10-K 1 d300800d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

x

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

For the fiscal year ended December 31, 2011

 

¨

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

For the transition period from              to             

Commission file numbers 001-14141 and 333-46983

L-3 COMMUNICATIONS HOLDINGS, INC.

L-3 COMMUNICATIONS CORPORATION

(Exact names of registrants as specified in their charters)

 

Delaware    13-3937434 and 13-3937436
(State or other jurisdiction of incorporation or organization)    (I.R.S. Employer Identification Nos.)
600 Third Avenue, New York, NY    10016
(Address of principal executive offices)    (Zip Code)

(212) 697-1111

(Telephone number)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class   Name of each exchange on which registered:

L-3 Communications Holdings, Inc.

common stock, par value $0.01 per share

  New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None.

Indicate by check mark if the registrants are well-known seasoned issuers, as defined in Rule 405 of the Securities Act.                                 x  Yes ¨ No

Indicate by check mark if the registrants are not required to file reports pursuant to Section 13 or Section 15(d) of the Act.                             ¨ Yes x No

Indicate by check mark whether the registrants (1) have 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) have been subject to such filing requirements for the past 90 days.                                                                                                                                                                    x Yes ¨ No

Indicate by check mark whether the registrants have submitted electronically and posted on their corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrants were required to submit and post such files).                                                                                                     x Yes ¨ No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants’ knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.                                                                                                                                                                     ¨

Indicate by check mark whether the registrants are large accelerated filers, accelerated filers, non-accelerated filers, or smaller reporting companies. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x   Accelerated filer ¨   Non-accelerated filer ¨   Smaller reporting company ¨
                                               (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrants are shell companies (as defined in Rule 12b-2 of the Act).

¨ Yes x No

The aggregate market value of the L-3 Communications Holdings, Inc. voting stock held by non-affiliates of the Registrants as of July 1, 2011 was approximately $9.3 billion. For purposes of this calculation, the Registrants have assumed that their directors and executive officers are affiliates.

There were 98,980,128 shares of L-3 Communications Holdings, Inc. common stock with a par value of $0.01 outstanding as of the close of business on February 24, 2012.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the definitive proxy statement to be filed with the Securities and Exchange Commission (“SEC”) pursuant to Regulation 14A relating to the Registrants’ Annual Meeting of Shareholders, to be held on April 24, 2012, will be incorporated by reference in this Form 10-K in response to Items 10,11,12,13 and 14 of Part III. The definitive proxy statement will be filed with the SEC no later than 120 days after the registrants’ fiscal year ended December 31, 2011.

 

 

 


Table of Contents

L-3 COMMUNICATIONS HOLDINGS, INC.

L-3 COMMUNICATIONS CORPORATION

INDEX TO ANNUAL REPORT ON FORM 10-K

For the Year Ended December 31, 2011

 

PART I

     

Item 1:

  

Business

     1   

Item 1A:

  

Risk Factors

     20   

Item 1B:

  

Unresolved Staff Comments

     29   

Item 2:

  

Properties

     30   

Item 3:

  

Legal Proceedings

     30   

Item 4:

  

Mine Safety Disclosures

     30   

PART II

     

Item 5:

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     31   

Item 6:

  

Selected Financial Data

     33   

Item 7:

  

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

     34   

Item 7A:

  

Quantitative and Qualitative Disclosures about Market Risk

     69   

Item 8:

  

Financial Statements and Supplementary Data

     69   

Item 9:

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

     69   

Item 9A:

  

Controls and Procedures

     69   

Item 9B:

  

Other Information

     70   

PART III

     

Item 10:

  

Directors, Executive Officers and Corporate Governance

     71   

Item 11:

  

Executive Compensation

     71   

Item 12:

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     71   

Item 13:

  

Certain Relationships and Related Transactions, and Director Independence

     71   

Item 14:

  

Principal Accountant Fees and Services

     71   

PART IV

     

Item 15:

  

Exhibits, Financial Statement Schedules

     72   

Signatures

        77   


Table of Contents

PART I

For convenience purposes in this filing on Form 10-K, “L-3 Holdings” refers to L-3 Communications Holdings, Inc., and “L-3 Communications” refers to L-3 Communications Corporation, a wholly-owned operating subsidiary of L-3 Holdings. “L-3”, “we”, “us” and “our” refer to L-3 Holdings and its subsidiaries, including L-3 Communications.

Item 1. Business

Overview

L-3 Holdings, a Delaware corporation organized in April 1997, derives all of its operating income and cash flows from its wholly-owned subsidiary, L-3 Communications. L-3 Communications, a Delaware corporation, is a prime contractor in Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (C3ISR) systems, aircraft modernization and maintenance, and government services. L-3 is also a leading provider of a broad range of electronic systems used on military and commercial platforms. Our customers include the United States (U.S.) Department of Defense (DoD) and its prime contractors, U.S. Government intelligence agencies, the U.S. Department of Homeland Security (DHS), U.S. Department of State (DoS), U.S. Department of Justice (DoJ), allied foreign governments, domestic and foreign commercial customers and select other U.S. federal, state and local government agencies.

For the year ended December 31, 2011, we generated sales of $15.2 billion, operating income of $1,598 million and net cash from operating activities of $1,484 million. The table below presents a summary of our 2011 sales by major category of end customer. For a more detailed presentation of our sales by end customer, see “Major Customers” on page 14.

 

     2011 Sales      % of
Total Sales
 
     (in millions)         

DoD

   $ 11,321         75

Other U.S. Government

     1,113         7   
  

 

 

    

 

 

 

Total U.S. Government

   $ 12,434         82

Foreign governments

     1,200         8   

Commercial – foreign

     905         6   

Commercial – domestic

     630         4   
  

 

 

    

 

 

 

Total sales

   $ 15,169         100
  

 

 

    

 

 

 

We have the following four reportable segments: (1) C3ISR, (2) Government Services, (3) Aircraft Modernization and Maintenance (AM&M), and (4) Electronic Systems. Financial information for our segments, including sales by geographic area, is included in “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in Note 22 to our audited consolidated financial statements.

On July 28, 2011, we announced that our Board of Directors approved a plan to spin-off a new, independent government services company that will be publicly traded. The new public company will be named Engility Holdings, Inc. (Engility). See “Part II – Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview and Outlook – Spin-Off of Businesses that will comprise Engility” on page 38 for additional information.

Business Strategy

Our business strategy is customer-focused and aims to increase shareholder value by expanding our strong positions in C3ISR, electronic systems and aircraft modernization and maintenance by leveraging our customer relationships and pursuing adjacent market opportunities. We intend to gain market share with disruptive,

 

1


Table of Contents

affordable solutions, collaboration across L-3 and demonstrated past performance that address customer imperatives. We will continue shifting our business portfolio to emphasize products, systems and proprietary services. The acquisition of the Kollmorgen Electro-Optical business completed on February 6, 2012, and our planned spin-off of the businesses that will comprise Engility are examples of this element of our strategy. Financially, our emphasis is on growing earnings per share and cash flow over time. Our strategy involves a flexible and balanced combination of organic growth, cost reductions, and select business acquisitions and divestitures, enabling us to grow the company and also return cash to our shareholders in a balanced and disciplined manner. Our strategy includes the elements discussed below.

Maintain an Entrepreneurial, Accountable and Results-Driven Culture. A key part of L-3’s strategy is our entrepreneurial, accountable, and results-driven culture that is focused on meeting our customers’ needs and on achieving L-3’s strategic goals and growth objectives. L-3’s culture is made up of diverse people providing creative solutions and ideas in an environment that fosters teamwork and collaboration across our business units. Operating with integrity and with a commitment to the highest standards of ethical conduct is an important part of our strategy to build and maintain the trust of our customers, shareholders, employees, suppliers and communities where we live and work.

Grow Sales Organically and Selectively Acquire Businesses. We intend to use our existing prime contractor and supplier positions and internal investments to grow our sales organically. We expect to continue to benefit from our position as a supplier to multiple bidders on select prime contract bids. We plan to maintain our diversified and broad business mix with limited reliance on any single contract, follow-on or new business opportunity. We also expect to continue to supplement our organic sales growth by acquiring, on a select basis, businesses that add new products, technologies, programs and contracts, or provide access to select DoD or non-DoD customers and provide attractive returns on investment.

Collaborate to Increase Growth Opportunities. We intend to deepen the collaboration among our diversified businesses to develop new business opportunities. The combination of our leading technologies and our ability to deliver the right solutions to our customers quickly and re-shape our portfolio underscores our reputation for performance and customer focus. We expect that our core strengths of agility, responsiveness and cost-effectiveness will allow us to continue to provide exceptional performance to our customers. We intend to continue our internal initiatives to consolidate and drive efficiency in our operations and develop our collaborative culture to continue our shift from a “black box” provider to a complete solutions provider.

Continuously Improve our Cost Structure and Right-Size our Businesses. We intend to continue to aggressively improve and reduce our direct contract costs and overhead costs, including general and administrative costs. Our effective management of labor, material, subcontractor and other direct costs is an important element of cost control and favorable contract performance. We believe that proactively re-sizing our businesses to their anticipated sales, combined with continuous cost improvement will enable us to increase our cost competitiveness, and to selectively invest in new product development, bids and proposals and other business development activities to organically grow our sales.

Align Research & Development with Customer Priorities. We intend to continue to align our products, services, internal investments in research and development and business development activities to proactively address customer priorities and requirements and invest in growth areas such as C3ISR, integrated sensor systems, cyber security and intelligence support. We also intend to grow our sales and gain market share through the introduction of innovative and disruptive solutions, new products and continued collaboration among our businesses to offer high quality and competitive solutions and services to our customers.

Expand our Prime Contractor and Supplier Positions. We intend to expand our prime contractor roles in select business areas where we have domain expertise, including C3ISR and aircraft modernization and maintenance and expand our supplier positions in electronic systems by leveraging our customer relationships and pursuing adjacent market opportunities. We also intend to enter into teaming arrangements with other prime contractors and platform original equipment manufacturers to compete for select new business opportunities. As an independent supplier of a broad range of products, subsystems and systems in several key business areas, our growth will partially be driven by expanding our share of existing programs and participating in new programs.

 

2


Table of Contents

We also expect to identify opportunities to use our customer relationships and leverage the capabilities of our various businesses, including proprietary technologies, to expand the scope of our products and services to existing and new customers.

Focus On Outstanding Program Performance. We believe that outstanding performance on our existing programs and contracts in terms of staying on-budget, on-schedule and in accordance with our contractual obligations is the foundation for successfully meeting our objectives of expanding L-3’s prime contractor and supplier positions and growing sales organically. We believe that a prerequisite for growing and winning new business is to retain our existing business by successfully meeting the performance criteria included in our existing contracts. We will continue to focus on delivering superior contract performance to our customers in order to maintain our reputation as an agile and responsive contractor and to differentiate ourselves from our competitors.

Attract and Retain Skilled Personnel. The success of our businesses is, to a large extent, dependent upon the knowledge and skills of our employees. We intend to continue to attract and retain employees who have management, contracting, engineering and technical skills and who have U.S. Government security clearances, particularly those with clearances of top-secret and above.

Business Acquisitions and Dispositions

During the years ended December 31, 2011, 2010 and 2009, we used cash of $20 million, $756 million and $90 million for business acquisitions, respectively. See “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Business Acquisitions and Dispositions” on page 40 for additional details about our business acquisitions, including their aggregate purchase prices, and our divestitures.

Products and Services

Our four reportable segments provide a wide range of products and services to various customers and are described below.

C3ISR Reportable Segment

In 2011, C3ISR net sales of $3,568 million represented 24% of our total net sales. The businesses in this segment provide products and services for the global ISR market, specializing in signals intelligence (SIGINT) and communications intelligence systems. These products and services provide the warfighter the unique ability to collect and analyze data from command centers, communication nodes and air defense systems for real-time situational awareness and response. The businesses in this reportable segment also provide C3 systems, networked communications systems and secure communications products for military and other U.S. Government and allied foreign government intelligence, reconnaissance and surveillance applications. We believe that these products and services are critical elements for a substantial number of major command, control and communication, intelligence gathering and space systems. These products and services are used to connect a variety of airborne, space, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring, and dissemination functions of these communication systems. Major products and services for this reportable segment include:

 

   

highly specialized fleet management sustainment and support services, including procurement, systems integration, sensor development, modifications and periodic depot maintenance for ISR and special mission aircraft and airborne systems;

 

   

strategic and tactical SIGINT systems that detect, collect, identify, analyze and disseminate information;

 

   

secure data links that enable real-time information collection and dissemination to users of networked communications for airborne, satellite, ground and sea-based remote platforms, both manned and unmanned;

 

3


Table of Contents
   

secure terminal and communication network equipment and encryption management; and

 

   

communication systems for surface and undersea vessels and manned space flights.

The table below provides additional information for the systems, products and services, selected applications and selected platforms or end users of our C3ISR reportable segment.

 

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

ISR Systems      
   

• Prime mission systems integration, sensor development and operations and support

 

• Signal processing, airborne SIGINT applications, antenna technology, real-time process control and software development

 

• U.S. Air Force (USAF), United Kingdom (U.K.) Ministry of Defence (MoD), and other allied foreign military ISR aircraft platforms and ground systems

   

• Fleet management of special mission aircraft, including avionics and mission system upgrades and logistics support

 

• Measurement collection and signal intelligence, special missions

 

• DoD and classified customers within the U.S. Government

   

• ISR operations and support

 

• Data link support and services, special applications, classified projects, spares and repairs

 

• USAF and U.S. Army ISR aircraft platforms and ground systems

   
Networked Communications      
   

• Airborne, space and surface data link terminals, ground stations, and transportable tactical SATCOM (satellite communications) systems

 

• High performance, wideband secure communication links for relaying of intelligence and reconnaissance information

 

• Manned aircraft, unmanned aerial vehicles (UAVs), naval ships, ground vehicles and satellites for the DoD

   

• Multi-band Manpack Receivers

 

• Portable, ruggedized terminals used for receiving reconnaissance video and sensor data from multiple airborne platforms

 

• U.S. Special Operations Command (USSOCOM), USAF and other DoD customers

   

• Satellite command and control sustainment and support

 

• Software integration, test and maintenance support, satellite control network and engineering support for satellite launch systems

 

• USAF Space Command (AFSC), USAF Satellite Control Network and launch ranges

   
Secure Communications Products      
   

• Secure communication terminals and equipment, and secure network encryption products

 

• Secure and non-secure voice, data and video communication for office, battlefield and secure internet protocol (IP) network applications

 

• DoD and U.S. Government intelligence agencies

   

• Ground-based satellite communication terminals and payloads

 

• Interoperable, transportable ground terminals

 

• DoD and U.S. Government intelligence agencies

   

• Shipboard communications systems

 

• Internal and external communications (radio rooms)

 

• U.S. Navy (USN), U.S. Coast Guard (USCG) and allied foreign navies

 

4


Table of Contents

Government Services Reportable Segment

In 2011, Government Services net sales of $3,621 million represented 24% of our total net sales. The businesses in this segment provide a full range of systems engineering and technical assistance (SETA), training, operational support, cyber security, intelligence, enterprise information technology (IT) and security solutions services to the DoD, DoS, DoJ and U.S. Government intelligence agencies and allied foreign governments. Major services for this reportable segment include:

 

   

communication software support, IT services and a wide range of engineering development services and integration support;

 

   

high-end engineering and information systems support services used for command, control, communications and ISR architectures for applications used by the DoD, DHS and U.S. Government intelligence agencies, including missile and space systems, UAVs and manned military aircraft;

 

   

developing and managing extensive programs in the United States and internationally that focus on teaching, training and education, logistics, strategic planning, organizational design, democracy transition and leadership development;

 

   

human intelligence support and other services, including linguist and translation services and related management to support contingency operations and current intelligence-gathering requirements;

 

   

command & control systems and software services in support of maritime and expeditionary warfare;

 

   

intelligence, analysis and solutions support to the DoD, including the U.S. Armed Services combatant commands and the U.S. Government intelligence agencies, including those within the U.S. Armed Services;

 

   

technical and management services, which provide support of intelligence, logistics, C3 and combatant commands; and

 

   

conventional high-end enterprise IT support, systems, including cyber security and other services to the DoD and other U.S. federal agencies.

 

5


Table of Contents

The table below provides additional information for the systems, products and services, selected applications and selected platforms or end users of our Government Services reportable segment.

 

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

Training and Operational Support      
   

• Training systems, and doctrine development

 

• Training, leadership development and education services for U.S. and allied foreign armed forces, counterintelligence and law enforcement personnel

 

• U.S. Army, U.S. Marine Corps (USMC), DoS, DoJ and allied foreign governments

   

• Acquisition management and staff augmentation

 

• Rapid fielding support for combatants and physical location management

 

• U.S. Army

   

• Specialized management, policy and training in energy, environmental and natural resource management

 

• Water and Coastal resource management, sustainable agriculture and food security, climate change mitigation strategies, emergency preparedness, response and reconstruction, power sector restructuring and energy economics and finance

 

• U.S. Agency for International Development, foreign governments, World Bank and Non-Governmental Organizations

   

• Linguistic, interpretation, translation and analyst services

 

• Counterintelligence, threat protection and counter terrorism

 

• U.S. Army

   
Command & Control Systems and Software    
   

• Software engineering/software sustainment, operations analysis, research, technical analysis, training, and test and evaluation

 

• Software, systems and field services support for C4ISR Systems, fixed and rotary wing aircraft, naval vessels and ground vehicles

 

• U.S. Army, USN and USMC

   

• Communication systems and software engineering services

 

• Value-added, critical software support for C3 ISR systems, electronic warfare and fire support systems

 

• U.S. Army Communications – Electronics Command (CECOM)

   

• Acquisition and Procurement Support

 

• Support defense acquisition programs, develop acquisition roadmaps, capability assessments and develop requirements

 

• U.S. Army, USN and USMC

   

• Systems Engineering and Integration Support

 

• System design and development, platform simulations, systems testing, prototype development and deployment and hardware and software integration

 

• USMC, U.S. Army and USSOCOM

   
Engineering Solutions      
   

• Engineering and technical solutions

 

• Systems engineering and design, analysis and integration, technical support and test & evaluation, Weapons of Mass Destruction (WMD) effects analysis and Improvised Explosive Device (IED) counter measures

 

• DoD and U.S. Government agencies

 

6


Table of Contents

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

   

• Program management and operational support

 

• Command center operations, systems acquisitions, emergency management training, continuity of operations and government planning

 

• Federal Emergency Management Agency, FAA, Joint Task Force — Civil Support

   
Enterprise IT Solutions      
   

• Network and enterprise administration and management

 

• Systems engineering, cyber security, assurance and risk management, network and systems administration, management, software development and life cycle support and systems integration

 

• U.S. Army, U.S. Joint Chiefs of Staff, USAF, USSOCOM, Federal Aviation Administration (FAA) and NASA

   

• Systems acquisition and advisory support and comprehensive operational support services

 

• Requirements definition, program management, planning and analysis, systems engineering, integration and development, intelligence analysis and managing and network engineering

 

• U.S. Army, USAF, USN and DHS

   
Intelligence Solutions and Support    
   

• System support and concept operations (CONOPS)

 

• C3ISR, modeling and simulation, and cyber security

 

• DoD, U.S. Missile Defense Agency (MDA), U.S. Government intelligence agencies, and NASA

   

• IT services

 

• IT infrastructure modernization and operations, and cyber security

 

• U.S. Government intelligence agencies and U.K. MoD

   

• Information management and IT systems support and software design, development and systems integration

 

• Intelligence and operations support, C3 systems, network centric operations and information operations

 

• DoD and U.S. Government intelligence agencies

   
Global Security Solutions      
   

• Surveillance systems and products, including installation and logistics support

 

• Remote surveillance for U.S. borders

 

• DHS

   

• Security Solutions

 

• Border security systems, area surveillance and access control, critical infrastructure protection, continuity planning and emergency management

 

• DHS, USMC and Customs and Border Patrol

As previously discussed, we plan to spin-off a part of our Government Services segment into a new, independent company that will be publicly traded. See “Part II – Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Overview and Outlook – Spin-off of Businesses that will comprise Engility” on page 38 for additional information. The new public company will be named Engility Holdings, Inc., and will include the SETA, training and operational support services businesses, which provide the training, operational support, command & control systems and software, and engineering solutions services described in the table above. L-3 will retain the cyber security, intelligence, enterprise IT and security solutions businesses, which provide the enterprise IT solutions, intelligence solutions and support, and global security solutions services described in the table above. The Government Services segment will be renamed National Security Solutions upon completion of the spin-off.

