,955

 

 

 

 

1,859,659

 

 

1,833,393

 

Less:

 

 

 

 

 

 

 

Current installments of long-term debt

 

 

5,150

 

 

4,622

 

Total long-term debt

 

 

$ 1,854,509

 

 

$ 1,828,771

 

 

The weighted average interest rate on the Company’s term loan borrowings under its Credit Facility was 6.9% as of December 31, 2006 (6.3% as of March 31, 2006). The weighted average interest rate under the revolving line of credit borrowings was 6.8% at December 31, 2006 (6.2% as of March 31, 2006).

14




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

From time to time, the Company enters into standby letters-of-credit and bank guarantee agreements with financial institutions and customers, primarily relating to the guarantee of its future performance on certain contracts to provide products and services and to secure advance payments it has received from its customers. As of December 31, 2006, $45.2 million was contingently payable under letters of credit and bank guarantees. Of this amount, approximately $0.9 million and $0.4 million in letters of credit and bank guarantees, respectively, as of December 31, 2006, were issued under a previous credit agreement and by a bank agreement for the Company’s U.K. subsidiary, respectively, and are not considered when determining the availability under the Company’s revolving line of credit. At December 31, 2006, the Company had $286.1 million of availability under its revolving line of credit.

On March 29, 2006, DRS Technologies Canada Company (DRS Canada) established a five-year senior secured term loan for approximately $9.9 million (C$11.5 million), maturing on April 1, 2011. The weighted average interest rate on the term loan was 6.0% as of December 31, 2006 (5.5% as of March 31, 2006).

Accrued interest expense at December 31, 2006 and March 31, 2006 was $28.9 million and $27.3 million, respectively.

The Company’s indebtedness is more fully described in Note 8 to the Company’s Consolidated Financial Statements for the year ended March 31, 2006.

9.   Earnings per Share

Basic earnings per share (EPS) is computed by dividing net earnings by the weighted average number of shares of common stock outstanding during each period. The computation of diluted earnings per share includes the effect of shares from the assumed exercise of dilutive stock options, restricted stock and restricted stock units. The following table presents the components of basic and diluted earnings per share:

 

 

Three Months Ended
December 31,

 

Nine Months Ended
December 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands, except per-share data)

 

Basic EPS computation

 

 

 

 

 

 

 

 

 

Net earnings

 

$ 35,094

 

$ 19,744

 

$ 81,583

 

$ 52,716

 

Weighted average common shares outstanding

 

39,879

 

27,778

 

39,742

 

27,645

 

Basic earnings per share

 

$   0.88

 

$   0.71

 

$   2.05

 

$   1.91

 

Diluted EPS computation

 

 

 

 

 

 

 

 

 

Net earnings

 

$ 35,094

 

$ 19,744

 

$ 81,583

 

$ 52,716

 

Diluted common shares outstanding

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

39,879

 

27,778

 

39,742

 

27,645

 

Stock options and restricted stock

 

861

 

942

 

932

 

951

 

Diluted common shares outstanding

 

40,740

 

28,720

 

40,674

 

28,596

 

Diluted earnings per share

 

$   0.86

 

$   0.69

 

$   2.01

 

$   1.84

 

 

At December 31, 2006 and 2005, there were 401,716 options and 22,500 options outstanding, respectively, that were excluded from the diluted EPS calculation because their inclusion would have had an antidilutive effect on EPS. For the three- and nine-month periods ended December 31, 2006, DRS’s 2%

15




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

Convertible Senior Notes had no impact on EPS because the average stock price during the periods was below $59.70 per share, and the convertible notes, if converted, would have required only cash at settlement.