 

7


Table of Contents

Aircraft Modernization and Maintenance (AM&M) Reportable Segment

In 2011, AM&M net sales of $2,440 million represented 16% of our total net sales. The businesses in this segment provide modernization, upgrades and sustainment, maintenance and logistics support services for military and various government aircraft and other platforms. We sell these services primarily to the DoD, the Canadian Department of National Defense (DND) and other allied foreign governments. Major products and services for this reportable segment include:

 

   

engineering, modification, maintenance, logistics and upgrades for aircraft, vehicles and personnel equipment;

 

   

turnkey aviation life cycle management services that integrate custom developed and commercial off-the-shelf products for various military fixed and rotary wing aircraft, including heavy maintenance and structural modifications and interior modifications and construction; and

 

   

aerospace and other technical services related to large fleet support, such as aircraft and vehicle modernization, maintenance, repair and overhaul, logistics, support and supply chain management, primarily for military training, tactical, cargo and utility aircraft.

The table below provides additional information for the systems, products and services, selected applications and selected platforms or end users of our AM&M reportable segment.

 

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

   
Aircraft and Base Support Services      
   

• Logistics support, maintenance and refurbishment

 

• Aircraft maintenance repair and overhaul, flight operations support for training, cargo and special mission aircraft

 

• U.S. Army, USAF, USN, Canadian DND and other allied foreign militaries

   

• Contract Field Teams (CFT)

 

• Deployment of highly mobile, quick response field teams to customer locations to supplement the customer’s resources for various ground vehicles and aircraft

 

• U.S. Army, USAF, USN and USMC

   

• Contractor operated and managed base supply (COMBS)

 

• Inventory management activities relating to flight support and maintenance, including procurement and field distribution

 

• Military training and cargo aircraft

   
Aircraft Modernization      
   

• Modernization and life extension maintenance upgrades and support

 

• Aircraft structural modifications and inspections, installation of mission equipment, navigation and avionics products, interior modifications

 

• USN, USAF, Canadian DND, Royal Australian Air Force, other allied foreign governments, various military, fixed and rotary wing aircraft, original equipment manufacturers (OEM), very important person and head of state aircraft

   

• Fabrication and assembly of fixed and rotary wing aeronautical structures

 

• Rotary wing cabin assemblies, new and modified wings and subassemblies, and parts fabrication for original equipment manufacturers

 

• U.S. Army, USN, USMC, Canadian DND and OEMs

 

8


Table of Contents

Electronic Systems Reportable Segment

In 2011, Electronic Systems net sales of $5,540 million represented 36% of our total net sales. The businesses in this reportable segment provide a broad range of products and services, including components, products, subsystems, systems and related services to military and commercial customers in several niche markets. The table below provides a summary of the segment’s business areas and the percentage that each contributed to Electronic Systems net sales in 2011.

 

Business Area

  % of 2011
Segment Sales
 

Microwave

    18

Power & Control Systems

    17   

Integrated Sensor Systems

    14   

Aviation Products

    10   

Simulation & Training

    10   

Warrior Systems

    8   

Precision Engagement

    7   

Security & Detection

    6   

Space & Propulsion

    5   

Undersea Warfare

    4   

Marine Services

    1   
 

 

 

 

Total Electronic Systems

    100
 

 

 

 

 

9


Table of Contents

The table below provides additional information for the systems, products, and services selected applications and selected platforms or end users of our Electronic Systems reportable segment.

 

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

   
Microwave      
   

• Passive and active microwave components and subsystems and non-ionizing radiation monitoring equipment

 

• Radio transmission, switching and conditioning, transponder control, channel and frequency separation, ground vehicles, aircraft and satellites

 

• DoD and original equipment manufacturers, SATCOM for DoD and various government agencies

   

• Traveling wave tubes, power modules, klystrons and digital broadcast

 

• Microwave vacuum electron devices and power modules

 

• DoD and allied foreign military manned/unmanned platforms, various missile programs and commercial broadcast

   

• Quick-deploy flyaway very small aperture terminals (VSAT) and vehicular satellite systems

 

• Satellite communication systems

 

• U.S. Army, USAF and various DoD agencies

   

• High dynamic small aperture Ku/Ka-band receive/transmit systems

 

• Off road use on military vehicles, watercraft, and airborne platforms to provide two-way broadband connectivity while on the move

 

• U.S. Army and various DoD agencies

   

• Tactical ground based signal intercept and direction finding systems

 

• Man portable and military vehicle mounted tactical signal intercept/exploitation and direction finding systems

 

• U.S. Army and other DoD/U.S. intelligence agencies

   

• Managed satellite networks and integrated remote VSAT satellite systems

 

• Deployment and support of global communication networks for tactical and enterprise applications

 

• U.S. Army, DoD/U.S. intelligence agencies, allied forces and commercial contractors

   

• Spread spectrum & time division multiple access modems that support ultra high frequency (UHF) using Ka band operation

 

• On the move SATCOM and other tactical communications systems utilizing small aperture terminals

 

• U.S. military and various international allied military and special forces customers

   

• Ultra-wide frequency and advanced radar antennas and radomes

 

• Surveillance and radar detection

 

• Military fixed and rotary winged aircraft, SATCOM

   

• Telemetry and instrumentation systems

 

• Spacecraft telemetry tracking and control, encryption and high data rate transmitters, satellite command and control software, airborne and ground test telemetry systems, and tactical intelligence receivers

 

• Aircraft, missiles and satellites

   
Power & Control Systems      
   

• Shipboard electrical power packages, electric drives and propulsion, automation, navigation, communication, entertainment solutions and safety systems

 

• Surface ships ranging from shipping vessels, container carriers, environmental and research ships, ferries, cruise liners and mega yachts

 

• Commercial shipbuilders and allied foreign navies

 

10


Table of Contents

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

   

• Naval power delivery, conversion and switching products, and hybrid electric drives

 

• Switching, distribution and protection, frequency and voltage conversion, propulsion motors and drive units

 

• Naval submarines, surface ships and aircraft carriers

   

• Automation, dynamic positioning, navigation, communications, and sensors

 

• Vessel bridge and machinery plant platform management systems

 

• U.S. and allied foreign navies, other government agencies, commercial shipyards, and utility companies

   

• Power plant simulation, modeling, computer systems, and training services

 

• Submarines, nuclear and other power plants

 

• Allied navies, nuclear and other power plant companies

   
Integrated Sensor Systems      
   

• Targeted stabilized camera systems with integrated sensors and wireless communication systems

 

• Intelligence Data Collection, Surveillance and Reconnaissance

 

• DoD, intelligence and security agencies, law enforcement, manned/unmanned platforms

   

• Airborne and ground based high energy laser beam directors, laser designators and high tracking rate telescopes

 

• Directed energy systems, space surveillance, satellite laser ranging and laser communications, airborne and ground target designation/illumination

 

• USAF and NASA

   
Aviation Products      
   

• Solid state crash protected cockpit voice and flight data recorders

 

• Aircraft voice and flight data recorders that continuously record voice and sounds from cockpit and aircraft intercommunications

 

• Commercial transport, business, regional and military aircraft

   

• Airborne traffic and collision avoidance systems, terrain awareness warning systems

 

• Reduce the potential for midair aircraft collisions and crashes into terrain by providing visual and audible warnings and maneuvering instructions to pilots

 

• Commercial transport, business, regional and military aircraft

   

• Advanced cockpit avionics

 

• Pilot safety, navigation and situation awareness products

 

• Commercial transport, business, regional and military aircraft

   

• Cockpit and mission displays

 

• High performance, ruggedized flat panel and cathode ray tube displays and processors

 

• Various military aircraft

   
Simulation & Training      
   

• Military aircraft flight simulators, reconfigurable training devices, distributed mission training suites

 

• Advanced simulation technologies and training for pilots, navigators, flight engineers, gunners and operators

 

• Fixed and rotary winged aircraft and ground vehicles for USAF, USN, U.S. Army, Canadian DND and allied foreign militaries

   

• Training services, courseware integrated logistics support and maintenance

 

• Systems management, operations, and maintenance

 

• Various DoD and allied foreign military customers

 

11


Table of Contents

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

   
Warrior Systems      
   

• Enhanced vision and weapon sights products

 

• Image intensified night vision goggles/sights, holographic weapon sights, thermal sights and images, and driver viewers for special forces, pilots and aircrews, soldiers, marines, sailors and law enforcement personnel

 

• U.S. Army, USN, USMC, DHS, allied foreign militaries and law enforcement agencies

   

• Weapons Training Systems

 

• Laser marksmanship training systems and advanced integrated technologies for security products and services

 

• DoD and law enforcement agencies

   
Precision Engagement      
   

• Unmanned systems and components

 

• Tactical unmanned air systems (UAS), medium altitude long endurance (MALE) UAS, small expendable UAS, flight controls, sensors and remote viewing systems

 

• U.S. DoD and allied foreign ministries of defense

   

• Global Positioning System (GPS) receivers

 

• Location tracking

 

• Guided projectiles and precision munitions

   

• Fuzing and ordnance systems

 

• Precision munitions, fuzes, and electronic and electro safety arming devices (ESADs)

 

• Various DoD and allied foreign military customers

   

• Remote viewing video and exploitation systems

 

• Portable situational awareness and video exploitation software and hardware for soldiers, ships and vehicles

 

• USMC, USN and Various DoD

   

• Lightweight man portable computer/displays for dismounted soldiers

 

• Situational awareness and connectivity for dismounted soldiers

 

• U.K. MoD

   
Security & Detection      
   

• Airport security systems, explosives detection systems and whole body imaging systems

 

• Rapid scanning of passenger checked baggage and carry-on luggage, scanning of large cargo containers

 

• DHS, including the U.S. Transportation and Security Administration (TSA), domestic and international airports and state and local governments

   

• Non-invasive security systems and portals, and sophisticated sensors with threat detection capabilities

 

• Aviation, rail and border crossing security

 

• TSA, U.S. Customs agency, various regulatory authorities and private security companies

   

• Force protection, electronic warfare and satellite monitoring

 

• Counter IED systems, jamming and satellite monitoring

 

• U.K. MoD and other international security agencies and ministries of defense

 

12


Table of Contents

Systems/Products/Services

 

Selected Applications

 

Selected Platforms/End Users

   
Space & Propulsion      
   

• Navigation systems and positioning navigation units

 

• Satellite launch and orbiting navigation and navigation for ground vehicles and fire control systems

 

• USAF, U.S. Army, USMC and NASA

   

• Ballistic missile targets

 

• Targets for ground based ballistic missile intercept systems

 

• Missile Defense Agency

   

• Heavy fuel engines, cross drive variable transmissions, turret drive systems, vehicle suspension, advanced drive systems and auxiliary power generators

 

• Power trains and suspension systems for military vehicles, power and energy management for military hybrid electric vehicles, non portable and under armor auxiliary power units, and heavy fueled engines for unmanned systems

 

• U.S. Army, USMC and allied foreign ministries of defense, manned/unmanned military platforms

   

• High power microwave sources, systems & effects, pulse power systems and electromagnetics hardened construction

 

• Forensic analysis of weapons of mass destruction, active detection of special nuclear material and irradiation systems for decontamination and industrial applications

 

• U.K. MoD, U.S. Defense Threat Reduction Agency, U.S. Army and USAF

   
Undersea Warfare      
   

• Airborne dipping sonars, submarine and surface ship towed arrays

 

• Submarine and surface ship detection and localization

 

• USN and allied foreign navies

   

• Underwater sensor ranges

 

• Monitor nuclear testing, track submarines and surface vessels

 

• U.S. and foreign military and commercial customers

   
Marine Services      
   

• Service life extensions

 

• Landing craft air cushion amphibious vehicle

 

• USN

   

• Ship repair, overhaul and maintenance, ship instructions, and battle force tactical training

 

• Embedded shipboard training systems

 

• USN, USCG and commercial shipowners

 

13


Table of Contents

Backlog and Orders

We define funded backlog as the value of funded orders received from customers, less the cumulative amount of sales recognized on such orders. We define funded orders as the value of contract awards received from the U.S. Government, for which the U.S. Government has appropriated funds, plus the value of contract awards and orders received from customers other than the U.S. Government. The table below presents our funded backlog, percent of funded backlog at December 31, 2011 expected to be recorded as sales in 2012 and funded orders for each of our reportable segments.

 

     Funded Backlog
at December 31,
     Percentage of
Funded Backlog at
December 31, 2011
Expected to be
Recorded as
Sales in 2012
    Funded Orders  
             2011                      2010                        2011                      2010          
     (in millions)            (in millions)  

Reportable Segment:

             

C3ISR

   $ 2,868       $ 2,615         70   $ 3,819       $ 3,657   

Government Services

     1,461         1,695         84     3,388         3,850   

AM&M

     1,731         1,872         74     2,296         2,996   

Electronic Systems

     4,635         4,909         67     5,286         5,149   
  

 

 

    

 

 

      

 

 

    

 

 

 

Consolidated

   $   10,695       $   11,091           71   $   14,789       $   15,652   
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

 

Our funded backlog does not include the full potential value of our contract awards, including those pertaining to multi-year, cost-plus type contracts, which are generally funded on an annual basis. Funded backlog also excludes the potential future orders and related sales from unexercised priced contract options that may be exercised by customers under existing contracts and the potential future orders and related sales of purchase orders that we may receive in the future under indefinite quantity contracts or basic ordering agreements during the term of such agreements.

Major Customers

The table below presents a summary of our 2011 sales by end customer and the percent contributed by each to our total 2011 sales. For additional information regarding domestic and foreign sales, see Note 22 to our audited consolidated financial statements.

 

       2011 Sales        % of
  Total Sales  
 
     (in millions)         

Army

   $ 3,931         26

Air Force

     3,864         25   

Navy/Marines

     2,358         16   

Other Defense

     1,168         8   
  

 

 

    

 

 

 

Total DoD

   $ 11,321         75

Other U.S. Government

     1,113         7   
  

 

 

    

 

 

 

Total U.S. Government

   $ 12,434         82

Foreign governments

     1,200         8   

Commercial — foreign

     905         6   

Commercial — domestic

     630         4   
  

 

 

    

 

 

 

Total sales

   $     15,169             100
  

 

 

    

 

 

 

Direct sales to the end customer represent approximately 70% of our consolidated sales, and we are a subcontractor or supplier for the remaining 30%. Additionally, approximately 70% of our DoD sales for 2011 were direct to the customer, and approximately 30% were indirect through other prime system contractors and subcontractors of the DoD.

 

14


Table of Contents

Our sales are predominantly derived from contracts with agencies of, and prime system contractors to, the U.S. Government. Various U.S. Government agencies and contracting entities exercise independent and individual purchasing decisions, subject to annual appropriations by the U.S. Congress. For the year ended December 31, 2011, our five largest contracts generated 11% of our consolidated sales. For the year ended December 31, 2011, our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Command. Under this contract, which generated approximately 3% of our 2011 sales, we provide maintenance and logistical support services for rotary wing aircraft assigned to Fort Rucker and satellite units in Alabama. The current contract is expected to end on September 30, 2012. We submitted our proposal in November 2011 for the contract re-competition and anticipate the award will be made by August 2012. We cannot provide any assurance that we will win the re-competition of the Fort Rucker Maintenance Support contract.

Research and Development

We conduct research and development activities that consist of projects involving applied research, new product and systems development and select concept studies. We employ scientific, engineering and other personnel to improve our existing product-lines and systems and develop new products, technologies, and systems. As of December 31, 2011, we employed approximately 12,500 engineers, a substantial portion of whom hold advanced degrees, and who work on company-sponsored research and development efforts and customer funded research and development contracts.

Company-sponsored (Independent) research and development costs for our businesses that are U.S. Government contractors are allocated to U.S. Government contracts and are charged to cost of sales when the related sales are recognized as revenue. Research and development costs for our commercial businesses are expensed as incurred and are also charged to cost of sales. The table below presents company-sponsored (Independent) research and development expenses incurred for the years ended December 31, 2011, 2010 and 2009 for our U.S. Government businesses and our commercial businesses.

 

     Year Ended December 31,  
           2011                  2010                  2009        

Company-Sponsored Research and Development Costs:

        

U.S. Government Contractor Businesses

   $ 207       $ 202       $ 198   

Commercial Businesses

     73         68         59   
  

 

 

    

 

 

    

 

 

 

Total

   $     280       $     270       $     257   
  

 

 

    

 

 

    

 

 

 

Customer-funded research and development costs pursuant to contracts (revenue arrangements) are not included in the table above because they are direct contract costs and are charged to cost of sales when the corresponding revenue is recognized. See Note 2 to our audited consolidated financial statements for additional information regarding research and development.

Competition

Our businesses generally encounter significant competition. We believe that we are a major provider for many of the products and services we offer to our DoD, government and commercial customers.

Our ability to compete for existing and new business depends on a variety of factors, including,

 

   

the effectiveness and innovation of our technologies, systems and research and development programs;

 

   

our ability to offer better program performance at an affordable and competitive cost;

 

   

historical technical, cost and schedule performance;

 

   

our ability to attain supplier positions on contracts;

 

15


Table of Contents
   

our ability to maintain an effective supplier and vendor base;

 

   

our ability to retain our employees and hire new ones, particularly those who have U.S. Government security clearances;

 

   

the capabilities of our facilities, equipment and personnel to undertake the business for which we compete; and

 

   

our ability to quickly and flexibly meet customer requirements and priorities.

In some instances, we are the incumbent supplier or have been the sole provider on a contract for many years, and we refer to these positions as “sole-source”. On our sole-source contracts, there may be other suppliers who have the capability to compete for the contracts involved, but they can only enter the market if the customer chooses to reopen the particular contract to competition. Sole-source contracts are generally re-competed every three to five years and at times more frequently. For the year ended December 31, 2011, contracts where we held sole-source positions accounted for 57% of our total sales and contracts which we had competitively won accounted for 43% of our total sales.

L-3 is a defense supplier with a broad and diverse portfolio of products and services. We are primarily a non-platform prime contractor and have diverse subcontractor positions. We supply our products and services to other prime system contractors. However, we also compete directly with other large prime system contractors for (1) certain products, subsystems and systems, where they have vertically integrated businesses and (2) niche areas where we are a prime contractor. We also compete with numerous other aerospace, defense and government technical services contractors, which generally provide similar products, subsystems, systems or services.

In addition, our ability to compete for select contracts may require us to “team” with one or more of the other prime system contractors that bid and compete for major platform programs, and our ability to “team” with them is often dependent upon the outcome of a competition for subcontracts they award.