10.   Comprehensive Earnings

The components of comprehensive earnings for the three- and nine-month periods ended December 31, 2006 and 2005 consisted of the following:

 

 

Three Months Ended
December 31,

 

Nine Months Ended
December 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

Net earnings

 

$ 35,094

 

$ 19,744

 

$ 81,583

 

$ 52,716

 

Other comprehensive earnings:

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustments

 

(1,047

)

(562

)

1,534

 

283

 

Minimum pension liability, net of income taxes

 

(251

)

 

(908

)

 

Unrealized net gains on hedging instruments arising during the period, net of income tax

 

 

 

(20

)

 

Amortization of unrealized gain on terminated instruments, net of income taxes

 

 

(49

)

 

(141

)

Comprehensive earnings

 

$ 33,796

 

$ 19,133

 

$ 82,189

 

$ 52,858

 

 

11.   Pensions and Other Employee Benefits

The following table summarizes the components of net periodic benefit cost for the Company’s pension and postretirement benefit plans for the three- and nine-month periods ended December 31, 2006 and 2005. These plans are more fully described in Note 12 to the Company’s Consolidated Financial Statements for the year ended March 31, 2006.

 

 

Funded
Pension Plans

 

Postretirement
Benefit Plans

 

Unfunded
Supplemental
Retirement
Plans

 

 

 

Three Months Ended December 31,

 

 

 

(in thousands)

 

 

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

Service cost

 

$ 1,834

 

$    988

 

$ 146

 

$ 150

 

$ 143

 

$ 136

 

Interest cost

 

3,243

 

1,511

 

320

 

241

 

318

 

279

 

Expected return on plan assets

 

(3,490

)

(1,769

)

(56

)

(42

)

 

 

Amortization of unrecognized loss (gain)

 

117

 

43

 

(8

)

(2

)

47

 

42

 

Amortization of transition obligation

 

 

 

28

 

27

 

 

 

Amortization of unrecognized
prior-service cost

 

39

 

1

 

(6

)

 

194

 

194

 

Net periodic benefit cost

 

$ 1,743

 

$    774

 

$ 424

 

$ 374

 

$ 702

 

$ 651

 

 

 

16




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

 

 

 

Funded
Pension Plans

 

Postretirement 
Benefit Plans

 

Unfunded
Supplemental
Retirement
Plans

 

 

 

Nine Months Ended December 31,

 

 

 

2006

 

2005

 

2006

 

2005

 

2006

 

2005

 

 

 

(in thousands)

 

Service cost

 

$   5,503

 

$ 2,964

 

$  437

 

$  450

 

$  429

 

$  408

 

Interest cost

 

9,728

 

4,533

 

959

 

723

 

955

 

837

 

Expected return on plan assets

 

(10,470

)

(5,307

)

(169

)

(126

)

 

 

Amortization of unrecognized loss (gain)

 

350

 

129

 

(25

)

(6

)

141

 

126

 

Amortization of transition obligation

 

 

 

84

 

81

 

 

 

Amortization of unrecognized prior-service cost

 

117

 

3

 

(18

)

 

583

 

582

 

Net periodic benefit cost

 

$   5,228

 

$ 2,322

 

$ 1,268

 

$ 1,122

 

$ 2,108

 

$ 1,953

 

 

The Company expects to contribute $7.9 million and $2.3 million to its pension and postretirement plans, respectively, during the fiscal year ended March 31, 2007, of which $6.4 million and $1.2 million, were contributed during the nine-month period ended December 31, 2006.

12.   Operating Segments

As discussed in Note 1, on October 2, 2006, the Company implemented a new organizational operating structure which realigned its three operating groups into four operating segments. The four operating segments are the Command, Control, Communications, Computers and Intelligence (C4I) Segment, the Reconnaissance, Surveillance and Target Acquisition (RSTA) Segment, the Sustainment Systems (SS) Segment and the Technical Services (TS) Segment. All other operations, primarily our Corporate Headquarters, are grouped in Other. Prior-year balances and results of operations for the C4I Group, SR Group and S3 Group have been reclassified to reflect this management reporting change.