Patents and Licenses

Generally, we do not believe that our patents, trademarks and licenses are material to our operations. Furthermore, most of our U.S. Government contracts generally permit us to use patents owned by other U.S. Government contractors. Similar provisions in U.S. Government contracts awarded to other companies make it impossible for us to prevent the use of our patents in most DoD work performed by other companies for the U.S. Government.

Raw Materials

Generally, our businesses engage in limited manufacturing activities and have minimal exposure to fluctuations in the supply of raw materials. L-3’s business mix is approximately 50% services work, and for those businesses that sell hardware and product, most of the value that we provide is labor oriented, such as design, engineering, assembly and test activities. In manufacturing our products, we use our own production capabilities as well as a diverse base of third party suppliers and subcontractors. Although certain aspects of our manufacturing activities require relatively scarce raw materials, we have not experienced difficulty in our ability to procure raw materials, components, sub-assemblies and other supplies required in our manufacturing processes.

Contracts

A significant portion of our sales are derived from sole-source contracts as discussed above. We believe that our customers award sole-source contracts to the most capable supplier in terms of quality, responsiveness,

 

16


Table of Contents

design, engineering and program management competency and cost. However, as discussed above, we are increasingly competing against other prime system contractors for major subsystems and systems business.

Generally, the sales price arrangements for our contracts are either fixed-price, cost-plus or time-and-material type. Generally, a fixed-price type contract offers higher profit margin potential than a cost-plus type or time-and-material type contract, which is commensurate with the greater levels of risk we assume on a fixed-price type contract.

On a fixed-price type contract (revenue arrangement), we agree to perform the contractual statement of work for a predetermined sales price. Although a fixed-price type contract generally permits us to retain profits if the total actual contract costs are less than the estimated contract costs, we bear the risk that increased or unexpected costs may reduce our profit or cause us to sustain losses on the contract. Accounting for the sales on a fixed-price type contract that is covered by contract accounting standards requires the preparation of estimates of (1) the total contract revenue, (2) the total costs at completion, which is equal to the sum of the actual incurred costs to date on the contract and the estimated costs to complete the contract’s statement of work, and (3) the measurement of progress towards completion. Adjustments to original estimates for a contract’s revenue, estimated costs at completion and estimated total profit or loss are often required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract may not change.

On a cost-plus type contract (revenue arrangement), we are paid our allowable incurred costs plus a profit which can be fixed or variable depending on the contract’s fee arrangement up to predetermined funding levels determined by our customers. Cost-plus type contracts with award and incentive fee provisions are our primary variable contract fee arrangement. Award fees provide for a fee based on actual performance relative to contractually specified performance criteria. Incentive fees provide for a fee based on the relationship which total allowable costs bear to target cost. The tables below present our sales from cost-plus type contracts with award fees and incentive fees and the percentage of available performance-based award fees we achieved for the years ended December 31, 2011, 2010 and 2009.

 

     Year Ended December 31,  
         2011                  2010                  2009        

Sales from Cost-Plus Contracts with:

        

Award fees

   $ 705       $ 907       $ 1,068   

Incentive fees

     848         944         751   
  

 

 

    

 

 

    

 

 

 

Performance based fees

   $   1,553       $   1,851       $   1,819   
  

 

 

    

 

 

    

 

 

 

 

     Year Ended December 31,  
         2011                  2010                  2009        

Percentage of Available Performance-Based Award Fees Achieved

     92%           90%           95%     

On a time-and-material type contract (revenue arrangement), we are paid on the basis of direct labor hours expended at specified fixed-price hourly rates (that include wages, overhead, allowable general and administrative expenses and profit) and materials at cost. Therefore, on cost-plus type and time-and-material type contracts we do not bear the risks of unexpected cost overruns, provided that we do not incur costs that exceed the predetermined funded amounts.

We believe we have a balanced mix of fixed-price, cost-plus and time-and-material type contracts, a diversified business base and an attractive customer profile with limited reliance on any single contract.

 

17


Table of Contents

The table below presents the percentage of our total sales generated from each contract-type for the years ended December 31, 2011, 2010, and 2009.

 

Contract-Type

   Year Ended December 31,  
         2011                 2010                 2009        

Fixed-price

     63     58     57

Cost-plus

     26     28     28

Time-and-material

     11     14     15
  

 

 

   

 

 

   

 

 

 

Total sales

         100         100         100
  

 

 

   

 

 

   

 

 

 

Substantially all of our cost-plus type contracts and time-and-material type contracts are with U.S. Government customers. Substantially all of our sales to commercial customers are transacted under fixed-price sales arrangements and are included in our fixed-price type contract sales.

Regulatory Environment

Most of our revenue arrangements with agencies of the U.S. Government, including the DoD, are subject to unique procurement and administrative rules. These rules are based on both laws and regulations, including the U.S. Federal Acquisition Regulation, that: (1) impose various profit and cost controls, (2) regulate the allocations of costs, both direct and indirect, to contracts and (3) provide for the non-reimbursement of unallowable costs. Unallowable costs include, but are not limited to, lobbying expenses, interest expenses and certain costs related to business acquisitions, including, for example, the incremental depreciation and amortization expenses arising from fair value increases to the historical carrying values of acquired assets. Our contract administration and cost accounting policies and practices are also subject to oversight by government inspectors, technical specialists and auditors. See “Part I — Item 1A — Risk Factors” beginning on page 20 for a discussion of certain additional business risks specific to our government contracts.

Our U.S. Government contracts are subject to extensive legal and regulatory requirements and, from time to time, agencies of the U.S. Government investigate whether our operations are being conducted in accordance with these requirements. Investigations could result in administrative, civil, or criminal liabilities, including repayments, disallowance of certain costs, or fines and penalties. As is common in the U.S. defense industry, we are subject to business risks, including changes in the U.S. Government’s procurement policies (such as greater emphasis on competitive procurement), governmental appropriations, national defense policies or regulations, service modernization plans, and availability of funds. A reduction in expenditures by the U.S. Government for products and services of the type we manufacture and provide, lower margins resulting from increasingly competitive procurement policies, a reduction in the volume of contracts or subcontracts awarded to us or the incurrence of substantial contract cost overruns could materially adversely affect our business.

Certain of our sales are under foreign military sales (FMS) agreements directly between the U.S. Government and allied foreign governments. In such cases, because we serve only as the supplier, we do not have unilateral control over the terms of the agreements. Certain of our sales are direct commercial sales to allied foreign governments. These sales are subject to U.S. Government approval and licensing under the Arms Export Control Act. Legal restrictions on sales of sensitive U.S. technology also limit the extent to which we can sell our products to allied foreign governments or private parties.

All of our U.S. Government contracts can be terminated by the U.S. Government either for its convenience or if we default by failing to perform under the contract. Termination for convenience provisions provide only for our recovery of costs incurred or committed settlement expenses and profit on the work completed prior to termination. Termination for default provisions provide for the contractor to be liable for excess costs incurred by the U.S. Government in procuring undelivered items from another source. Our contracts with foreign governments generally contain similar provisions relating to termination at the convenience of the customer.

 

18


Table of Contents

Environmental Matters

Our operations are subject to various environmental laws and regulations relating to the discharge, storage, treatment, handling, disposal and remediation of certain materials, substances and wastes used in our operations. We continually assess our obligations and compliance with respect to these requirements.

We have also assessed the risk of environmental contamination for our various manufacturing facilities, including our acquired businesses and, where appropriate, have obtained indemnification, either from the sellers of those acquired businesses or through pollution liability insurance. We believe that our current operations are in substantial compliance with all existing applicable environmental laws and permits. We believe our current expenditures will allow us to continue to be in compliance with applicable environmental laws and regulations. While it is difficult to determine the timing and ultimate cost to be incurred in order to comply with these laws, based upon available internal and external assessments, with respect to those environmental loss contingencies of which we are aware, we believe there are no environmental loss contingencies that, individually or in the aggregate, would be material to our consolidated results of operations, financial position or cash flows.

Employees

As of December 31, 2011, we employed approximately 61,000 full-time and part-time employees, 84% of whom were located in the United States. Of these employees, approximately 16% are covered by 180 separate collective bargaining agreements with various labor unions. The success of our business is, to a large extent, dependent upon the knowledge of our employees and on the management, contracting, engineering and technical skills of our employees. In addition, our ability to grow our businesses, obtain additional orders for our products and services and to satisfy contractual obligations under certain of our existing revenue arrangements is largely dependent upon our ability to attract and retain employees who have U.S. Government security clearances, particularly those with clearances of top-secret and above. We believe that relations with our employees are positive.

L-3 Holdings Obligations

The only obligations of L-3 Holdings at December 31, 2011 were: (1) its 3% Convertible Contingent Debt Securities (CODES) due 2035, which were issued by L-3 Holdings on July 29, 2005, (2) its guarantee of borrowings under the revolving credit facility of L-3 Communications and (3) its guarantee of other contractual obligations of L-3 Communications and its subsidiaries. L-3 Holdings’ obligations relating to the CODES have been jointly, severally, fully and unconditionally guaranteed by L-3 Communications and certain of its wholly-owned domestic subsidiaries. In order to generate the funds necessary to repurchase its common stock and pay dividends declared and principal and interest on its outstanding indebtedness, if any, L-3 Holdings relies on dividends and other payments from its subsidiaries.

Available Information

We are subject to the informational requirements of the Securities Exchange Act of 1934 and, in accordance therewith, file reports, including annual, quarterly and current reports, proxy statements and other information with the SEC. Such reports and other information can be inspected and copied at the Public Reference Room of the SEC located at 100 F Street, N.E., Washington, D.C. 20549. Copies of such material can be obtained from the Public Reference Room of the SEC at prescribed rates. You may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Such material may also be accessed electronically by means of the SEC’s home page on the Internet at http://www.sec.gov.

You may also obtain a free copy of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy statement for the annual shareholders’ meeting, as well as any amendments to those reports as soon as reasonably practicable after electronic filing with the SEC through our website on the Internet at http://www.L-3com.com.

 

19


Table of Contents

We also have a Corporate Governance webpage. You can access our Corporate Governance Guidelines and charters for the audit, compensation and nominating/corporate governance committees of our Board of Directors through our website, http://www.L-3com.com, by clicking on the “Corporate Governance” link under the heading “Investor Relations.” We post our Code of Ethics and Business Conduct on our Code of Ethics webpage under the link “Code of Ethics and Business Conduct.” Our Code of Ethics and Business Conduct applies to all directors, officers and employees, including our chairman, president and chief executive officer, our senior vice president and chief financial officer, and our vice president, controller and principal accounting officer. We will post any amendments to the Code of Ethics and Business Conduct, and any waivers that are required to be disclosed by the rules of either the SEC or the New York Stock Exchange, Inc. (“NYSE”), on our website within the required periods. The information on our website is not incorporated by reference into this report.

To learn more about L-3, please visit our website at http://www.L-3com.com. We use our website as a channel of distribution of material company information. Financial and other material information regarding L-3 is routinely posted on our website and is readily accessible.

Item 1A. Risk Factors

You should carefully consider the following risk factors and other information contained or incorporated by reference in this Form 10-K, including “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations”. Any of these risks could materially affect our business and our financial condition, results of operations and cash flows, which could in turn materially affect the price of our common stock.

Our contracts (revenue arrangements) with U.S. Government customers entail certain risks.

A decline in or a redirection of the U.S. defense budget could result in a material decrease in our sales, results of operations and cash flows.

Our government contracts and sales are highly correlated and dependent upon the U.S. defense budget which is subject to the congressional budget authorization and appropriations process. Congress usually appropriates funds for a given program on a September 30 fiscal year basis, even though contract periods of performance may extend over many years. Consequently, at the beginning of a major program, the contract is usually partially funded, and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress in future fiscal years. DoD budgets are a function of several factors beyond our control, including, but not limited to, changes in U.S. procurement policies, budget considerations, current and future economic conditions, presidential administration priorities, changing national security and defense requirements, geo-political developments and actual fiscal year congressional appropriations for defense budgets. Any of these factors could result in a significant decline in, or redirection of, current and future DoD budgets and impact our future results of operations, including our sales and operating income growth rates.

In August 2011, Congress enacted the Budget Control Act of 2011 (the BCA). The BCA immediately imposes spending caps that contain approximately $487 billion in reductions to the DoD base budgets over the next ten years (FY 2012 to FY 2021), compared to previously proposed DoD base budgets for the same fiscal years. An automatic sequestration process was also triggered by the BCA and becomes effective on January 3, 2013, unless modified by the enactment of new law. The sequestration process imposes additional cuts of approximately $50 billion per year to the currently proposed DoD budgets for each fiscal year beginning with FY 2013 through FY 2021.

On February 13, 2012, President Obama submitted his FY 2013 proposed budget (FY 2013 DoD Plan) to Congress. The FY 2013 DoD Plan complies with the first phase of the BCA imposed spending cuts. The FY 2013 DoD Plan reduces proposed DoD base budgets by $259 billion for FY 2013 to FY 2017, compared to the previously proposed DoD base budgets. The enacted DoD budget (base and OCO) for FY 2012 is 6% lower than the FY 2011 enacted budget. In addition, the FY 2013 DoD Plan projects a decline in the total DoD budget of 5% in FY 2013 and 6% in FY 2014, and a 2% increase in each year beginning in FY 2015 through FY 2017. The FY 2013 DoD Plan does not address or provision for the automatic sequestration process.

 

20


Table of Contents

The declining DoD budgets will reduce funding for some of our revenue arrangements and generally will have a negative impact on our sales, results of operations and cash flows. Additionally, the planned withdrawal of U.S. military forces from Afghanistan by the end of 2014 is expected to negatively impact our sales related to supporting U.S. military operations in Afghanistan.

We rely predominantly on sales to U.S. Government entities, and the loss or delay of a significant number of our contracts would have a material adverse effect on our results of operations and cash flows.

Our sales are predominantly derived from contracts (revenue arrangements) with agencies of, and prime system contractors to, the U.S. Government. The loss or delay of all or a substantial portion of our sales to the U.S. Government would have a material adverse effect on our results of operations and cash flows. Approximately 82%, or $12.4 billion, of our sales for the year ended December 31, 2011 were made directly or indirectly to U.S. Government agencies, including the DoD. Aggregate sales from our five largest contracts (revenue arrangements) amounted to approximately $1.7 billion, or 11% of our sales for the year ended December 31, 2011. For the year ended December 31, 2011, our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Command, which is included in our AM&M segment. Under this contract, which generated approximately 3% of our 2011 sales, we provide maintenance and logistical support services for rotary wing aircraft assigned to Fort Rucker and satellite units in Alabama. The current contract is expected to end on September 30, 2012. We submitted our proposal in November 2011 for the contract re-competition and anticipate the award will be made by August 2012. We cannot provide any assurance that we will win the re-competition of the Fort Rucker Maintenance Support contract.

A substantial majority of our total sales are for products and services under contracts with various agencies and procurement offices of the DoD or with prime contractors to the DoD. Although these various agencies, procurement offices and prime contractors are subject to common budgetary pressures and other factors, our customers exercise independent purchasing decisions. Because of this concentration of contracts, if a significant number of our DoD contracts and subcontracts are simultaneously delayed or cancelled for budgetary, performance or other reasons, it would have a material adverse effect on our results of operations and cash flows.

In addition to contract cancellations and declines in agency budgets, our backlog and future financial results may be adversely affected by:

 

   

curtailment of the U.S. Government’s use of technology or other services and product providers, including curtailment due to government budget reductions and related fiscal matters;

 

   

developments in Afghanistan, or other geopolitical developments that affect demand for our products and services;

 

   

our ability to hire and retain personnel to meet increasing demand for our services; and

 

   

technological developments that impact purchasing decisions or our competitive position.

The DoD’s wide-ranging efficiencies initiative, which targets affordability and cost growth, could have a material effect on the procurement process and may adversely affect our existing contracts and the award of new contracts.

The U.S. Government has issued guidance regarding changes to the procurement process that is intended to control cost growth throughout the acquisition cycle by developing a competitive strategy for each program. As a result, the Company expects to engage in more frequent negotiations and re-competitions on a cost or price analysis basis with every competitive bid in which it participates. This initiative is organized into five major areas: affordability and cost growth; productivity and innovation; competition; services acquisition; and

 

21


Table of Contents

processes and bureaucracy. Because this initiative significantly changes the way the U.S. Government solicits, negotiates and manages its contracts, this initiative could result in a reduction in expenditures for the type of products we manufacture for, and services we provide to, the U.S. Government and could have a material negative impact on our future sales, earnings and cash flows.

In addition, the FY 2013 DoD Plan seeks reductions in contractor support services and consolidation of enterprise IT systems as part of an effort to achieve another $60 billion of efficiency savings over the five fiscal years FY 2013 through FY 2017. This initiative will primarily affect our businesses within the Government Services reportable segment and could result in the loss of certain of our existing contracts (revenue arrangements) depending on how the DoD implements this initiative.

Our government contracts contain unfavorable termination provisions and are subject to audit and modification. If a termination right is exercised by the government, it could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Companies engaged primarily in supplying defense-related equipment and services to U.S. Government agencies are subject to certain business risks peculiar to the defense industry. These risks include the ability of the U.S. Government to unilaterally:

 

   

suspend us from receiving new contracts pending resolution of alleged violations of procurement laws or regulations;

 

   

terminate existing contracts;

 

   

reduce the value of existing contracts; and

 

   

audit our contract-related costs and fees, including allocated indirect costs.

All of our U.S. Government contracts can be terminated by the U.S. Government either for its convenience or if we default by failing to perform under the contract. Termination for convenience provisions provide only for our recovery of costs incurred or committed settlement expenses and profit on the work completed prior to termination. Termination for default provisions provide for the contractor to be liable for excess costs incurred by the U.S. Government in procuring undelivered items from another source. Our contracts with foreign governments generally contain similar provisions relating to termination at the convenience of the customer.

U.S. Government agencies, including the Defense Contract Audit Agency and various agency Inspectors General, routinely audit and investigate our costs and performance on contracts, as well as our accounting and general business practices. Based on the results of such audits, the U.S. Government may adjust our contract related costs and fees, including allocated indirect costs. In addition, under U.S. Government purchasing regulations, some of our costs, including certain business acquisition costs, most financing costs, portions of research and development costs, and certain marketing expenses may not be reimbursable under U.S. Government contracts.

We currently have a backlog of funded orders, primarily under contracts with the U.S. Government. Our total funded backlog was $10,695 million at December 31, 2011. As described above, the U.S. Government may unilaterally modify or terminate its contracts with us. Accordingly, most of our backlog could be modified or terminated by the U.S. Government, which would negatively impact our future sales, results of operations and cash flows.

 

22


Table of Contents

We may not be able to win competitively awarded contracts or receive required licenses to export our products, which could have a material adverse effect on our business, financial condition, results of operations and future prospects.

Our government contracts are subject to competitive bidding. We obtain many of our U.S. Government contracts through a competitive bidding process. We may not be able to continue to win competitively awarded contracts. In addition, awarded contracts may not generate sales sufficient to result in our profitability. We are also subject to risks associated with the following:

 

   

the frequent need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties and/or cost overruns;

 

   

the substantial time, effort and experience required to prepare bids and proposals for competitively awarded contracts that may not be awarded to us;

 

   

design complexity and rapid technological obsolescence; and

 

   

the constant need for design improvement.

In addition to these U.S. Government contract risks, we are not permitted to export some of our products and are also required to obtain licenses from U.S. Government agencies to export many of our products and systems. Failure to receive required licenses would eliminate our ability to sell our products and systems outside the United States.

Intense competition and bid protests may adversely effect our sales, results of operations and cash flows.