In connection with the realignment the Company recorded net severance-related charges of $3.7 million during the second quarter of fiscal 2007.  During the third quarter of fiscal 2007 approximately $2.2 million of the reserve was utilized, net of additions of $0.2 million.  The Company expects the payments to be substantially complete by the end of the fourth quarter of fiscal 2007.

The Command, Control, Communications and Intelligence (C4I) Segment is comprised of the following business areas: Command, Control and Communications (C3), which includes naval display systems, ship communications systems, radar systems, technical support, electronic manufacturing and system integration services, secure voice and data communications, air combat training, electronic warfare and network systems, and high-speed digital data and imaging systems; Power Systems, which includes naval and industrial power generation, conversion, propulsion, distribution and control systems; Intelligence Technologies, which includes signals intelligence, communications intelligence, data collection, processing and dissemination equipment, and unmanned vehicles and mission and flight recorders; and Tactical Systems, which includes battle management tactical computer systems, peripherals, electronic test, and diagnostics and vehicle electronics.

The Reconnaissance, Surveillance & Target Acquisition (RSTA) Segment develops and produces electro-optical sighting, targeting and weapon sensor systems, aircraft weapons alignment systems and

17




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

image intensification (I2 ) night vision, combat identification and laser aimers/illuminator products, and provides electronic manufacturing services.

The Sustainment Systems (SS) Segment designs, engineers and manufactures integrated military electronics, equipment transporters, environmental control systems, fuel and water distribution systems, power generators and power supplies primarily for the U.S. Department of Defense and allied military forces.

The Technical Services (TS) Segment provides engineering services, logistics and training services, advanced technology services, asset protection systems and services, telecommunication systems integration and information technology services, and vehicle armor kits for military, humanitarian, disaster recovery and emergency responder applications.

Other includes the activities of DRS Corporate Headquarters and certain non-operating subsidiaries of the Company.

Transactions between segments generally are negotiated and accounted for under terms and conditions that are similar to other government and commercial contracts; however, these intercompany transactions are eliminated in consolidation. The Company evaluates segment-level performance based on revenues and operating income, as presented in the Consolidated Statements of Earnings. Operating income, as shown, includes amounts allocated from DRS Corporate operations using an allocation methodology prescribed by U.S. government regulations for government contractors.

18




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

 

 

 

 

 

RSTA

 

SS

 

TS

 

 

 

 

 

 

 

C4I Segment

 

Segment

 

Segment

 

Segment

 

Other

 

Total

 

 

 

(in thousands)

 

Three Months Ended December 31, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

 

$

268,816

 

 

$

167,910

 

$

104,004

 

$

152,409

 

$

 

$

693,139

 

Intersegment revenues

 

 

(763

)

 

(1,124

)

(8,010

)

(2,881

)

 

(12,778

)

External revenues

 

 

$

268,053

 

 

$

166,786

 

$

95,994

 

$

149,528

 

$

 

$

680,361

 

Operating income

 

 

$

27,669

 

 

$

20,588

 

$

17,039

 

$

11,390

 

$

(59

)

$

76,627

 

Total assets

 

 

1,245,035

 

 

464,241

 

1,300,872

 

988,539

 

165,954

 

4,164,641

 

Depreciation and amortization

 

 

         6,015

 

 

      3,379

 

         4,840

 

      3,311

 

      1,214

 

      18,759

 

Capital expenditures

 

 

         4,750

 

 

      2,179

 

         1,629

 

         642

 

      1,695

 

      10,895

 

Three Months Ended December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

 

$

276,607

 

 

$

114,240

 

$

 

$

 

$

 

$

390,847

 

Intersegment revenues

 

 

(747

)

 

(610

)

 

 

 

(1,357

)

External revenues

 

 

$

275,860

 

 

$

113,630

 

$

 

$

 

$

 

$

389,490

 

Operating income (loss)

 

 

$

31,101

 

 

$

13,744

 

$

 

$

 

$

(18

)

$

44,827

 

Total assets

 

 

1,195,024

 

 

380,074

 

               —

 

            —

 

316,775

 

1,891,873

 

Depreciation and amortization

 

 

         6,260

 

 

      3,446

 

               —

 

            —

 

      1,072

 

      10,778

 

Capital expenditures

 

 

         3,502

 

 

      4,704

 

               —

 

            —

 

      1,851

 

      10,057

 

Nine Months Ended December 31, 2006

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

 

$

815,150

 

 

$

433,975

 

$

319,436

 

$

504,909

 

$

 

$

2,073,470

 

Intersegment revenues

 

 

(3,406

)

 

(3,825

)

(39,109

)

(4,966

)

 

(51,306

)

External revenues

 

 

$

811,744

 

 

$

430,150

 

$

280,327

 

$

499,943

 

$

 

$

2,022,164

 

Operating income

 

 

$

88,072

 

 

$

46,412

 

$

41,654

 

$

36,578

 

$

784

 

$

213,500

 

Total assets

 

 

1,245,035

 

 

464,241

 

1,300,872

 

988,539

 

165,954

 

4,164,641

 

Depreciation and amortization

 

 

      18,790

 

 

   10,755

 

      13,424

 

   10,397

 

      3,756

 

      57,122

 

Capital expenditures

 

 

      18,270

 

 

      8,368

 

         4,262

 

      2,895

 

      4,318

 

      38,113

 

Nine Months Ended December 31, 2005

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

 

$

797,285

 

 

$

295,936

 

$

 

$

 

$

 

$

1,093,221

 

Intersegment revenues

 

 

(1,445

)

 

(1,897

)

 

 

 

(3,342

)

External revenues

 

 

$

795,840

 

 

$

294,039

 

$

 

$

 

$

 

$

1,089,879

 

Operating income (loss)

 

 

$

84,372

 

 

$

36,544

 

$

 

$

 

$

(2,454

)

$

118,462

 

Total assets

 

 

1,195,024

 

 

380,074

 

               —

 

            —

 

316,775

 

1,891,873

 

Depreciation and amortization

 

 

      18,587

 

 

   10,201

 

               —

 

            —

 

      2,931

 

      31,719

 

Capital expenditures

 

 

      11,181

 

 

   11,008

 

               —

 

            —

 

      4,122

 

      26,311

 

 

19




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

13.   Supplemental Cash Flow Information

 

 

Nine Months Ended
December 31,

 

 

 

2006

 

2005

 

 

 

(in thousands)

 

Cash paid for:

 

 

 

 

 

Income taxes

 

$

31,003

 

$

35,624

 

Interest

 

$

85,487

 

$

43,038

*

Supplemental disclosure of significant non-cash investing and financing activities:

 

 

 

 

 

Acquisition costs for business combinations, net

 

$

 

$

11,848

 

Acquisition earn-out - Night Vision Systems, Inc.

 

$

6,627

 

$

 

Acquisition earn-out - WalkAbout

 

$

279

 

$

 

Contribution of fixed assets to joint venture

 

$

1,000

 

$

 


*                    Excludes the advanced interest of $2.0 million that was repaid in conjunction with the semi-annual interest payments on the 67¤8% senior subordinated notes. See Note 8 to the Company’s Consolidated Financial Statements for the year ended March 31, 2006.

14.   Cash Dividends on DRS Common Stock

On November 2, 2006, the Board of Directors declared a $0.03 per common share cash dividend, payable on December 29, 2006 to stockholders of record as of December 15, 2006. Cash dividends paid for the three- and nine-month periods ended December 31, 2006 were  $1.2 million and $3.6 million, respectively. On February 8, 2007,  the Board of Directors declared a $0.03 per common share cash dividend, payable on March 30, 2007 to stockholders of record as of March 15, 2007.