The defense and commercial industries in which our businesses operate are highly competitive. We expect that the DoD’s increased use of commercial off-the-shelf products and components in military equipment will continue to encourage new competitors to enter the market. We also expect increased competition for our products and services due to the uncertainty of future U.S. defense budgets. Furthermore, the current competitive environment has resulted in an increase of bid protests from unsuccessful bidders, which typically extends the time until work on a contract can begin. Additionally, some of our competitors are larger than we are and have more financial and other resources than we have. For more information concerning the factors that affect our ability to compete, see “Part I — Item 1 — Business — Competition” beginning on page 15.

We are subject to government investigations, which could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.

U.S. Government contracts are subject to extensive legal and regulatory requirements, and from time to time agencies of the U.S. Government investigate whether such contracts were and are being conducted in accordance with these requirements. We are currently cooperating with the U.S. Government on several investigations, including those discussed in Note 19 to our audited consolidated financial statements beginning on page F-41. Under U.S. Government regulations, an indictment of the Company by a federal grand jury, or an administrative finding against us as to our present responsibility to be a U.S. Government contractor or subcontractor, could result in us being suspended for a period of time from eligibility for awards of new government contracts or task orders or in a loss of export privileges. A conviction, or an administrative finding against us that satisfies the requisite level of seriousness, could result in debarment from contracting with the federal government for a specific term.

 

23


Table of Contents

We are subject to the risks of current and future legal proceedings, which could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.

At any given time, we are a defendant in various material legal proceedings and litigation matters arising in the ordinary course of business, including litigation, claims and assessments that have been asserted against acquired businesses, which we have assumed. Although we maintain insurance policies, these policies may not be adequate to protect us from all material judgments and expenses related to current or future claims and may not cover the conduct that is the subject of the litigation. Desired levels of insurance may not be available in the future at economical prices or at all. In addition, we believe that while we have valid defenses with respect to legal matters pending against us, the results of litigation can be difficult to predict, including those involving jury trials. Accordingly, our current judgment as to the likelihood of our loss (or our current estimate as to the potential range of loss, if applicable) with respect to any particular litigation matter may turn out to be wrong. A significant judgment against us, arising out of any of our current or future legal proceedings and litigation, could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects. For a discussion of material litigation to which we are currently a party, see Note 19 to our audited consolidated financial statements on page F-41.

If we are unable to keep pace with rapidly evolving products and service offerings and technological change, there could be a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.

The rapid change of technology is a key feature of most of the markets in which our products, services and systems oriented businesses operate. To succeed in the future, we will need to continue to design, develop, manufacture, assemble, test, market and support new products and enhancements on a timely and cost-effective basis. Historically, our technology has been developed through customer-funded and internally funded research and development and through certain business acquisitions. We may not be able to continue to maintain comparable levels of research and development or successfully complete such acquisitions. In the past, we have allocated substantial funds to capital expenditures, programs and other investments. This practice will continue to be required in the future. Even so, we may not be able to successfully identify new opportunities and may not have the necessary financial resources to develop new products and systems in a timely or cost-effective manner. At the same time, products and technologies developed by others may render our products, services and systems obsolete or non-competitive.

Our business acquisition strategy involves risks, and we may not successfully implement our strategy.

We opportunistically seek to acquire businesses that enhance our capabilities and add new technologies, products, services, programs, contracts, and customers to our existing businesses. We may not be able to continue to identify acquisition candidates on commercially reasonable terms or at all. If we make additional business acquisitions, we may not realize the benefits anticipated from these acquisitions, including sales growth, cost synergies and improving margins. Furthermore, we may not be able to obtain additional financing for business acquisitions, since such additional financing could be restricted or limited by the terms of our debt agreements or due to unfavorable credit market conditions.

The process of integrating the operations of acquired businesses into our existing operations may result in unforeseen difficulties and may require significant financial and managerial resources that would otherwise be available for the ongoing development or expansion of our existing operations. Possible future business acquisitions could result in the incurrence of additional debt and related interest expense and contingent liabilities, each of which could result in an increase to our already significant level of outstanding debt, as well as more restrictive covenants.

We consider and may enter into strategic business acquisitions on an ongoing basis and may be evaluating acquisitions or engaging in acquisition negotiations at any given time. We regularly evaluate potential

 

24


Table of Contents

acquisitions and joint venture transactions and have not entered into any agreements with respect to any material transactions at this time. Furthermore, in certain of our business acquisitions we have assumed all claims against and liabilities of the acquired business, including both asserted and unasserted claims and liabilities.

Goodwill represents a significant asset on our balance sheet and may become impaired.

Goodwill represents the largest asset on our balance sheet, with an aggregate balance of $8,697 million at December 31, 2011. We review goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also review goodwill annually in accordance with the accounting standards for goodwill and intangible assets. The annual impairment test requires us to determine the fair value of our reporting units in comparison to their carrying values. A decline in the estimated fair value of a reporting unit could result in a goodwill impairment, and a related non-cash impairment charge against earnings, if estimated fair value for the reporting unit is less than the carrying value of the net assets of the reporting unit, including its goodwill. The fair value of eight of our reporting units exceeded the carrying value of the net assets of those reporting units by less than 20% at November 30, 2011. In addition, we recorded a non-cash goodwill impairment charge of $43 million in 2011 due to a decline in the estimated fair value of the Marine Services business, which is part of the Electronic Systems segment, as a result of a decline in its projected future cash flows. A decline in the estimated fair value of one or more of our reporting units could result in a material adverse effect on our financial condition and results of operations. See “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies” beginning on page 41.

Our results of operations and cash flows are substantially affected by our mix of fixed-price, cost-plus and time-and-material type contracts.

Our sales are transacted using written revenue arrangements, or contracts, which are generally fixed-price, cost-plus or time-and-material. For a description of our revenue recognition policies, see “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies” beginning on page 41.

The table below presents the percentage of our total sales generated from each contract-type.

 

     Year Ended December 31,  
             2011                     2010                     2009          

Contract-Type

      

Fixed-price

     63     58     57

Cost-plus

     26     28     28

Time-and-material

     11     14     15
  

 

 

   

 

 

   

 

 

 

Total sales

         100         100         100
  

 

 

   

 

 

   

 

 

 

Substantially all of our cost-plus and time-and-material type contracts are with the U.S. Government, primarily the DoD. Substantially all of our sales to commercial customers are transacted under fixed-price sales arrangements, and are included in our fixed-price type contract sales.

On a fixed-price type contract (revenue arrangement), we agree to perform the contractual statement of work for a predetermined sales price. Although a fixed-price type contract generally permits us to retain profits if the total actual contract costs are less than the estimated contract costs, we bear the risk that increased or unexpected costs may reduce our profit or cause us to sustain losses on the contract.

On a cost-plus type contract (revenue arrangement), we are paid our allowable incurred costs plus a profit which can be fixed or variable depending on the contract’s fee arrangement up to predetermined funding levels

 

25


Table of Contents

determined by our customers. On a time-and-material type contract (revenue arrangement), we are paid on the basis of direct labor hours expended at specified fixed-price hourly rates (that include wages, overhead, allowable general and administrative expenses and profit) and materials at cost. Therefore, on cost-plus type and time-and-material type contracts, we do not bear the risks of unexpected cost overruns, provided that we do not incur costs that exceed the predetermined funded amounts.

Additionally, the impact of revisions in profit or loss estimates for all types of contracts subject to percentage of completion accounting are recognized on a cumulative catch-up basis in the period in which the revisions are made. Provisions for anticipated losses on contracts are recorded in the period in which they become evident. Amounts representing contract change orders or claims are included in sales only when they can be reliably estimated and their realization is reasonably assured. The revisions in contract estimates, if significant, can materially affect our results of operations and cash flows, as well as reduce the valuations of receivables and inventories; and in some cases, result in liabilities to complete contracts in a loss position.

Our significant level of debt and our ability to make payments on or service our indebtedness may adversely affect our financial and operating activities or our ability to incur additional debt.

At December 31, 2011, we had approximately $4,139 million in aggregate principal amount of outstanding debt. In addition, at December 31, 2011 we had borrowing capacity of $997 million available to us under our three-year $1 billion revolving credit facility that was due to expire on October 23, 2012 (Revolving Credit Facility), after reductions of $3 million for outstanding letters of credit. On February 3, 2012, we amended and restated our Revolving Credit Facility (Amended and Restated Revolving Credit Facility), which also extended the expiration date to February 3, 2017. In the future, we may increase our borrowings, subject to limitations imposed on us by our debt agreements. The first scheduled maturity of our existing debt is our $500 million aggregate principal amount of our 63/8% Senior Subordinated Notes maturing October 15, 2015. See “Part II – Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources – Debt” beginning on page 62 and Note 10 to our audited consolidated financial statements.

Our ability to make scheduled payments of principal and interest on our indebtedness and to refinance our existing debt depends on our future financial performance as well as our ability to access the capital markets, and the relative attractiveness of available financing terms. We do not have complete control over our future financial performance because it is subject to economic, political, financial (including credit market conditions), competitive, regulatory and other factors affecting the aerospace and defense industry, as well as commercial industries in which we operate. It is possible that in the future our businesses may not generate sufficient cash flow from operations to allow us to service our debt and make necessary capital expenditures. If this situation occurs, we may have to reduce costs and expenses, sell assets, restructure debt or obtain additional equity capital. We may not be able to do so in a timely manner or upon acceptable terms in accordance with the restrictions contained in our debt agreements. Our level of indebtedness has important consequences to us. These consequences may include:

 

   

requiring a substantial portion of our net cash flow from operations to be used to pay interest and principal on our debt and therefore be unavailable for other purposes, including acquisitions, capital expenditures, paying dividends to our shareholders, repurchasing shares of our common stock, research and development and other investments;

 

   

limiting our ability to obtain additional financing for acquisitions, working capital, investments or other expenditures, which, in each case, may limit our ability to carry out our acquisition strategy;

 

   

increasing interest expense due to higher interest rates on our Amended and Restated Revolving Credit Facility as it has a variable interest rate;

 

   

heightening our vulnerability to downturns in our business or in the general economy and restricting us from making acquisitions, introducing new technologies and products or exploiting business opportunities; and

 

26


Table of Contents
   

impacting debt covenants that limit our ability to borrow additional funds, dispose of assets, pay cash dividends to our shareholders or repurchase shares of our common stock. Failure to comply with such covenants could result in an event of default which, if not cured or waived, could result in the acceleration of our outstanding indebtedness.

Additionally, on December 31, 2011, we had $9,212 million of contractual obligations (including outstanding indebtedness). For a detailed listing of the components of our contractual obligations, see “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contractual Obligations” on page 64.

Our debt agreements restrict our ability to finance our future operations and, if we are unable to meet our financial ratios, could cause our existing debt to be accelerated.

Our debt agreements contain a number of significant covenants that, among other things, restrict our ability to:

 

   

sell assets;

 

   

incur more indebtedness;

 

   

repay certain indebtedness;

 

   

make certain investments or business acquisitions;

 

   

make certain capital expenditures;

 

   

engage in business mergers or consolidations; and

 

   

engage in certain transactions with subsidiaries and affiliates.

These restrictions could impair our ability to finance our future operations or capital needs or engage in other business activities that may be in our interest. In addition, some of our debt agreements also require us to maintain compliance with certain financial ratios, including (1) total consolidated earnings before interest, taxes, depreciation and amortization to total consolidated cash interest expense, (2) total consolidated funded indebtedness less designated cash balances to total consolidated earnings before interest, taxes, depreciation and amortization, and (3) consolidated senior indebtedness less designated cash balances to consolidated earnings before interest, taxes, depreciation and amortization. Our ability to comply with these ratios and covenants may be affected by events beyond our control. A breach of any of these agreements or our inability to comply with the required financial ratios or covenants could result in a default under those debt agreements. In the event of any such default, the lenders under those debt agreements could elect to:

 

   

declare all outstanding debt, accrued interest and fees to be due and immediately payable;

 

   

require us to apply all of our available cash to repay our outstanding senior debt; and

 

   

prevent us from making debt service payments on our other debt.

For further discussion of our financial ratios, debt agreements and other payment restrictions, see Note 10 to our audited consolidated financial statements on page F-23.

 

27


Table of Contents

If we are unable to attract and retain key management and personnel, we may become unable to operate our business effectively.

Our future success depends to a significant degree upon the continued contributions of our management, and our ability to attract and retain highly qualified management and technical personnel, including employees who have U.S. Government security clearances, particularly clearances of top-secret and above. We do not maintain any key person life insurance policies for members of our management. We face competition for management and technical personnel from other companies and organizations. Failure to attract and retain such personnel would damage our future prospects.

Environmental laws and regulations may subject us to significant liability.

Our operations are subject to various U.S. federal, state and local as well as certain foreign environmental laws and regulations within the countries in which we operate relating to the discharge, storage, treatment, handling, disposal and remediation of certain materials, substances and wastes used in our operations.

New laws and regulations, stricter enforcement of existing laws and regulations, the discovery of previously unknown contamination or the imposition of new clean-up requirements may require us to incur a significant amount of additional costs in the future and could decrease the amount of cash flow available to us for other purposes, including capital expenditures, research and development and other investments and could have a material adverse effect on our business, financial condition, results of operations, cash flows and future prospects.

Our sales to certain foreign customers expose us to risks associated with operating internationally.

For the year ended December 31, 2011, sales to foreign customers, excluding our foreign sales made under FMS agreements directly between the U.S. Government and allied foreign governments, represented approximately 11% of our consolidated sales. Consequently, our businesses are subject to a variety of risks that are specific to international operations, including the following:

 

   

export regulations that could erode profit margins or restrict exports;

 

   

compliance with the U.S. Foreign Corrupt Practices Act and similar non-U.S. regulations;

 

   

the burden and cost of compliance with foreign laws, treaties and technical standards and changes in those regulations;

 

   

contract award and funding delays;

 

   

potential restrictions on transfers of funds;

 

   

currency fluctuations;

 

   

import and export duties and value added taxes;

 

   

transportation delays and interruptions;

 

   

uncertainties arising from foreign local business practices and cultural considerations; and

 

   

potential military conflicts and political risks.

While we have and will continue to adopt measures to reduce the potential impact of losses resulting from the risks of our foreign business, we cannot ensure that such measures will be adequate.

 

28


Table of Contents

Our business could be negatively impacted by security threats and other disruptions.

As a U.S. defense contractor, we face various security threats, including cyber security attacks to our information technology infrastructure, attempts to gain access to our proprietary or classified information as well as threats to the physical security of our facilities and employees. Although we utilize various procedures and controls to monitor and mitigate these threats, there can be no assurance that these procedures and controls will be sufficient to prevent disruptions in mission critical systems, the unauthorized release of confidential information and corruption of data. Accordingly, any significant operational delays, or any destruction, manipulation or improper use of our data, information systems or networks could adversely affect our financial results and damage the reputation for our products and services.

We announced the planned spin-off of a part of our Government Services segment into a new, independent publicly traded company, which will be named Engility. This transaction will likely require significant time and attention of our management and we may not be able to complete the transaction or, if completed, realize the anticipated benefits.

On July 28, 2011, we announced a plan to spin-off a part of our Government Services segment. In order to effectuate the spin-off, among other things, we will be required to file a registration statement on Form 10 with the Securities and Exchange Commission (SEC). Our ability to complete the spin-off in a timely manner, if at all, could be subject to several factors, including but not limited to: (1) changes in the newly created entity’s operating performance, (2) our ability to obtain any necessary consents or approvals, (3) our ability to obtain any necessary financing for the newly created entity as well as the terms of such financing, (4) changes in governmental regulations, (5) changes in the underlying businesses, its contracts, or customers, (6) overall political and economic conditions at the time of the spin-off, and (7) obtaining an opinion of counsel as to the satisfaction of certain requirements necessary for the spin-off to receive tax-free treatment upon which the Internal Revenue Service (IRS) does not rule. Additionally, execution of the proposed spin-off transaction will likely require significant time and attention from management, which could distract management from the operation of our business and the execution of our other strategic initiatives. We may not be able to complete the spin-off within the expected time frame or complete the spin-off at all. In addition, even if completed, we may not realize the anticipated benefits from the spin-off.

The Company’s proposed spin-off of Engility could result in substantial tax liability to the Company and its shareholders.

We have received an IRS Ruling stating that L-3 and its shareholders will not recognize any taxable income, gain or loss for U.S. federal income tax purposes as a result of the spin-off. In addition, certain requirements for tax-free treatment that are not covered in the IRS Ruling will be addressed in an opinion of counsel which we expect to receive immediately prior to the completion of the spin-off. An opinion of counsel is not binding on the IRS. Accordingly, the IRS or the courts may reach conclusions with respect to the spin-off that are different from the conclusions reached in the opinion of counsel. Moreover, both the IRS Ruling and the opinion of counsel are based on certain factual statements and representations made by us, which, if incomplete or untrue in any material respect, could invalidate the IRS Ruling or opinion of counsel.

If, notwithstanding receipt of the IRS Ruling and opinion of counsel, the spin-off and certain related transactions were determined to be taxable, then we would be subject to a substantial tax liability. In addition, if the spin-off were taxable, each holder of our common stock who receives shares of Engility would generally be treated as receiving a taxable distribution of property in an amount equal to the fair market value of the shares of Engility received.

Item 1B. Unresolved Staff Comments

None.

 

29


Table of Contents

Item 2. Properties

At December 31, 2011, we operated in 491 locations consisting of manufacturing facilities, administration, research and development and other properties throughout the United States and internationally. Of these, we owned 37 locations consisting of approximately 5.7 million square feet and leased space at 454 locations consisting of approximately 15.9 million square feet.

Our reportable segments have major operations at the following locations:

 

   

C3ISR — Camden, New Jersey; Deerfield, Ohio; Greenville and Rockwall, Texas; and Salt Lake City, Utah.

 

   

Government Services — Annapolis, Maryland; and Alexandria, Chantilly and Reston, Virginia.

 

   

AM&M — Crestview, Florida; Madison, Mississippi; Waco, Texas; and Quebec, Canada.

 

   

Electronic Systems — Phoenix and Tempe, Arizona; Anaheim, Menlo Park, San Carlos, San Diego, San Leandro, Simi Valley, Sylmar and Torrance, California; Orlando, Sarasota and St. Petersburg, Florida; Ayer, Massachusetts; Grand Rapids and Muskegon, Michigan; Londonderry, New Hampshire; Budd Lake, New Jersey; Albuquerque, New Mexico; Binghamton, Hauppauge and Victor, New York; Cincinnati and Mason, Ohio; Tulsa, Oklahoma; Philadelphia, Pittsburgh and Williamsport, Pennsylvania; Arlington and Garland, Texas; Ontario, Canada; and Elmenhorst, Jemgum, Leer and Hamburg, Germany.

 

   

Corporate and other locations — New York, New York and Arlington, Virginia.

A summary of square footage by reportable segment as of December 31, 2011 is presented below.

 

             Leased                      Owned                      Total          
     (Square feet in millions)  

C3ISR

     5.0         0.2         5.2   

Government Services

     2.2                 2.2   

AM&M

     0.9         1.7         2.6   

Electronic Systems

     7.7         3.8         11.5   

Corporate

     0.1                 0.1   
  

 

 

    

 

 

    

 

 

 

Total

     15.9         5.7         21.6   
  

 

 

    

 

 

    

 

 

 

Management believes all of our properties have been well maintained, are in good condition, and are adequate to meet our current contractual requirements.

Item 3. Legal Proceedings

The information required with respect to this item can be found in Note 19 to our audited consolidated financial statements and is incorporated by reference into this Item 3.

Item 4. Mine Safety Disclosures

None.

 

30


Table of Contents

PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The common stock of L-3 Holdings is traded on the NYSE under the symbol “LLL”. On February 21, 2012, the number of holders of L-3 Holdings’ common stock was approximately 39,650. On February 28, 2012, the closing price of L-3 Holdings’ common stock, as reported by the NYSE, was $70.28 per share.

The table below sets forth the high and low closing price of L-3 Holdings’ common stock as reported on the NYSE composite transaction tape and the amount of dividends paid per share during the past two calendar years.

 

    Dividends Paid     Closing Price
(High-Low)
 
          2011                 2010           2011           2010        

Common Stock — Dividends Paid and Market Prices

       

First Quarter

  $ 0.45      $ 0.40      $ 80.85 — $70.84      $ 94.62 — $83.34   

Second Quarter

    0.45        0.40        88.31 — 74.95         97.54 — 74.85    

Third Quarter

    0.45        0.40        86.77 — 58.94         76.65 — 66.60    

Fourth Quarter

    0.45        0.40        70.97 — 60.04         73.90 — 68.87    
 

 

 

   

 

 

     

Year Ended December 31

  $         1.80      $         1.60        88.31 — 58.94         97.54 — 66.60    
 

 

 

   

 

 

     

On February 7, 2012, L-3 Holdings announced that its Board of Directors had increased L-3 Holdings’ regular quarterly cash dividend by 11% to $0.50 per share, payable on March 15, 2012, to shareholders of record at the close of business on March 1, 2012.

L-3 Holdings relies on dividends received from L-3 Communications to generate the funds necessary to pay dividends on L-3 Holdings’ common stock. See Note 10 to our audited consolidated financial statements for the financial and other restrictive covenants that limit the payment of dividends by L-3 Communications to L-3 Holdings.

Issuer Purchases of Equity Securities

The following table provides information about share repurchases made by L-3 Holdings of its common stock that are registered pursuant to Section 12 of the Exchange Act during the 2011 fourth quarter. Repurchases are made from time to time at management’s discretion in accordance with applicable federal securities laws. All share repurchases of L-3 Holdings’ common stock have been recorded as treasury shares.

 

     Total Number
of Shares
Purchased
     Average
Price Paid
Per Share
     Total Number of
Shares  Purchased As
Part of Publicly
Announced Plans
or Programs
     Maximum Number
(or Approximate
Dollar Value) of
Shares That May
Yet Be Purchased
Under The Plans
or Programs(1)
 
                          (in millions)  

October 1 — October 31, 2011

     1,203,781       $ 64.94         1,203,781       $ 1,214   

November 1 — 30, 2011

     627,007         65.24         627,007       $ 1,173   

December 1 — 31, 2011

     601,616         65.16         601,606       $ 1,134   
  

 

 

       

 

 

    

Total

     2,432,404       $ 65.07         2,432,404      
  

 

 

       

 

 

    

 

 

(1)

The share repurchases described in the table above were made pursuant to the $1.5 billion share repurchase program authorized by L-3 Holdings’ Board of Directors on April 26, 2011, which has a stated termination date of April 30, 2013.

 

31


Table of Contents

From January 1, 2012 through February 29, 2012, L-3 Holdings has repurchased 934,086 shares of its common stock at an average price of $69.68 per share for an aggregate amount of approximately $65 million.

The graph below compares the cumulative total returns of our common stock with the cumulative total return of the Standard & Poor’s 500 Composite Stock Index and the Standard & Poor’s 1500 Aerospace & Defense Index, for the period from December 31, 2006 to December 31, 2011. These figures assume that all dividends paid over the performance period were reinvested, and that the starting value of each index and the investment in our common stock was $100 on December 31, 2006.

We are one of the companies included in the Standard & Poor’s 1500 Aerospace & Defense Index and the Standard & Poor’s 500 Composite Stock Index. The starting point for the measurement of our common stock cumulative total return was our stock price of $81.78 per share on December 29, 2006. The graph is not, and is not intended to be, indicative of future performance of our common stock.

 

LOGO

 

32


Table of Contents

Item 6. Selected Financial Data

We derived the selected financial data presented below at December 31, 2011 and 2010 and for each of the three years in the period ended December 31, 2011 from our audited consolidated financial statements included elsewhere in this Form 10-K. We derived the selected financial data presented below at December 31, 2009, 2008 and 2007 and for the years ended December 31, 2008 and 2007 from our audited consolidated financial statements not included in this Form 10-K. The selected financial data should be read in conjunction with our “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements. Our results of operations, cash flows and financial position are affected significantly, in some periods, by our business acquisitions, the more significant of which are described elsewhere herein.

 

     Year Ended December 31,  
          2011(1)              2010              2009               2008(2)              2007      
     (in millions, except per share data)  

Statement of Operations Data:

             

Net sales

   $ 15,169       $ 15,680       $ 15,615       $ 14,901      $ 13,961   

Cost of sales

     13,528         13,930         13,959         13,342        12,513   

Impairment charge

     43                                  

Litigation gain

                             126 (3)        
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Operating income

     1,598         1,750         1,656         1,685        1,448   

Interest and other income, net

             21         19         28        31   

Interest expense

     235         269         279         290 (3)      314   

Debt retirement charge

     35         18         10                  
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Income from continuing operations before income taxes

     1,328         1,484         1,386         1,423        1,165   

Provision for income taxes

     360         518         475         494        411   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Income from continuing operations

     968         966         911         929        754   

Less: Noncontrolling interests

     12         11         10         11        9   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Income from continuing operations attributable to L-3

   $ 956       $ 955       $ 901       $ 918      $ 745   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Net income attributable to L-3

   $ 956       $ 955       $ 901       $ 938      $ 745   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Earnings per share allocable to L-3 Holdings’ common shareholders:

             

Basic:

             

Income from continuing operations

   $ 9.14       $ 8.31       $ 7.65       $ 7.50      $ 5.92   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Net income

   $ 9.14       $ 8.31       $ 7.65       $ 7.67      $ 5.92   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Diluted:

             

Income from continuing operations

   $ 9.03       $ 8.25       $ 7.61       $ 7.43      $ 5.86   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Net income

   $ 9.03       $ 8.25       $ 7.61       $ 7.59      $ 5.86   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

L-3 Holdings’ weighted average common shares outstanding:

             

Basic

     104.4         114.3         116.8         121.2        124.9   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Diluted

     105.6         115.1         117.4         122.4        126.2   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Cash dividends declared per share on L-3 Holdings’ common stock

   $ 1.80       $ 1.60       $ 1.40       $ 1.20      $ 1.00   
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) 

The year ended December 31, 2011 includes: (1) a tax benefit of $78 million, or $0.74 per diluted share, for a net reversal of amounts previously accrued related to tax years for which the statutes of limitations had expired, (2) a non-cash goodwill impairment charge of $43 million ($42 million after income taxes), or $0.40 per diluted share, due to a decline in the estimated fair value of our Marine Services business and (3) $14 million ($8 million after income taxes), or $0.08 per diluted share for our portion of an impairment charge for long-lived assets at an equity method investment.

 

33


Table of Contents
(2) 

The year ended December 31, 2008 includes: (1) a gain of $12 million ($7 million after income taxes, or $0.06 per diluted share) related to the sale of a product line, (2) a non-cash impairment charge of $28 million ($17 million after income taxes, or $0.14 per diluted share) related to a write-down of capitalized software development costs associated with a general aviation product, and (3) an after-tax gain of $20 million, or $0.16 per diluted share, related to the sale of our 85% ownership interest in Medical Education Technologies, Inc. on October 8, 2008. (The gain is excluded from income from continuing operations for the year ended December 31, 2008.)

 

(3) 

The year ended December 31, 2008 includes a gain of $133 million ($81 million after income taxes, or $0.66 per diluted share) related to the reversal of a $126 million current liability for pending and threatened litigation and $7 million of related accrued interest as a result of a June 27, 2008 decision by the U.S. Court of Appeals which vacated an adverse 2006 jury verdict.

 

     Year Ended December 31,  
         2011             2010             2009             2008             2007      
     (in millions)  

Balance Sheet Data (at year end):

          

Working capital

   $     2,554      $     2,345      $     2,669      $     2,254      $     2,181   

Total assets

     15,497        15,451        14,875        14,484        14,389   

Long-term debt

     4,125        4,126        4,112        4,493        4,472   

Equity

     6,724        6,855        6,660        5,941        6,114   

Cash Flow Data:

          

Net cash from operating activities

   $ 1,484      $ 1,461      $ 1,407      $ 1,387      $ 1,270   

Net cash used in investing activities

     (203     (945     (272     (432     (388

Net cash used in financing activities

     (1,120     (918     (1,005     (840     (464

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Financial Section Roadmap

Management’s discussion and analysis (MD&A) can be found on pages 34 to 68, the report related to the financial statements and internal control over financial reporting can be found on page 69 and the financial statements and related notes can be found on pages F-1 to F-63. The following table is designed to assist in your review of MD&A.

 

Topic

  

Location

Overview and Outlook:

     

L-3’s Business

   Pages    35-36

Industry Considerations

   Pages    36-37

Key Performance Measures

   Pages    37-38

Spin-Off of Businesses that will comprise Engility

   Pages    38-39

Other 2011 Events

   Page    39

Business Acquisitions and Dispositions

   Pages    40-41

Critical Accounting Policies:

     

Contract Revenue Recognition and Contract Estimates

   Pages    41-43

Goodwill and Identifiable Intangible Assets

   Pages    43-49

Pension Plan and Postretirement Benefit Plan Obligations

   Page    49

Valuation of Deferred Income Tax Assets and Liabilities

   Pages    49-50

Liabilities for Pending and Threatened Litigation

   Page    50

Valuation of Long-Lived Assets

   Page    50

Results of Operations, including business segments

   Pages    51-58

Liquidity and Capital Resources:

     

Anticipated Sources of Cash Flow

   Page    58

Balance Sheet

   Pages    58-60

Pension Plans

   Pages    60-61

Statement of Cash Flows

   Pages    61-64

Contractual Obligations

   Page    64

Off Balance Sheet Arrangements

   Page    65

Legal Proceedings and Contingencies

   Page    65

 

34


Table of Contents

Overview and Outlook

L-3’s Business

L-3 is a prime contractor in Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (C3ISR) systems, aircraft modernization and maintenance, and government services. L-3 is also a leading provider of a broad range of electronic systems used on military and commercial platforms. Our customers include the United States (U.S.) Department of Defense (DoD) and its prime contractors, U.S. Government intelligence agencies, the U.S. Department of Homeland Security (DHS), U.S. Department of State (DoS), U.S. Department of Justice (DoJ), allied foreign governments, domestic and foreign commercial customers, and select other U.S. federal, state and local government agencies.

We have the following four reportable segments: (1) C3ISR, (2) Government Services, (3) Aircraft Modernization and Maintenance (AM&M), and (4) Electronic Systems. Financial information with respect to each of our segments is included in Note 22 to our audited consolidated financial statements. C3ISR provides products and services for the global ISR market, C3 systems, networked communications systems and secure communications products. We believe that these products and services are critical elements for a substantial number of major command, control and communication, intelligence gathering and space systems. These products and services are used to connect a variety of airborne, space, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring, and dissemination functions of these communication systems. Government Services provides a full range of systems engineering and technical assistance (SETA), training, operational support, cyber security, intelligence, enterprise IT and security solutions services to the DoD, DoS, DoJ, and U.S. Government intelligence agencies and allied foreign governments. AM&M provides modernization, upgrades and sustainment, maintenance and logistics support services for military and various government aircraft and other platforms. We sell these services primarily to the DoD, the Canadian Department of Defense and other allied foreign governments. Electronic Systems provides a broad range of products and services, including components, products, subsystems, systems, and related services to military and commercial customers in several niche markets across several business areas, including microwave, power & control systems, integrated sensor systems, aviation products, simulation & training, warrior systems, precision engagement, security & detection, space & propulsion, undersea warfare and marine services.

On July 28, 2011, we announced that our Board of Directors approved a plan to spin-off a new, independent government services company that will be publicly traded. The new public company will be named Engility Holdings, Inc. (Engility) and will include the SETA, training and operational support services businesses that are currently part of L-3’s Government Services segment. See “Spin-Off of Businesses that will comprise Engility” below for additional information.

Due to re-alignments in our management and organizational structure during the quarter ended April 1, 2011, we made certain reclassifications among our C3ISR, Government Services and Electronic Systems segments. See Note 22 to our audited consolidated financial statements for the prior period sales, operating income and assets reclassified between segments.

 

35


Table of Contents

For the year ended December 31, 2011, we generated sales of $15,169 million. Our primary customer was the DoD. The table below presents a summary of our 2011 sales by end customer and the percent contributed by each to our total 2011 sales.

 

       2011 Sales        % of
 Total Sales 
 
     (in millions)         

Army

    $ 3,931          26

Air Force

     3,864          25   

Navy/Marines

     2,358          16   

Other Defense

     1,168          8   
  

 

 

    

 

 

 

Total DoD

    $   11,321          75

Other U.S. Government

     1,113          7   
  

 

 

    

 

 

 

Total U.S. Government

    $ 12,434          82

Foreign governments

     1,200          8   

Commercial — foreign

     905          6   

Commercial — domestic

     630          4   
  

 

 

    

 

 

 

Total sales

    $ 15,169           100
  

 

 

    

 

 

 

Most of our contracts (revenue arrangements) with the U.S. Government are subject to U.S. Defense Contract Audit Agency audits and various cost and pricing regulations, and include standard provisions for termination for the convenience of the U.S. Government. Multiyear U.S. Government contracts and related orders are subject to cancellation if funds for contract performance for any subsequent year become unavailable. Foreign government contracts generally include comparable provisions relating to termination for the convenience of the relevant foreign government.

Industry Considerations

As described above, sales to the DoD represent approximately 75% of our total sales. The U.S. Government fiscal year ends on September 30th. From fiscal year (FY) 2000 to FY 2010, the DoD budget, including wartime funding for Overseas Contingency Operations (OCO) grew at a compound annual rate of approximately 9%. The total DoD budget (base and OCO) for FY 2011 was approximately flat compared to fiscal year 2010. During the year ended December 31, 2011, the U.S. Government completed its drawdown of U.S. military troops from Iraq, and began to drawdown troops from Afghanistan, in accordance with the Obama Administration plan to complete the drawdown from Afghanistan by the end of 2014. While the U.S. is expected to maintain a presence in the Middle East to deter aggression and prevent the emergence of new threats, there will be a rebalance toward other regions of the world such as the Asia-Pacific theatre. In addition, the U.S. Government has been under increasing pressure to reduce the U.S. fiscal budget deficit and national spending.

In August 2011, Congress enacted the Budget Control Act of 2011 (the BCA). The BCA immediately imposes spending caps that contain approximately $487 billion in reductions to the DoD base budgets over the next ten years (FY 2012 to FY 2021), compared to previously proposed DoD base budgets for the same fiscal years. An automatic sequestration process was also triggered and becomes effective on January 3, 2013, unless modified by the enactment of new law. The sequestration process imposes additional cuts of approximately $50 billion per year to the currently proposed DoD budgets for each fiscal year beginning with FY 2013 through FY 2021, for which FY 2013 to FY 2017 proposed DoD budgets are presented below.

 

36


Table of Contents

On February 13, 2012, President Obama submitted his FY 2013 proposed budget (FY 2013 DoD Plan) to Congress. The FY 2013 DoD Plan complies with the first phase of the BCA imposed spending cuts. The FY 2013 DoD Plan reduces proposed DoD base budgets by $259 billion for FY 2013 to FY 2017, compared to the previously proposed DoD base budgets. The FY 2013 DoD Plan does not address or provision for the automatic sequestration process. The FY 2013 DoD Plan reflects a revised national security strategy that includes a more disciplined use of resources from: (1) various efficiency initiatives, (2) military force structure reductions, (3) equipment modernization savings, including program terminations, restructuring and deferrals, and (4) military personnel compensation changes. The table below presents the enacted DoD budget (base and OCO) for FY 2012 and the proposed DoD budgets for FY 2013 to FY 2017, as provided in the FY 2013 DoD Plan.

 

Fiscal Year

   Base      OCO      Total      Annual
Total
Budget
  Change  

2012

    $ 530.6          $ 115.1          $ 645.7         -6%

2013

    $ 525.4          $ 88.5          $ 613.9         -5%

2014

    $ 533.6          $ 44.2          $ 577.8         -6%

2015

    $ 545.9          $ 44.2          $ 590.1         2%

2016

    $ 555.9          $ 44.2          $ 600.1         2%

2017

    $     567.3          $     44.2          $     611.5         2%

The FY 2013 DoD Plan is expected to continue to focus on advanced ISR (intelligence, surveillance and reconnaissance), communications, strike aircraft, precision-guided weapons, unmanned systems, networked information technologies, cyber security, special operations forces, missile defense and space programs, and generally, systems and capabilities that are critical to both conventional and irregular warfare, and the ability to project power in denied environments. We believe L-3 is well positioned to benefit from the DoD’s focus in several of these areas. The declining DoD budgets, however, will reduce funding for some of our revenue arrangements and generally, will have a negative impact on our sales, results of operations and cash flows. Additionally, the planned withdrawal of U.S. military forces from Afghanistan by the end of 2014 is expected to negatively impact our sales related to supporting U.S. military operations in Afghanistan.

Key Performance Measures

The primary financial performance measures that L-3 uses to manage its businesses and monitor results of operations are sales trends and operating income trends. Management believes that these financial performance measures are the primary growth drivers for L-3’s earnings per common share and net cash from operating activities. One of L-3’s primary business objectives is to increase sales from organic growth and select business acquisitions. We define organic sales growth as the increase or decrease in sales for the current period compared to the prior period, excluding sales in the: (1) current period from business acquisitions that are included in L-3’s actual results of operations for less than twelve months, and (2) prior period from business divestitures that are included in L-3’s actual results of operations for the twelve-month period prior to the divestiture date. We expect to supplement our organic sales growth by selectively acquiring businesses that: (1) add important new technologies and products, (2) provide access to select customers, programs and contracts, and (3) provide attractive returns on investment. The two main determinants of our operating income growth are sales growth and improvements in direct and indirect contract costs. We define operating margin as operating income as a percentage of sales. Improving operating margins is one of several methods for growing earnings per common share and net cash from operating activities.

Sales Trends. For the year ended December 31, 2011, consolidated net sales of $15,169 million declined by 3.3%, comprised of an organic sales decline of 4.3%, partially offset by net sales from business acquisitions of 1.0%, compared to the year ended December 31, 2010. Our average annual sales growth for the five years ended December 31, 2011, was 4%, with average annual organic sales growth of approximately 3% and average annual sales growth from business acquisitions, net of divestitures, of approximately 1%.

 

37


Table of Contents

For the years ended December 31, 2011 and 2010, our largest contract (revenue arrangement) in terms of annual sales was the Fort Rucker Maintenance Support contract with the U.S. Army Aviation and Missile Command, which is included in our AM&M segment. Under this contract, which generated approximately 3% of our 2011 and 2010 sales, we provide maintenance and logistical support services for rotary wing aircraft assigned to Fort Rucker and satellite units in Alabama. The current contract is expected to end on September 30, 2012. We submitted our proposal in November 2011 for the contract re-competition and anticipate the award will be made by August 2012. We cannot provide any assurance that we will win the re-competition of the Fort Rucker Maintenance support contract.

The Special Operations Forces Support Activity (SOFSA) contract, which was included in our AM&M segment, generated $332 million of sales for the year ended December 31, 2010. In June 2010, the follow-on contract was awarded to another contractor and the transition to the successor contractor ended in October 2010.