15.   Contingencies and Related Party Transactions

Contingencies—Various legal actions, claims, assessments and other contingencies arising out of previous business combinations and arising in the normal course of the Company’s business, including certain matters described below, are pending against the Company and certain of its subsidiaries. These matters are subject to many uncertainties, and it is possible that some of these matters could be ultimately decided, resolved or settled adversely. The Company has recorded accruals totaling $4.4 million and $4.3 million at December 31, 2006 and March 31, 2006, respectively, for losses related to those matters that it considers to be probable and that can be reasonably estimated (certain legal and environmental matters are discussed in detail below). Based on the Company’s ongoing analysis of various factual, legal and equitable considerations it has recorded an accrual of $11.8 million against goodwill reflecting the probable income tax impact of information uncovered in our ongoing internal investigation of historical ESSI stock option practices. Although the ultimate amount of liability at December 31, 2006 that may result from those matters for which the Company has recorded accruals is not ascertainable, the Company believes that any amounts exceeding the Company’s recorded accruals should not materially affect the Company’s financial condition or liquidity. It is possible, however, that the ultimate resolution of those matters could result in a material adverse effect on the Company’s results of operations and/or cash flows from operating activities for a particular reporting period.

Some environmental laws, such as the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (also known as CERCLA or the Superfund law) and similar state statutes, can impose

20




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

liability for the entire cost of the clean up of contaminated sites upon any of the current or former site owners or operators (or upon parties who send waste to these sites), regardless of the lawfulness of the original activities that led to the contamination. In July 2000, prior to its acquisition by Integrated Defense Technologies Inc. (IDT), and prior to DRS’s acquisition of IDT, Tech-Sym Corporation received a Section 104(e) Request for Information from the National Park Service (NPS), pursuant to CERCLA, regarding a site known as the Orphan Mine site in the Grand Canyon National Park, Arizona, which is the subject of an NPS investigation regarding the presence of residual radioactive materials and contamination. A corporation of which Tech-Sym is an alleged successor operated this uranium mine from 1956 to 1967. In 1962, the land was sold to the U.S. government and the alleged predecessor of Tech-Sym was given a 25-year mining lease. In 1967, the mining rights were transferred to a third party by a trustee in bankruptcy, and the Company believes that the mine was operated by such third party until approximately 1969. The Company understands that there are other companies in the chain of title to the mining rights subsequent to Tech-Sym’s alleged predecessor, and, accordingly, that there are other potentially responsible parties (PRPs) for the environmental conditions at the site, including the U.S. government as owner, operator and arranger at the site. During its period of ownership, IDT retained a technical consultant in connection with this matter, who conducted a limited, preliminary review of site conditions and communicated with the NPS regarding actions that may be required at the site by all of the PRPs. On February 6, 2005, the NPS sent the Company an Engineering Evaluation/Cost Analysis Work Plan (the “NPS EE/CA”) under CERCLA (the ‘‘CERCLA Letter’’) with regards to Operable Unit 1 of the Orphan Mine site. In the Company’s view, the NPS EE/CA included additional clean up not covered by CERCLA. The CERCLA Letter also requested (a) payment of $0.5 million for costs incurred by the NPS related to the Orphan Mine, and (b) a ‘‘good faith offer’’ to conduct the response activity outlined by the NPS and to reimburse the NPS for future costs. The NPS advised that a similar letter has been sent to another PRP. The Company initiated discussions with the other PRP and with NPS, and engaged a technical consultant to evaluate the existing documentation and the site in depth. As a result, on September 29, 2005, the technical consultant submitted to the NPS, on behalf of the Company and the other PRP, an alternative Engineering Evaluation/Cost Analysis Work Plan (the “alternative EE/CA”) with regards to Operating Units 1 and 2 of the Orphan Mine site.