Our sales trends are highly correlated to DoD budgets because we derive approximately 75% of our annual sales from the DoD. The currently proposed DoD base and OCO budgets are a function of several factors beyond our control, including, but not limited to, changes in U.S. procurement policies, budget considerations, current and future economic conditions, presidential administration priorities, changing national security and defense requirements, geo-political developments and actual fiscal year congressional appropriations for defense budgets. Any of these factors could result in a significant decline in or redirection of current and future DoD budgets and impact L-3’s future results of operations, including our sales and operating income growth rates. Additionally, L-3’s future results of operations will be affected by our ability to retain our existing business and to successfully compete for new business, which largely depend on: (1) our successful performance on existing contracts, (2) the effectiveness and innovation of our technologies and research and development activities, (3) our ability to offer better program performance than our competitors at an affordable cost, and (4) our ability to retain our employees and hire new ones, particularly those employees who have U.S. Government security clearances.

Operating Income Trends. For the year ended December 31, 2011, our consolidated operating income was $1,598 million and our consolidated operating margin was 10.5%. Our consolidated operating income and consolidated operating margin for the year ended December 31, 2011 were reduced by a non-cash goodwill impairment charge of $43 million recorded in the 2011 fourth quarter, as further discussed below. The goodwill impairment charge is excluded from segment operating income because it was excluded by management for purposes of assessing segment operating performance. Our segment operating income was $1,641 million for the year ended December 31, 2011, a decrease of 6% from $1,750 million for the year ended December 31, 2010, and our segment operating margin was 10.8% for the year ended December 31, 2011, a decrease of 40 basis points from 11.2% for the year ended December 31, 2010. See Results of Operations, including segment results below for a discussion of operating margin.

We are focused on increasing operating margin, to the extent possible, by reducing our indirect costs and improving our overall contract performance. Our 2011 operating margin was lower than our 2010 operating margin and we expect our 2012 annual operating margin to decline as compared to 2011. While we are taking action to increase operating margin, we may not be able to do so in the future. Furthermore, in the future, select business acquisitions and select new business, including contract renewals and new contracts, could have lower operating margins than L-3’s operating margin on existing business and contracts. Changes in the competitive environment and DoD procurement practices and reductions in our consolidated sales levels could also result in lower operating margin.

Spin-Off of Businesses that will comprise Engility

As previously discussed, we plan to spin-off a part of our Government Services segment into a new, independent company that will be publicly traded. The new public company will be named Engility. The spin-off, which is intended to be tax-free to L-3 and its shareholders, is expected to be completed in the first half of 2012. Upon completion, L-3 shareholders will own 100% of the shares of both L-3 and Engility. The spin-off is not subject to a shareholder vote.

 

38


Table of Contents

Under the plan, Engility will include the SETA, training and operational support services businesses that are currently part of L-3’s Government Services segment. For the year ended December 31, 2011, the businesses that will comprise Engility had sales of approximately $2.0 billion, or 56% of total Government Services net sales, and operating income of approximately $178 million, or 64% of total Government Services operating income. The businesses that will comprise Engility had approximately 9,000 employees at December 31, 2011.

L-3 will retain the cyber security, intelligence, enterprise IT and security solutions businesses that are also part of L-3’s Government Services segment. The Government Services segment will be renamed National Security Solutions (NSS) upon completion of the spin-off, and will continue to leverage synergies across L-3 to develop unique solutions to address growing challenges for our DoD, intelligence and global security customers. During the year ended December 31, 2011, L-3’s businesses that will comprise NSS had sales of approximately $1.6 billion, or 44% of total Government Services net sales, and operating income of approximately $102 million, or 36% of total Government Services operating income.

The completion of the spin-off is subject to certain customary conditions, including filing of required documents with the SEC, and an opinion of counsel as to the satisfaction of certain requirements necessary for the spin-off to receive tax-free treatment upon which the IRS does not rule, which is expected to be received immediately prior to the completion of the spin-off transaction. There can be no assurance that any separation transaction will ultimately occur, or if one does occur, its terms or timing.

Other 2011 Events

Our 2011 results were impacted by the items discussed below, which increased net income attributable to L-3 by $28 million and diluted earnings per share by $0.26 (collectively referred to as the Q4 2011 Items):

 

   

A tax benefit of $78 million, or $0.74 of diluted earnings per share, for a net reversal of amounts previously accrued related to tax years for which the statutes of limitations expired; and

 

   

Non-cash impairment charges of $57 million ($50 million after income taxes), or $0.48 of diluted earnings per share. The impairment charges include: (1) a goodwill impairment charge of $43 million, ($42 million after income taxes), or $0.40 per diluted share, which is included in operating income and (2) $14 million, ($8 million after income taxes), or $0.08 per diluted share, which is included in interest and other income, net, for our portion of an impairment charge for long-lived assets at an equity method investment. The goodwill impairment charge was due to a decline in the estimated fair value of the Marine Services business, which is part of the Electronic Systems segment, as a result of a decline in its projected future cash flows.

Debt Repurchases, Issuances and Redemptions. On February 2, 2011, we repurchased approximately $11 million of our CODES as a result of the exercise by the holders of their contractual right to require us to repurchase their CODES.

On February 7, 2011, L-3 Communications issued $650 million in principal amount of 4.95% Senior Notes that mature on February 15, 2021 (2021 Senior Notes). The 2021 Senior Notes were issued at a discount of $4 million. On March 9, 2011, the net cash proceeds from this offering, together with cash on hand, were used to redeem L-3 Communications’ $650 million 57/8% Senior Subordinated Notes due January 15, 2015 (57/8% 2015 Notes). In connection with the redemption of the 57/8% 2015 Notes, we recorded a debt retirement charge of $18 million ($11 million after income taxes, or $0.10 per diluted share).

On November 22, 2011, L-3 Communications issued $500 million in principal amount of 3.95% Senior Notes that mature on November 15, 2016 (2016 Senior Notes). The 2016 Senior Notes were issued at a discount of $4 million. On December 22, 2011, the net proceeds from this offering, together with cash on hand, were used to redeem $500 million of L-3 Communications’ 63/8% Senior Subordinated Notes due 2015 (63/8% 2015 Notes). In connection with the redemption of the 63/8% 2015 Notes, we recorded a debt retirement charge of $17 million ($10 million after income tax, or $0.10 per diluted share).

 

39


Table of Contents

Business Acquisitions and Dispositions

As discussed above, one aspect of our strategy is to selectively acquire businesses that add new products and technologies, or provide access to select customers, programs and contracts. We intend to continue acquiring select businesses for reasonable valuations that will provide attractive returns to L-3. Our business acquisitions, depending on their contract-type, sales mix or other factors, could reduce L-3’s consolidated operating margin while still increasing L-3’s operating income, earnings per share, and net cash from operating activities. In addition, we may also dispose of certain businesses if we determine that they no longer fit into L-3’s overall business strategy and we are able to receive an attractive price.

Business Acquisitions and Divestitures

Acquisitions. The table below summarizes the acquisitions that we have completed during the years ended December 31, 2009, 2010 and 2011, referred to herein as business acquisitions. See Note 4 to our audited consolidated financial statements for further information regarding our business acquisitions. During the year ended December 31, 2011, we used $20 million of cash for business acquisitions, including earnout payments for certain business acquisitions completed prior to January 1, 2011.

 

Business Acquisitions

   Date Acquired      Purchase
Price(1)
 
            (in millions)  

2009

     

Chesapeake Sciences Corporation

     January 30, 2009        $ 91 (2) 
     

 

 

 

2010

     

Insight Technology Incorporated

     April 14, 2010        $ 611   

Airborne Technologies, Inc.

     August 4, 2010         34   

3Di Technologies (3Di)

     September 17, 2010         60 (3) 

FUNA International, GmbH

     December 22, 2010         50   
     

 

 

 

Total 2010

       $     755   
     

 

 

 

2011

     

Communications and engineering business of ComHouse Wireless L.P.

     July 1, 2011        $ 13 (4) 

Cargo radiation screening business of Detector Network International (DNI)

     October 28, 2011         5 (4)(5) 
     

 

 

 

Total 2011

       $ 18   
     

 

 

 

 

(1) 

The purchase price represents the contractual consideration for the acquired business, excluding adjustments for net cash acquired and acquisition transaction costs.

 

(2) 

Includes additional purchase price of approximately $4 million for certain acquired tax benefits.

 

(3) 

Excludes additional purchase price, not to exceed $11 million, which is contingent upon the post acquisition financial performance of 3Di through December 31, 2012.

 

(4) 

The final purchase price is subject to adjustment based on the closing date actual net assets.

 

(5) 

Excludes additional purchase price, not to exceed $10 million, which is contingent upon the post acquisition financial performance of DNI through December 31, 2014.

All of our business acquisitions are included in our consolidated results of operations from their dates of acquisition. We regularly evaluate potential business acquisitions. On February 6, 2012, we acquired the Kollmorgen Electro-Optical (KEO) business of Danaher Corporation for a purchase price of $210 million, which was financed with cash on hand. KEO develops and manufactures specialized equipment, including submarine photonics systems and periscopes, ship fire control systems, visual landing aids, ground electro-optical and sensor-cueing systems for the U.S. military and allied foreign governments.

 

40


Table of Contents

Divestitures. On February 22, 2011, we divested Microdyne Corporation (Microdyne) and on December 17, 2010, we divested InfraredVision Technology Corporation (ITC), both of which were within the Electronic Systems segment. These divestiture transactions resulted in pre-tax losses of approximately $2 million for Microdyne and $1 million for ITC. Microdyne’s and ITC’s annual revenues (approximately $8 million and $4 million, respectively), pre-tax income and net assets were not material for any period presented, and, therefore, these divestitures are not reported as discontinued operations.

Critical Accounting Policies

Our significant accounting policies are described in Note 2 to our audited consolidated financial statements. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of sales and cost of sales during the reporting period. The most significant of these estimates and assumptions relate to contract revenue, profit and loss recognition, fair values of assets acquired and liabilities assumed in business combinations, market values for inventories reported at lower of cost or market, pension and post-retirement benefit obligations, stock-based employee compensation expense, income taxes, including the valuations of deferred tax assets, litigation reserves and environmental obligations, accrued product warranty costs and the recoverability, useful lives and valuation of recorded amounts of long-lived assets, identifiable intangible assets and goodwill. Changes in estimates are reflected in the period during which they become known. Actual amounts will differ from these estimates and could differ materially. We believe that our critical accounting estimates have the following attributes: (1) we are required to make assumptions about matters that are uncertain and inherently judgmental at the time of the estimate; (2) use of reasonably different assumptions could have changed our estimates, particularly with respect to estimates of contract revenues and costs, and recoverability of assets, and (3) changes in the estimate could have a material effect on our financial condition or results of operations. We believe the following critical accounting policies contain the more significant judgments and estimates used in the preparation of our financial statements.

Contract Revenue Recognition and Contract Estimates. Approximately 40% of our consolidated net sales are generated from contracts (revenue arrangements) that require us to design, develop, manufacture, modify, upgrade, test and integrate complex aerospace and electronic equipment, and to provide related engineering and technical services according to the buyer’s specifications. These revenue arrangements or contracts are generally fixed price, cost-plus, or time-and-material and are covered by accounting standards for construction-type and production-type contracts and federal government contractors. Substantially all of our cost-plus type and time-and-material type contracts are with the U.S. Government, primarily the DoD. Certain of our contracts with the U.S. Government are multi-year contracts that are funded annually by the customer, and sales on these multi-year contracts are based on amounts appropriated (funded) by the U.S. Government. Our remaining sales are accounted for in accordance with accounting standards for revenue arrangements with commercial customers.

Sales and profits on fixed-price type contracts that are covered by accounting standards for construction-type and production-type contracts and federal government contractors are substantially recognized using percentage-of- completion (POC) methods of accounting. Sales on such contracts represent approximately 30% of our consolidated net sales. Sales and profits on fixed-price production contracts under which units are produced and delivered in a continuous or sequential process are recorded as units are delivered based on their contractual selling prices (the “units-of-delivery” method). Sales and profits on each fixed-price production contract under which units are not produced and delivered in a continuous or sequential process, or under which a relatively few number of units are produced, are recorded based on the ratio of actual cumulative costs incurred to total estimated costs at completion of the contract multiplied by the total estimated contract revenue, less cumulative sales recognized in prior periods (the “cost-to-cost” method). Under both POC methods of accounting, a single estimated total profit margin is used to recognize profit for each contract over its entire period of performance, which can exceed one year.

 

41


Table of Contents

Accounting for the sales on these fixed-price contracts requires the preparation of estimates of (1) the total contract revenue, (2) the total costs at completion, which is equal to the sum of the actual incurred costs to date on the contract and the estimated costs to complete the contract’s statement of work, and (3) the measurement of progress towards completion. The estimated profit or loss at completion on a contract is equal to the difference between the total estimated contract revenue and the total estimated cost at completion. Under the units-of-delivery method, sales on a fixed-price type contract are recorded as the units are delivered during the period based on their contractual selling prices. Under the cost-to-cost method, sales on a fixed-price type contract are recorded at amounts equal to the ratio of actual cumulative costs incurred divided by total estimated costs at completion, multiplied by (i) the total estimated contract revenue, less (ii) the cumulative sales recognized in prior periods. The profit recorded on a contract in any period using either the units-of-delivery method or cost-to-cost method is equal to (i) the current estimated total profit margin multiplied by the cumulative sales recognized, less (ii) the amount of cumulative profit previously recorded for the contract. In the case of a contract for which the total estimated costs exceed the total estimated revenues, a loss arises, and a provision for the entire loss is recorded in the period that the loss becomes evident. The unrecoverable costs on a loss contract that are expected to be incurred in future periods are recorded as a component of other current liabilities entitled “Estimated cost in excess of estimated contract value to complete contracts in process in a loss position.”

Adjustments to estimates for a contract’s revenue, estimated costs at completion and estimated profit or loss are often required as work progresses under a contract, as experience is gained and as more information is obtained, even though the scope of work required under the contract may not change, or if contract modifications occur. The impact of revisions in profit (loss) estimates for all types of contracts subject to percentage-of-completion accounting are recognized on a cumulative catch-up basis in the period in which the revisions are made. Amounts representing contract change orders or claims are included in sales only when they can be reliably estimated and their realization is reasonably assured. The revisions in contract estimates, if significant, can materially affect our results of operations and cash flows, as well as reduce the valuations of receivables and inventories, and in some cases result in liabilities to complete contracts in a loss position. Net changes in contract estimates increased consolidated operating income by $73 million, or 4%, for the year ended December 31, 2011, $46 million, or 3%, for the year ended December 31, 2010, and $76 million, or 5%, for the year ended December 31, 2009.

Sales and profits on cost-plus type contracts that are covered by accounting standards for government contractors are recognized as allowable costs are incurred on the contract, at an amount equal to the allowable costs plus the estimated profit on those costs. Sales on such contracts represent approximately 10% of our consolidated net sales. The estimated profit on a cost-plus contract is fixed or variable based on the contractual fee arrangement. Incentive and award fees are our primary variable fee contractual arrangement. Incentive and award fees on cost-plus type contracts are included as an element of total estimated contract revenues and recorded to sales when a basis exists for the reasonable prediction of performance in relation to established contractual targets and we are able to make reasonably dependable estimates for them. Sales and profits on time-and-material type contracts are recognized on the basis of direct labor hours expended multiplied by the contractual fixed rate per hour, plus the actual costs of material and other direct non-labor costs. On a time-and-material type contract, the fixed hourly rates include amounts for the cost of direct labor, indirect contract costs and profit. Cost-plus type or time-and-material type contracts generally contain less estimation risks than fixed-price type contracts.

Sales on arrangements for (1) fixed-price type contracts that require us to perform services that are not related to production of tangible assets (Fixed-Price Service Contracts), and (2) certain commercial customers are recognized in accordance with accounting standards for revenue arrangements with commercial customers. Sales for our businesses whose customers are primarily commercial business enterprises are substantially generated from single element revenue arrangements. Sales are recognized when there is persuasive evidence of an arrangement, delivery has occurred or services have been performed, the selling price to the buyer is fixed or determinable and collectability is reasonably assured. Sales for Fixed-Price Service Contracts that do not contain measurable units of work performed are generally recognized on a straight-line basis over the contractual service

 

42


Table of Contents

period, unless evidence suggests that the revenue is earned, or obligations fulfilled, in a different manner. Sales for Fixed-Price Service Contracts that contain measurable units of work performed are generally recognized when the units of work are completed. Sales and profit on cost-plus and time-and-material type contracts within the scope of revenue recognition accounting standards for revenue arrangements with commercial customers are recognized in the same manner as those within the scope of contract accounting standards, except for incentive and award fees. Cost-based incentive fees are recognized when they are realizable in the amount that would be due under the contractual termination provisions as if the contract was terminated. Performance based incentive fees and award fees are recorded as sales when awarded by the customer.

For contracts with multiple deliverables, we apply the separation and allocation guidance under the accounting standard for revenue arrangements with multiple deliverables, unless all the deliverables are covered by contract accounting standards, in which case we apply the separation and allocation guidance under contract accounting standards. Revenue arrangements with multiple deliverables are evaluated to determine if the deliverables should be separated into more than one unit of accounting. We recognize revenue for each unit of accounting based on the revenue recognition policies discussed above.

Sales and profit in connection with contracts to provide services to the U.S. Government that contain collection risk because the contracts are incrementally funded and subject to the availability of funds appropriated, are deferred until the contract modification is obtained, indicating that adequate funds are available to the contract or task order.

Goodwill and Identifiable Intangible Assets. In accordance with the accounting standards for business combinations, we record the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition (commonly referred to as the purchase price allocation). As part of the purchase price allocations for our business acquisitions, identifiable intangible assets are recognized as assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired business and sold, transferred, licensed, rented or exchanged. However, we do not recognize any intangible assets apart from goodwill for the assembled workforces of our business acquisitions.

Generally, the largest separately identifiable intangible asset from the businesses that we acquire is the value of their assembled workforces, which includes the human capital of the management, administrative, marketing and business development, scientific, engineering and technical employees of the acquired businesses. The success of our businesses, including their ability to retain existing business (revenue arrangements) and to successfully compete for and win new business (revenue arrangements), is primarily dependent on the management, marketing and business development, contracting, engineering and technical skills and knowledge of our employees, rather than on productive capital (plant and equipment, and technology and intellectual property). Additionally, for a significant portion of our businesses, our ability to attract and retain employees who have U.S. Government security clearances, particularly those with top-secret and above clearances, is critical to our success, and is often a prerequisite for retaining existing revenue arrangements and pursuing new ones. Generally, patents, trademarks and licenses are not material for our acquired businesses. Furthermore, our U.S. Government contracts (revenue arrangements) generally permit other companies to use our patents in most domestic work performed by such other companies for the U.S. Government. Therefore, because intangible assets for assembled workforces are part of goodwill, the substantial majority of the intangible assets for our acquired business acquisitions are recognized as goodwill. Additionally, the value assigned to goodwill for our business acquisitions also includes the value that we expect to realize from cost reduction measures that we implement for our acquired businesses. Goodwill equals the amount of the purchase price of the business acquired in excess of the sum of the fair value of identifiable acquired assets, both tangible and intangible, less the fair value of liabilities assumed. At December 31, 2011, we had goodwill of $8,697 million and identifiable intangible assets of $410 million.