In December 2005 and August 2006, the PRPs and NPS met to discuss the technical merits of the alternative EE/CA and ways to resolve certain differences between the alternative EE/CA and the NPS EE/CA provided with the CERCLA Letter. Since late 2005, the parties have also discussed certain legal issues relating to the process for implementing an alternative EE/CA and entering into a settlement agreement that would memorialize the parties’ intent. The potential liability associated with implementation of an EE/CA can change substantially due to such factors as additional information on the nature or extent of contamination, methods of remediation that might be recommended or required, changes in the apportionment of costs among the responsible parties and other actions by governmental agencies or private parties.

In connection with the Company’s acquisition of Engineered Support Systems, Inc. (“ESSI”) in January 2006, the Company has been made aware of certain legal actions, claims, assessments and other contingencies, certain of which are described below.

In December 2004, ESSI was notified by the Enforcement Division of the SEC of the issuance of a formal order directing a private investigation captioned In the Matter of Engineered Support Systems, Inc. and was notified that the SEC had issued subpoenas to various individuals associated with ESSI to produce

21




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

certain documents. The SEC staff also requested that ESSI produce certain documents in connection with the investigation. The subpoenas related to trading in ESSI stock around ESSI’s earnings releases in 2003 and to the adequacy of certain disclosures made by ESSI regarding related-party transactions in 2002 and 2003 involving insurance policies placed by ESSI through an insurance brokerage firm in which an ESSI director was a principal at the time of the transactions.

On or about September 23, 2005, the SEC staff advised ESSI’s counsel that it had issued a subpoena directed to ESSI and expanded its investigation to include ESSI’s disclosure of a November 2004 stop work order relating to ESSI’s Deployable Power Generation and Distribution Systems (“DPGDS”) program for the U.S. Air Force, and relating to trading in ESSI stock by certain individuals associated with ESSI.

In connection with the foregoing SEC investigation, ESSI and certain of its directors and officers have provided information and/or testimony to the SEC. On November 14, 2005, ESSI was informed by the Enforcement Division of the SEC that one of ESSI’s former directors and officers, and subsequently a consultant to ESSI, had been issued a so-called Wells notice informing him that the staff of the SEC was considering recommending that the SEC bring a civil injunctive action against him in connection with the SEC’s investigation into trading in ESSI common stock in 2003. A Wells notice provides prospective defendants with an opportunity to respond to the SEC staff members before the staff makes a formal recommendation on whether the SEC should pursue disciplinary action against them. ESSI, itself, has not received a Wells notice and continues to cooperate with the investigation.

In January 2006, ESSI was informed that the Office of the U.S. Attorney for the Eastern District of Missouri was initiating an investigation into ESSI’s disclosure of the DPGDS stop-work order and into trading in ESSI stock by ESSI insiders which preceded such disclosure. The U.S. Attorney’s office advised ESSI that although it considered ESSI to be a subject of its investigation, ESSI was not a target. In connection with this investigation, the U.S. Attorney’s office issued ESSI a subpoena requesting specified information, which ESSI continues to furnish.

In May 2006, the Company was advised that the Enforcement Division of the SEC and the U.S. Attorney’s office had each expanded its investigation to include possible “backdating” of the timing of option grants at ESSI prior to the time ESSI was acquired by DRS. As a part of its investigation, the SEC issued subpoenas to certain officers and employees of ESSI to provide testimony and produce certain documents. In February 2007, the SEC filed civil injunctive actions in the United States District Court for the Eastern District of Missouri, Eastern Division alleging that ESSI’s former Chief Financial Officer and former controller participated in a backdating scheme.  The SEC reported that the former controller had settled this action by consenting to disgorgement, financial penalties, an officer and director bar and a permanent suspension from practicing before the SEC as an accountant. Although ESSI continues to be a subject of the U.S. Attorney’s office’s investigation, the U.S. Attorney’s office has advised the Company that ESSI is not a target. Because the events being investigated occurred prior to the time of the Company’s acquisition of ESSI, the U.S. Attorney’s office has further advised the Company that it considers DRS to be a witness, not a subject or target of its investigation.

The Company is committed to full cooperation with regard to the foregoing investigations. The Company is unable to determine at this time either the timing of the SEC or U.S. Attorney’s office investigations or the impact, if any, the investigations could have on the Company.

22




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

In September 2006, ESSI was advised that the Internal Revenue Service was commencing an audit of its Federal tax return for the fiscal year ended October 31, 2004. In January 2007, ESSI was advised that the Internal Revenue Service had expanded its audit to include ESSI’s Federal tax returns for the tax periods ended October 31, 2005 and January 31, 2006. In connection  with these audits, ESSI has received several information document requests (“IDRs”) asking for specific information relating to stock option deductions provided therein. The Company is cooperating with this process.

The Company has recorded an accrual against goodwill to reflect the likely disallowance of certain compensation deductions taken on several of ESSI’s previous State and Federal income tax returns. Principally, this adjustment was made to account for Internal Revenue Code Section 162(m) and its limitations on the deductibility of certain non-performance based compensation.

In July 2006, DRS and one of the Company’s subsidiaries, DRS Training and Control Systems, Inc. (“TCS”) were each issued a subpoena by the United States District Court for the Northern District of Florida (“Florida District Court”). The subpoenas were issued in connection with an inquiry being conducted by the Antitrust Division of the U.S. Department of Justice (“DOJ”) and require TCS to produce certain documents related to an investigation the Company believes involves allegations of anticompetitive activity in certain international markets. In addition, certain employees and officers of TCS were served with subpoenas to testify before the grand jury of the Florida District Court with regard to this matter. The DOJ is continuing its investigation, but we have no information as to when the DOJ will conclude this process. The Company has cooperated with the DOJ in producing documents in response to the subpoenas. The Company has commenced an internal investigation regarding this matter, which the Company expects to continue through the conclusion of the DOJ’s investigatory process.

Related Party Transactions   The Company currently leases a building in Oakland, New Jersey, owned by LDR Realty Co., a partnership that was wholly owned in equal amounts by David E. Gross, DRS’s cofounder and the former President and Chief Technical Officer, and the late Leonard Newman, DRS’s cofounder, the former Chairman of the Board, Chief Executive Officer, and Secretary and the father of Mark S. Newman, the Company’s current Chairman of the Board, President and Chief Executive Officer. The lease agreement with a monthly rental of $21,200 expires on April 30, 2007. Following Leonard Newman’s death in November 1998, Mrs. Ruth Newman, the wife of Leonard Newman and the mother of Mark S. Newman, succeeded to Leonard Newman’s interest in LDR Realty Co.

Skadden, Arps, Slate, Meagher & Flom LLP, a law firm to which a member of our Board is of counsel, provided legal services to the Company during the nine months ended December 31, 2006 and 2005. Fees paid to Skadden, Arps, Slate, Meagher & Flom LLP for the nine months ended December 31, 2006 and 2005 were $3.0 million and $2.2 million, respectively.

Kronish Lieb Weiner & Hellman LLP, a law firm of which Alison Newman, sister of Mark S. Newman, is a partner, provided legal services to the Company during the nine months ended December 31, 2005. The Company paid fees to Kronish Lieb Weiner & Hellman LLP of $0.2 million for the nine months ended December 31, 2005.

16.   Guarantor and Non-Guarantor Financial Statements

As presented in Note 8, “Debt”, the Company has $350.0 million 65¤8% Senior Notes, $550.0 million 67¤8% Senior Subordinated Notes, $250.0 million 75¤8% Senior Subordinated Notes and $345.0 million 2% Convertible Senior Notes outstanding (collectively, the Notes). The Notes are fully and unconditionally

23




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements (Continued)
(Unaudited)

guaranteed, jointly and severally, by the Company’s wholly-owned domestic subsidiaries (the Guarantor Subsidiaries). The foreign subsidiaries and certain domestic subsidiaries of DRS (the Non-Guarantor Subsidiaries) do not guarantee the Notes.