The most significant identifiable intangible asset that is separately recognized in accordance with U.S. GAAP for our business acquisitions is customer contractual relationships. All of our customer relationships are established through written customer contracts (revenue arrangements). The fair value for customer contractual

 

43


Table of Contents

relationships is determined, as of the date of acquisition, based on estimates and judgments regarding expectations for the estimated future after-tax earnings and cash flows (including cash flows from working capital) arising from the follow-on sales on contract (revenue arrangement) renewals expected from customer contractual relationships over their estimated lives, including the probability of expected future contract renewals and sales, less a contributory asset charge, all of which is discounted to present value. All identifiable intangible assets are amortized over their estimated useful lives as the economic benefits are consumed, ranging from four to thirty years. We review customer contractual relationships for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable in accordance with the accounting standards for long-lived assets. If any such event or change in circumstances occurs, and, if our revised estimates of future after-tax cash flows are significantly lower than our estimates at the date we acquired the customer contractual relationships, we may be required to record an impairment charge to write down these intangible assets to their realizable values. We review and update our estimates of the duration of our customer contractual relationships. If such estimates indicate that the duration of our customer contractual relationships has decreased compared to the estimates made as of the date we acquired these intangible assets, then we accelerate the amortization period for our customer contractual relationships over their remaining useful economic lives.

We review goodwill for impairment at least annually as of November 30, and whenever events or changes in circumstances indicate that the carrying amount may not be recoverable in accordance with the accounting standards for goodwill. The goodwill for each reporting unit is tested using a two-step process. A reporting unit is an operating segment, as defined by the segment reporting accounting standards, or a component of an operating segment. A component of an operating segment is a reporting unit if the component constitutes a business for which discrete financial information is available and is reviewed by operating segment management. Two or more components of an operating segment may be aggregated and deemed a single reporting unit for goodwill impairment testing purposes if the components have similar economic characteristics.

L-3 had 17 reporting units at December 31, 2011, and 19 reporting units at December 31, 2010. The composition of our reporting units and associated goodwill balances changed in 2011 as compared to 2010 due to business realignments that resulted in the consolidation of two reporting units into one and the elimination of a reporting unit. The reporting units had fair values in excess of their carrying values at the time of the realignments and the related goodwill for each was allocated based on a relative fair value. In addition, the aggregate balance of goodwill declined by $33 million to $8,697 million at December 31, 2011 from $8,730 million at December 31, 2010 due to a $43 million impairment charge (discussed below) and $17 million of foreign currency translation adjustments, which were partially offset by additions of $27 million for business acquisitions.

The table below presents the number of reporting units and the associated goodwill, at December 31, 2011 for each of our reportable segments.

 

Reportable Segment

   Number of
 Reporting  Units 
     Aggregate
Goodwill
 
            (in millions)  

C3ISR

     3       $ 866   

Government Services

     1         2,191   

AM&M

     1         1,169   

Electronic Systems

     12         4,471   
  

 

 

    

 

 

 

Total

     17       $ 8,697   
  

 

 

    

 

 

 

The first step in the process of testing goodwill for potential impairment is to compare the carrying value of the reporting unit to its fair value. If a potential impairment is identified, the second step is to measure the impairment loss by comparing the implied fair value of goodwill with the carrying value of goodwill of the reporting unit. Our methodology for determining the fair value of a reporting unit is estimated using a discounted cash flow (DCF) valuation approach, and is dependent on estimates for future sales, operating income, depreciation and amortization, income tax payments, working capital changes, and capital expenditures, as well

 

44


Table of Contents

as, expected long-term growth rates for cash flows. All of these factors are affected by economic conditions related to the industries in which we operate (predominantly the U.S. defense industry), as well as, conditions in the U.S. capital markets.

During the fourth quarter of 2011, we recorded a non-cash impairment charge of $43 million ($42 million after income taxes), or $0.40 per diluted share, for the impairment of goodwill based on its annual impairment test as of November 30. The goodwill impairment charge was due to a decline in the estimated fair value of the Marine Services reporting unit, which is part of the Electronics Systems segment, as a result of a decline in its projected future cash flows. The decline in projected future cash flows was due to: (1) lower DoD budgets which have caused shipyards to retain work that has been typically outsourced to Marine Services and (2) lower margins on existing and expected future contracts due to increased competition. In 2010, we disclosed that the Marine Services reporting unit was identified as one of six reporting units that when applying a hypothetical decrease of at least 20% would have had a carrying value in excess of its estimated fair value. The 2010 estimated fair value of the Marine Services reporting unit exceeded its carrying value after a hypothetical decrease of 10% to its fair value.

The more significant assumptions used in our DCF valuations to determine the fair values of our reporting units in connection with the goodwill valuation assessment at November 30, 2011, were: (1) detailed three-year cash flow projections for each of our reporting units, which are based primarily on our estimates of future sales, operating income, and cash flows, (2) the expected long-term growth rates for each of our reporting units, which approximate the expected long-term growth rate for the U.S. economy and the respective industries in which the reporting units operate, and (3) risk adjusted discount rates, which represent the weighted average cost of capital (WACC) for each reporting unit and include the estimated risk-free rate of return that is used to discount future cash flow projections to their present values. Although certain refinements to the process used to estimate the WACC were implemented, there were no significant changes to the underlying methods used in 2011 as compared to the prior year DCF valuations of our reporting units.

Each reporting unit WACC was comprised of: (1) an estimated required rate of return on equity, based on publicly traded companies with business and economic risk characteristics comparable to each of L-3’s reporting units (Market Participants), including a risk free rate of return of 3.06% on the 30 year U.S. Treasury Bond as of November 30, 2011 (4.1% as of November 30, 2010) and an equity risk premium of 6% (5% for 2010) and (2) an after-tax rate of return on Market Participants’ debt, each weighted by the relative market value percentages of Market Participants’ equity and debt. The WACC assumptions for each reporting unit are based on a number of market inputs that are outside of our control and are updated annually to reflect changes to such market inputs as of the date of our annual goodwill impairment assessments, including changes to: (1) the estimated required rate of return on equity based on historical returns on common stock securities of Market Participants and the Standard & Poor’s 500 Index over the prior two-year period, (2) the risk free rate of return based on the prevailing market yield on the 30 year U.S. Treasury bond, (3) the rate of return of Market Participants publically traded debt securities, and (4) the relative market value percentages of Market Participants’ equity and debt.

The table below presents the weighted average risk adjusted discount rate assumptions used in our DCF valuation for each of our reportable segments for our goodwill impairment assessments at November 30, 2011.

 

Reportable Segment

   WACC  

C3ISR(1)

     7.1%   

Government Services(2)

     7.1%   

AM&M(2)

     7.1%   

Electronic Systems(3)

     7.5%   

 

(1) 

All reporting units within the C3ISR reportable segment used the risk adjusted discount rates as presented in the table above.

 

(2) 

The Government Services and AM&M reportable segments are each comprised of one reporting unit.

 

(3) 

The weighted average risk adjusted discount rate for the Electronic Systems reportable segment is comprised of separate assumptions for each reporting unit that range that from 6.9% to 9.1%.

 

45


Table of Contents

As presented in the table below, L-3’s historical three-year average annual cash flow growth rates for 2011, 2010 and 2009 for our reportable segments ranged from a negative 4% to a positive 35%. The annual cash flows generated by each of our reporting units varies from year to year, and, therefore, the annual cash flow growth rates do not result in linear trends, due to a number of factors. The factors that affect the level of annual cash flows in each of our reporting units include, but are not limited to: (1) variability of annual sales volume and sales growth rates, (2) increases and decreases in working capital, including customer advance payments and billings on multi-year contracts (revenue arrangements) with long-term performance periods (exceeding one year), (3) the timing of invoicing and cash collections between fiscal years from receivables due from customers on multi-year contracts (revenue arrangements) that are affected by the financing terms of individual contracts, (4) the timing of increases and decreases of select inventories procured and produced in anticipation of future product sales, which frequently overlap the ending and beginning of fiscal years, (5) the timing of the receipt of award fee and incentive fee payments from customers on contracts (revenue arrangements), (6) variability in annual cash outlays for research and development costs, (7) changes in cash outlays for capital expenditures for property, plant and equipment, and (8) increases in annual sales and costs and expense volumes of a reporting unit resulting from business acquisitions. As a result of the factors discussed above and the varying sizes of our reporting units, the annual cash flow levels and growth rates at the reporting unit level tend to fluctuate significantly from year to year.

The 2011 cash flow amount and the cash flow growth rate for each of the last three years for each of our segments are presented in the following table.

 

Reportable Segment

   Estimated
Cash Flow(1)
     Estimated Annual Cash Flow Growth Rate(1)  
      (in millions) 
2011
     2011     2010     2009       3 Yr. Average    

C3ISR(2)

   $ 260         117       (44)     32     35

Government Services(3)

   $ 341         20     9       (41)     (4)

AM&M(4)

   $ 174           (24)     46     (30)     (3)

Electronic Systems(5)

   $     522         (8)     5     5     1

 

(1) 

Reportable segment estimated cash flow excludes interest payments on debt and other corporate cash flows.

 

(2) 

The increase in cash flow in 2011 for C3ISR was due to working capital improvements, timing of billings and cash receipts on fixed price contracts, and growth in operating income. The decrease in cash flow for C3ISR in 2010 was due to the timing of billings and cash receipts on certain fixed price contracts for networked communications and higher working capital requirements, partially offset by growth in sales and operating income. The increase in cash flow in 2009 for C3ISR was primarily due to growth in sales and operating income.

 

(3) 

The increase in cash flows in 2011 for Government Services was primarily due to working capital reductions due to lower sales volume and a decrease in tax payments due to a lower effective tax rate and lower operating income. The increase in cash flows for Government Services in 2010 was primarily due to working capital reductions due to lower sales volume and the timing of advanced payments for certain contracts for foreign customers. The decrease in cash flows for Government Services in 2009 was primarily due to lower sales and operating income in comparison to the prior year, driven primarily by lower Iraq-related linguist services.

 

(4) 

The decrease in cash flows in 2011 for AM&M was primarily due to higher working capital, primarily for inventory on new contracts that began in 2011 and timing of billings, partially offset by an increase in advanced payments. The increase in cash flows for AM&M in 2010 was primarily due to working capital reductions, primarily for billed receivables on contracts nearing completion and the loss of the SOFSA contract, and lower capital expenditures. In 2009, the decrease in cash flow for AM&M was primarily due to cash used for working capital attributable to increased billed receivables associated with 2009 sales growth, primarily system field services.

 

(5) 

The decrease in cash flows in 2011 for Electronic Systems was primarily due to lower operating income compared to 2010 for warrior systems, training & simulation, space & propulsion and microwave and liquidation of advance payments at microwave, partially offset by lower working capital requirements at warrior systems. The increase in cash flows for Electronic Systems in 2010 was primarily due to higher operating income compared to 2009 for integrated sensor systems, microwave, aviation products and undersea warfare. The increase in cash flows for Electronic Systems in 2009 was primarily due to higher operating income compared to 2008 for several business areas, primarily integrated sensor systems and power and control systems.

We consistently consider several factors to determine expected future annual cash flows for our reporting units, including, historical multi-year average cash flow trends by reporting unit and the expected future cash

 

46


Table of Contents

flow growth rates for each of our reporting units primarily based on our estimates of future sales, operating income, and working capital changes. Furthermore, the substantial majority of our reporting units are primarily dependent upon the DoD budget and spending. Historically, approximately 75% of L-3’s annual sales have been generated from DoD customers. Accordingly, to determine expected future annual cash flows for our reporting units we also consider: (1) the DoD budget and spending priorities, (2) expansion into new markets, (3) changing conditions in existing markets for our products, systems, and services, (4) possible termination of certain government contracts, (5) expected success in new business competitions and re-competitions on existing business, and (6) anticipated operating margins and working capital requirements, which vary significantly depending on the stage of completion (early, mature, ending) of contracts (revenue arrangements). We closely monitor changes in these factors and their impact on the expected cash flow of our reporting units.

In addition to the factors noted in the previous paragraph that were relevant and specific to each of our reporting units, our goodwill impairment assessments as of November 30, 2011 assumed a declining DoD budget through 2014 with modest growth beginning in fiscal year 2015, consistent with our discussion of industry considerations on page 36. However, our current estimates and assumptions may not result in the projected cash flow outcomes due to a number of factors, including:

 

   

the impact on our businesses of the recent DoD base budget cuts, including $22 billion of cuts in the FY 2012 enacted budget compared to the FY 2012 budget request, and $259 billion of cuts to the proposed DoD base budgets for FY 2013 to FY 2017 compared to the previously proposed DoD base budgets, and their impact on our future results of operations and cash flows; and

 

   

the outcome of potential additional cuts of $500 billion for FY 2013 through FY 2021 due to the sequestration process, which becomes effective on January 3, 2013, unless Congress enacts new legislation to rescind them.

Additionally, our actual cash flows may be higher than our projections and the DCF valuation does not reflect actions that we may take to increase the profitability and cash flows of our reporting units, including our eight reporting units with fair value cushions of less than 20% in the table on page 48. Actions we may take include, consolidating and streamlining select business operations, creating future synergies with other L-3 businesses, or pursuing incremental targeted growth opportunities. Additionally, the DCF valuations do not assume future business acquisitions or divestitures.

The table below presents the estimated (1) 2012 cash flow amount, (2) average cash flow growth rates for 2012 – 2014, and (3) weighted average cash flow growth rates for 2015 and 2016 and after 2016 for each of our reportable segments.

 

Reportable Segment

   Estimated
  Cash  Flow  
     Estimated Average Cash Flow Growth Rates    
     (in millions)
2012
    2012 – 2014
3 Yr. Average
    2015 – 2016     After 2016  

C3ISR

   $ 272 (1)      (8 )%      0     1.4

Government Services

   $ 193 (2)      (16 )%      0     1.0

AM&M

   $ 125 (3)      (14 )%      0     .5

Electronic Systems

   $      444 (4)      1     (2.3 )%      1.0

 

(1) 

C3ISR projected cash flows are expected to increase by $12 million from $260 million in 2011 to $272 million in 2012. The increase is primarily due to slight improvements in sales, operating income and working capital requirements.

 

(2) 

Government Services projected cash flows are expected to decrease by $148 million from $341 million in 2011 to $193 million in 2012. The decrease is due primarily to lower expected sales, operating income, and margins.

 

(3) 

AM&M projected cash flows are expected to decrease by $49 million from $174 million in 2011 to $125 million in 2012. The decrease is primarily due to lower margins and higher capital expenditures due to IT Systems and facility upgrades.

 

(4) 

Electronic Systems projected cash flows are expected to decrease by $78 million from $522 million in 2011 to $444 million in 2012. The decrease is due to lower operating income and margins at undersea warfare, aviation products and power systems, and liquidation of advance payments on contracts with non-DoD customers at undersea warfare. These decreases are partially offset by margin and working capital improvements at warrior systems.

 

47


Table of Contents

A decline in the estimated fair value of a reporting unit could result in a goodwill impairment, and a related non-cash impairment charge against earnings, if the estimated fair value for the reporting unit is less than the carrying value of the net assets of the reporting unit, including its goodwill. A large decline in estimated fair value of a reporting unit could result in an adverse effect on our financial condition and results of operations.

In order to evaluate the sensitivity of the fair value calculations relating to our goodwill impairment assessment, we applied hypothetical decreases to the estimated fair values of each of our reporting units. We determined that a decrease in fair value of at least 20% would be required before any reporting unit, with the exception of eight, would have a carrying value in excess of its fair value. The table below presents the: (1) risk adjusted discount rates, (2) annual cash flow and three-year average growth rate, (3) 2011 cash flow, (4) goodwill balance, and (5) excess fair value percentage and dollar amount, for each of these eight reporting units.

 

          Estimated Annual Cash Flow                
          Growth Rate(1)   Estimated
2011
Cash Flows(1)
           

Reporting Unit                                

  Risk Adjusted
Discount  Rates
   

2011

 

2010

 

2009

 

3 Year

  Average  

    Goodwill
Balance(2)
   

Excess

Fair  Value(3)

 

Power & Control Systems(4)

    7.1   21%   (34)%   41%   9%   $81   $ 776        18%      $ 155   

Undersea Warfare(5)

    7.1   (33)%   24%   1,441%   477%   $33   $ 203        17%      $ 29   

Microwave Group(6)

    7.6   (41)%   46%   (26)%   (7)%   $61   $ 790        14%      $ 172   

Marine Services(7)

    6.9   (66)%   (66)%   593%   153%   $3   $ 63        13%      $ 9   

Government Services(8)

    7.1   20%   9%   (41)%   (4)%   $341   $   2,192        11%      $   318   

AM&M(9)

    7.1   (24)%   46%   (30)%   (2.5)%   $174   $ 1,166        11%      $ 173   

Space & Propulsion Systems(10)

    7.1   (46)%   (19)%   (10)%   (25)%   $22   $ 250        8%      $ 27   

Warrior Systems(11)

    7.1   (40)%   (24)%   22%   (14)%   $18   $ 559        7%      $ 69   

 

(1) 

Reporting unit cash flow excludes interest payments on debt and other corporate cash flows.

(2) 

The goodwill balance is as of November 30, 2011, our goodwill impairment testing date except for the Marine Services reporting unit, whose goodwill balance represents the amount of goodwill remaining after the non-cash impairment charge of $43 million.

 

(3) 

The excess fair value represents the percentage and dollar amount by which the fair value of a reporting unit must decline before a potential impairment is identified and would require the second step of the goodwill impairment assessment to be performed.

 

(4) 

Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 51% in 2012 compared to 2011 due to the wind down of a U.S. Army Indefinite Delivery Indefinite Quality (IDIQ) contract, as well as the liquidation of advance payments as a result of deliveries to foreign customers. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will be approximately 35% and 34% below 2011 in 2013 and 2014, respectively, due to continued weakness in the commercial shipbuilding market and further liquidation of advances to foreign customers. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.

 

(5) 

Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 157% in 2012 compared to 2011 levels due to liquidations of advance payments on contracts with non-DoD customers and contracts nearing completion. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will remain approximately 56% and 58% below 2011 levels in 2013 and 2014, respectively, reflecting continued lower demand from allied foreign navies. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.

 

(6) 

Our DCF valuation for this reporting unit assumed higher projected cash flow of approximately 43% in 2012 compared to 2011. The unit’s 2011 cash flows were negatively impacted by lower manufacturing yields which delayed shipments of power devices for satellite communications systems. The DCF for 2012 reflects the expected resolution of lower manufacturing yields encountered in 2011, as well an increase in expected receipt of advance payments in 2012. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will be approximately 35% and 39% above 2011 levels in 2013 and 2014, respectively, due to expected higher manufacturing yields. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.

 

(7) 

The goodwill balance for the Marine Services reporting unit is the balance remaining after the non-cash impairment change of $43 million. Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 128% in 2012 compared to 2011 levels due to lower DoD budgets which caused shipyards to retain work that had been typically outsourced and lower margins on existing and expected follow on contracts due to pricing pressure resulting from increased competition. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will be approximately 76% to 80% above depressed 2011 levels in 2013 and 2014, respectively, as we expect shipyards to begin outsourcing work to Marine Services. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.

 

(8)

Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 43% in 2012 compared to 2011 levels due to lower expected sales, operating income, and margins resulting from: contract re-compete losses in 2011, the drawdown of U.S. military forces from Iraq that was completed in December 2011 and the impact of DoD efficiency initiatives. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will remain approximately 44% and 45% below 2011 levels in 2013 and 2014, respectively, reflecting continued constraints on the DoD budget. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.

 

48


Table of Contents
(9)

Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 28% in 2012 compared to 2011 levels due to lower margins and higher capital expenditures due to IT Systems and facility upgrades. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will remain approximately 33% and 37% below 2011 levels in 2013 and 2014, respectively, reflecting continued constraints on the DoD budget. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow .5% annually after 2016.