The following condensed consolidating financial information in the Condensed Consolidating Balance Sheets as of December 31, 2006 and March 31, 2006, the Condensed Consolidating Statements of Earnings for the three- and nine-month periods ended December 31, 2006 and 2005, and the Condensed Consolidating Statements of Cash Flows for the nine months ended December 31, 2006 and 2005 presents:

a)                DRS Technologies, Inc. (the Parent),

b)               the Guarantor Subsidiaries,

c)                the Non-Guarantor Subsidiaries, and

d)               DRS Technologies, Inc. on a consolidated basis

The information includes elimination entries necessary to consolidate the Parent with the Guarantor and Non-Guarantor Subsidiaries.

The Guarantor and Non-Guarantor subsidiaries are presented on a combined basis. The principal elimination entries eliminate investments in subsidiaries and intercompany balances and transactions. Separate financial information for each of the Guarantor and Non-Guarantor Subsidiaries are not presented because management believes such financial statements would not be meaningful to investors.

24




DRS TECHNOLOGIES, INC. AND SUBSIDIARIES
Notes to the Consolidated Financial Statements  (Continued)
(Unaudited)

Condensed Consolidating Balance Sheet
As of December 31, 2006
(in thousands)

 

 

Parent
Company

 

Guarantor
Subsidiaries

 

Non-
Guarantor
Subsidiaries

 

Eliminations

 

Consolidated

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

30,117

 

$

(2,006

)

 

$

21,440

 

 

$

 

 

$

49,551

 

 

Accounts receivable, net

 

4

 

476,902

 

 

26,191

 

 

 

 

503,097

 

 

Inventories, net

 

(5,709

)

330,193

 

 

39,496

 

 

 

 

363,980

 

 

Prepaid expenses and other current assets

 

6,237

 

115,179

 

 

12,466

 

 

(7,267

)

 

126,615

 

 

Intercompany receivables

 

2,095,317

 

 

 

24,115

 

 

(2,119,432

)

 

 

 

Total current assets

 

2,125,966

 

920,268

 

 

123,708

 

 

(2,126,699

)

 

1,043,243

 

 

Property, plant and equipment, net

 

14,612

 

201,285

 

 

9,194

 

 

 

 

225,091

 

 

Acquired intangibles, net

 

 

204,546

 

 

553

 

 

 

 

205,099

 

 

Goodwill

 

24,115

 

2,570,195

 

 

39,655

 

 

 

 

2,633,965

 

 

Deferred income taxes and other noncurrent assets

 

48,948

 

8,076

 

 

10,151

 

 

(9,932

)

 

57,243

 

 

Investment in subsidiaries

 

1,147,206

 

46,643

 

 

 

 

(1,193,849

)

 

 

 

Total assets

 

$

3,360,847

 

$

3,951,013

 

 

$

183,261

 

 

$

(3,330,480

)

 

$

4,164,641

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current installments of long-term debt

 

$

2,750

 

$

196

 

 

$

2,204

 

 

$

 

 

$

5,150

 

 

Accounts payable

 

5,783

 

205,419

 

 

19,113

 

 

 

 

230,315

 

 

Accrued expenses and other current liabilities

 

54,175

 

401,765

 

 

30,256

 

 

(7,218

)

 

478,978

 

 

Intercompany payables

 

 

888,972

 

 

23,828

 

 

(912,800

)

 

 

 

Total current liabilities

 

62,708

 

1,496,352

 

 

75,401

 

 

(920,018

)

 

714,443

 

 

Long-term debt, excluding current installments

 

1,842,923

 

3,295

 

 

8,291

 

 

 

 

1,854,509

 

 

Other liabilities

 

4,230

 

126,995

 

 

23,410

 

 

(9,931

)

 

144,704

 

 

Total liabilities

 

1,909,861</