 

(10) 

Our DCF valuation for this reporting unit assumed lower projected cash flow of approximately 43% in 2012 compared to 2011 levels due to liquidation of advance payments on a international contract. In addition, our DCF valuation for this reporting unit assumed that projected cash flow will grow 25% and 23% above depressed 2011 levels in 2013 and 2014, respectively, reflecting growth in M-60 tank refurbishments for foreign militaries and a ramp up in Bradley production in 2014. Projected cash flows are expected to decrease 6.6% from 2015 to 2016 and then grow .6% annually after 2016.

 

(11) 

The warrior systems reporting unit was created in the third quarter of 2010 as a result of our acquisition of Insight Technology on April 14, 2010, and its combination with two existing integrated sensor systems businesses. Cash flow data for 2009 includes the cash flows from the two former integrated sensor systems businesses and the 2010 cash flow includes these two businesses and Insight Technology from the acquisition date. The DCF valuation for this reporting unit assumed an average cash flow growth rate of 98% during 2012 through 2014. This increase is primarily attributable to an increase of $52 million or 297% in 2012 due to margin and working capital improvements. The cash flows assume an average negative 1.5% growth rate in 2013 and 2014 due to higher working capital needs. Projected cash flows are expected to remain flat from 2015 to 2016 and then grow 1% annually after 2016.

Pension Plan and Postretirement Benefit Plan Obligations. The obligations for our pension plans and postretirement benefit plans and the related annual costs of employee benefits are calculated based on several long-term assumptions, including discount rates and expected mortality for employee benefit liabilities, and rates of return on plan assets, and expected annual rates for salary increases for employee participants in the case of pension plans, and expected annual increases in the costs of medical and other health care benefits in the case of postretirement benefit obligations. These long-term assumptions are subject to revision based on changes in interest rates, financial market conditions, expected versus actual returns on plan assets, expected participant mortality and other actuarial assumptions, including future rates of salary increases, benefit formulas and levels, and rates of increase in the costs of benefits. Changes in the assumptions, if significant, could materially affect the amount of annual net periodic benefit costs recognized in our results of operations from one year to the next, the liabilities for the pension plans and postretirement benefit plans, and our annual cash requirements to fund these plans. Our pension expense for 2012 is expected to increase by $34 million to $179 million from $145 million in 2011. Our discount rate assumption decreased from a weighted average rate of 5.57% in 2010 to 5.02% in 2011. The increase in our 2012 pension expense is primarily due to the decrease in discount rate and a decrease in the expected long-term return on plan assets assumption for our U.S. pension plans from 8.75% in 2011 to 8.25% in 2012. See “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Pension Plans” on page 60 for a further discussion of our estimated 2012 pension expense.

Discount rates are used to determine the present value of our pension obligations and also affect the amount of pension expense in any given period. The discount rate assumptions used to determine our pension and postretirement benefit obligations at December 31, 2011 and 2010 were based on a hypothetical AA yield curve represented by a series of annualized individual discount rates. Each bond issue underlying the yield curve is required to have a rating of AA or better by Moody’s Investors Service, Inc. and/or Standard & Poor’s. The resulting discount rate reflects the matching of plan liability cash flows to the yield curve. For a sensitivity analysis projecting the impact of a change in the discount rate on our projected benefit obligation and pension expense, see “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Pension Plans” on page 60.

Valuation of Deferred Income Tax Assets and Liabilities. At December 31, 2011, we had deferred tax assets of $651 million, deferred tax liabilities of $923 million and a valuation allowance of $14 million. The deferred tax assets include $19 million for loss carryforwards and $10 million for tax credit carryforwards which are subject to various limitations and will expire if unused within their respective carryforward periods. Deferred income taxes are determined separately for each of our tax-paying entities in each tax jurisdiction. The future realization of our deferred income tax assets ultimately depends on our ability to generate sufficient taxable income of the appropriate character (for example, ordinary income or capital gains) within the carryback and carryforward periods available under the tax law and, to a lesser extent, our ability to execute successful tax planning

 

49


Table of Contents

strategies. Based on our estimates of the amounts and timing of future taxable income and tax planning strategies, we believe that we will be able to realize our deferred tax assets, except for capital losses and certain foreign and state net operating losses. A change in the ability of our operations to continue to generate future taxable income, or our ability to implement desired tax planning strategies, could affect our ability to realize the future tax deductions underlying our deferred tax assets, and require us to provide a valuation allowance against our deferred tax assets. The recognition of a valuation allowance would result in a reduction to net income and, if significant, could have a material impact on our effective tax rate, results of operations and financial position in any given period.

Liabilities for Pending and Threatened Litigation. We are subject to litigation, government investigations, proceedings, claims or assessments and various contingent liabilities incidental to our business or assumed in connection with certain business acquisitions. In accordance with the accounting standards for contingencies, we accrue a charge for a loss contingency when we believe it is both probable that a liability has been incurred, and the amount of the loss can be reasonably estimated. If the loss is within a range of specified amounts, the most likely amount is accrued, and if no amount within the range represents a better estimate we accrue the minimum amount in the range. Generally, we record the loss contingency at the amount we expect to pay to resolve the contingency and the amount is generally not discounted to the present value. Amounts recoverable under insurance contracts are recorded as assets when recovery is deemed probable. Contingencies that might result in a gain are not recognized until realizable. Changes to the amount of the estimated loss, or resolution of one or more contingencies could have a material impact on our results of operations, financial position and cash flows. See Note 19 to our audited consolidated financial statements for further discussion of our litigation matters.

Valuation of Long-Lived Assets. In addition to goodwill and identifiable intangible assets recognized in connection with our business acquisitions, our long-lived assets also include property, plant and equipment, capitalized software development costs for software to be sold, leased or otherwise marketed, and certain long-term investments. As of December 31, 2011, the consolidated carrying values of our property, plant and equipment were $934 million, certain long-term investments were $43 million, and capitalized software development costs were $39 million. As of December 31, 2011, the carrying value of our property, plant and equipment represented 6% of total assets and the carrying value of our capitalized software development costs and certain long-term investments each represented less than 1% of total assets. We review the valuation of our long-lived assets whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable. An impairment loss is recognized when the carrying amount of a long-lived asset exceeds its fair value or net realizable value expected to result from the asset’s use and eventual disposition. We use a variety of factors to assess valuation, depending upon the asset. Long-lived assets are evaluated based upon the expected period the asset will be utilized, and other factors depending on the asset, including estimated future sales, profits and related cash flows, estimated product acceptance and product life cycles, changes in technology and customer demand, and the performance of invested companies and joint ventures. Changes in estimates and judgments on any of these factors could have a material impact on our results of operations and financial position.

 

50


Table of Contents

Results of Operations

The following information should be read in conjunction with our audited consolidated financial statements. Our results of operations for the periods presented are affected by our business acquisitions. See Note 4 to our audited consolidated financial statements for a discussion of our business acquisitions.

Consolidated Results of Operations

The table below provides selected financial data for L-3 for the years ended December 31, 2011 compared with 2010 and 2010 compared with 2009.

 

      Year Ended
December 31,
    Increase/
    (decrease)    
    Year Ended
December 31,
    Increase/
(decrease)
 
(in millions, except per share data)    2011(1)     2010       2010     2009    

Net sales

   $     15,169      $     15,680      $     (511)      $     15,680      $     15,615      $       65   

Operating income

   $ 1,598      $ 1,750      $ (152)      $ 1,750      $ 1,656      $ 94   

Goodwill impairment charge

     43               43                        
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Segment operating income

   $ 1,641      $ 1,750      $ (109)      $ 1,750      $ 1,656      $ 94   
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating margin

     10.5     11.2     (70)  bpts      11.2     10.6     60  bpts 

Goodwill impairment charge

     0.3            30  bpts                      
    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Segment operating margin

     10.8     11.2     (40)  bpts      11.2     10.6     60  bpts 

Net interest expense and other income

   $ 235      $ 248      $ (13)      $ 248      $ 260      $ (12)   

Debt retirement charge

   $ 35      $ 18      $ 17      $ 18      $ 10      $ 8   

Effective income tax rate

     27.1     34.9     nm        34.9     34.3     60  bpts 
   

Net income attributable to L-3

   $ 956      $ 955      $ 1      $ 955      $ 901      $ 54   
   

Diluted earnings per share

   $ 9.03      $ 8.25      $ 0.78      $ 8.25      $ 7.61      $ 0.64   
   

Diluted weighted average common shares outstanding

     105.6        115.1        (9.5)        115.1        117.4        (2.3)   

 

              

(1)      The year ended December 31, 2011 includes: (1) a tax benefit of $78 million, or $0.74 of diluted earnings per share, for a net reversal of amounts previously accrued related to tax years for which the statue of limitations has expired, (2) a non-cash goodwill impairment charge of $43 million ($42 million after income taxes), or $0.40 per diluted share due to a decline in the estimated fair value of our Marine Services business and (3) $14 million ($8 million after income taxes), or $0.08 per diluted share for our share of an impairment charge for long-lived assets at an equity method investment.

             

nm   - Not meaningful.

      

2011 Compared with 2010

Net Sales: For the year ended December 31, 2011, consolidated net sales of $15.2 billion decreased by 3% compared to the year ended December 31, 2010. Lower sales from the AM&M, Government Services and Electronic Systems were partially offset by sales growth from the C3ISR segments. Acquired businesses, which are all included in the Electronics Systems segment, contributed $160 million to net sales for the year ended December 31, 2011.

Sales from services, primarily from our Government Services, AM&M and C3ISR segments, decreased by $478 million to $7,606 million, representing approximately 50% of consolidated net sales, for the year ended December 31, 2011, compared to $8,084 million, or approximately 52% of consolidated net sales for the year ended December 31, 2010. Sales from services decreased primarily due to the loss of the SOFSA, Afghanistan Ministry of Defense (MoD) support and Federal Aviation Administration (FAA) IT support services contracts, reduced subcontractor pass-through sales related to U.S. Army systems and software engineering and services (SSES), and lower linguist services, training, intelligence support and logistics support services for the U.S.

 

51


Table of Contents

Army due to the drawdown of U.S. military forces from Iraq. These decreases were partially offset by increased contractor logistics support (CLS) services for U.S. Army C-12 aircraft, and increased intelligence and information technology (IT) support services for U.S. Government agencies.

Sales from products, which primarily include products from our C3ISR and Electronic Systems segments, decreased by $33 million to $7,563 million, representing approximately 50% of consolidated net sales for the year ended December 31, 2011, compared to $7,596 million, or approximately 48% of consolidated net sales, for the year ended December 31, 2010. The decrease in product sales was due to sales volume declines primarily for Joint Cargo Aircraft (JCA), night vision products, combat propulsion systems, mobile satellite communication systems and simulation & training devices. The decreases were partially offset by sales from acquired businesses, and organic sales growth primarily for networked communication and integrated sensor systems. See the reportable segment results below for additional discussion of our segment sales.

Operating income and operating margin: Consolidated operating income for the year ended December 31, 2011 decreased by $152 million, or 9%, compared to the year ended December 31, 2010. Segment operating income for the year ended December 31, 2011 decreased by $109 million, or 6%, compared to the year ended December 31, 2010. Segment operating margin decreased by 40 basis points to 10.8% for the year ended December 31, 2011 compared to 11.2% for the year ended December 31, 2010. Lower operating margins in the C3ISR, Government Services and Electronic Systems segments were partially offset by higher operating margins for the AM&M segment. See the reportable segment results below for additional discussion of operating margin.

Net interest expense and other income: Net interest expense and other income decreased by $13 million for the year ended December 31, 2011 compared to the prior year. The decrease was primarily due to lower amortization of bond discounts and lower interest expense as a result of recent debt refinancings, partially offset by $14 million for our share of an impairment charge for long-lived assets at an equity method investment.

Debt Retirement Charge: During 2011, we redeemed our 5 7/8% 2015 Notes and $500 million of our 6 3/8% 2015 Notes and recorded related debt retirement charges of $35 million. During 2010, we redeemed our 6 1/8% Senior Subordinated Notes due 2013 and 2014 and recorded related debt retirement charges of $18 million. See Liquidity and Capital Resources – Statement of Cash Flows – Debt Repayments for additional information.

Effective income tax rate: The effective tax rate for the year ended December 31, 2011 decreased to 27.1% from 34.9% for the year ended December 31, 2010. Excluding the Q4 2011 Items, the effective tax rate would have decreased to 32.1% for 2011. This decrease was primarily due to: (1) $12 million for the reversal of previously accrued amounts in the second quarter of 2011, (2) additional federal tax benefits on the repatriation of foreign earnings, and (3) a 2010 tax provision of $5 million, or $0.04 per diluted share, related to the unfavorable tax treatment of the U.S. Federal Patient Protection and Affordable Care Act that did not recur in 2011.

Net income attributable to L-3 and diluted earnings per share: Net income attributable to L-3 increased by $1 million to $956 million for the year ended December 31, 2011, compared to last year and diluted earnings per share (EPS) increased 9% to $9.03 from $8.25. Excluding the Q4 2011 Items of $28 million, or $0.26 per share, net income attributable to L-3 decreased $27 million to $928 million and diluted EPS increased $0.52, or 6%, to $8.77.

Diluted weighted average common shares outstanding: Diluted weighted average common shares outstanding for the year ended December 31, 2011 decreased by 9.5 million shares, or 8%, compared to the year ended December 31, 2010. The decrease was due to repurchases of our common stock in connection with our share repurchase programs authorized by our Board of Directors, partially offset by additional shares issued in connection with various employee stock-based compensation programs and contributions to employee savings plans made in common stock.

 

52


Table of Contents

2010 Compared with 2009

Net Sales: For the year ended December 31, 2010, consolidated net sales of approximately $15.7 billion increased slightly compared to the year ended December 31, 2009. Sales growth from the C3ISR segment was offset by lower sales from the Government Services and Electronic Systems reportable segments and the AM&M reportable segment, primarily due to the loss of the SOFSA contract. Acquired businesses, primarily Insight Technology and 3Di, contributed $207 million to net sales for the year ended December 31, 2010.

Sales from services decreased by $15 million to $8,084 million for the year ended December 31, 2009, compared to $8,099 million for the year ended December 31, 2009. Sales from services represented approximately 52% of consolidated net sales for each of the years. The decrease was due primarily to reduced SSES pass-through volume, the loss of the SOFSA contract and the loss of an aircraft maintenance contract with the U.S. Customs and Border Patrol, and lower sales volume for marine services and simulation & training due to contracts nearing completion. These decreases were partially offset by organic sales growth in airborne ISR logistics support and fleet management services for the U.S. Air Force and information technology (IT) support services for the U.S. Special Operations Command (SOCOM) and other U.S. Government agencies.

Sales from products increased by $80 million to $7,596 million for the year ended December 31, 2010, compared to $7,516 million for the year ended December 31, 2009. Sales from products represented approximately 48% of consolidated net sales for each of the years. The increase was primarily due to organic growth from networked communications, aircraft modernization, integrated sensor systems, microwave, and security & detection systems and sales from the Insight acquired business. These increases were partially offset by sales declines for combat propulsion systems, commercial shipbuilding products, precision engagement, displays, and marine services. See the reportable segment results below for additional discussion of our segment sales.

Operating income and operating margin: Consolidated operating income for the year ended December 31, 2010 increased by $94 million, or 6%, to $1,750 million from $1,656 million from the year ended December 31, 2009. Operating margin increased to 11.2% for the year ended December 31, 2010 from 10.6% for the year ended December 31, 2009. Higher sales and improved contract performance for the C3ISR segment and favorable sales mix across several businesses, improved contract performance, and $9 million from the sale of a technology license in the Electronic Systems segment increased operating margin by 80 basis points. Lower pension expense of $16 million ($10 million after income taxes, or $0.09 per diluted share) increased operating margin by 10 basis points. These increases were partially offset by lower operating margins in the Government Services segment, which reduced operating margin by 20 basis points. Severance charges, primarily in the Electronic Systems segment, of $17 million reduced operating margin by 10 basis points. See the reportable segment results below for additional discussion of segment operating margin.

Net interest expense and other income: Net interest expense and other income decreased by $12 million for the year ended December 31, 2010 compared to the prior year primarily as a result of lower outstanding debt and higher income from investments accounted for using the equity method.

Debt Retirement Charge: During 2010, we redeemed our 6 1/8% Senior Subordinated Notes due 2013 and 2014 and recorded related debt retirement charges of $18 million. During 2009, we redeemed our 7 5/8% Senior Subordinated Notes due 2012 and recorded a related $10 million debt retirement charge. See Liquidity and Capital Resources – Statement of Cash Flows – Debt repayments for additional information.

Effective income tax rate: The effective tax rate for the year ended December 31, 2010 increased by 60 basis points to 34.9% compared to last year. The increase was primarily due to higher tax benefits for the resolution of tax contingencies in 2009. In addition, the year ended December 31, 2010 included a tax provision of $5 million, or $0.04 per diluted share, related to the U.S. Federal Patient Protection and Affordable Care Act, which changed the tax treatment for certain retiree prescription drug benefits and increased the tax rate by 30 basis points.

 

53


Table of Contents

Net income attributable to L-3 and diluted earnings per share: Net income attributable to L-3 increased by $54 million, or 6%, to $955 million for the year ended December 31, 2010 from $901 million for the year ended December 31, 2009. Diluted EPS increased by $0.64, or 8%, to $8.25 for the year ended December 31, 2010 from $7.61 for the year ended December 31, 2009.

Diluted weighted average common shares outstanding: Diluted weighted average common shares outstanding for the year ended December 31, 2010 decreased by 2.3 million shares, or 2%, compared to the year ended December 31, 2009. The decrease was due to repurchases of our common stock in connection with our share repurchase programs authorized by our Board of Directors, partially offset by additional shares issued in connection with various employee stock-based compensation programs and contributions to employee savings plans made in common stock.

Reportable Segment Results of Operations

The table below presents selected data by reportable segment reconciled to consolidated totals. See Note 22 to our audited consolidated financial statements for additional reportable segment data.

 

     Year Ended December 31,  
     2011     2010(1)     2009(1)  
     (dollars in millions)  

Net sales:(2)

      

C3ISR

   $ 3,568.2      $ 3,322.8      $ 3,015.9   

Government Services

     3,621.4        3,926.4        4,030.9   

AM&M

     2,439.5        2,780.9        2,827.8   

Electronic Systems

     5,539.6        5,649.5        5,740.1   
  

 

 

   

 

 

   

 

 

 

Consolidated net sales

   $     15,168.7      $     15,679.6      $     15,614.7   
  

 

 

   

 

 

   

 

 

 

Operating income:

      

C3ISR

   $ 409.1      $ 391.2      $ 338.9   

Government Services

     279.8        341.7        383.3   

AM&M

     231.8        229.1        242.7   

Electronic Systems

     719.9        788.1        691.3   
  

 

 

   

 

 

   

 

 

 

Total segment operating income

   $ 1,640.6      $ 1,750.1      $ 1,656.2   

Goodwill impairment charge

     (42.6              
  

 

 

   

 

 

   

 

 

 

Consolidated operating income

     1,598.0        1,750.1        1,656.2   
  

 

 

   

 

 

   

 

 

 

Operating margin:

      

C3ISR

     11.5     11.8     11.2

Government Services

     7.7     8.7     9.5

AM&M

     9.5     8.2     8.6

Electronic Systems

     13.0     13.9     12.0

Total segment operating margin

     10.8     11.2     10.6

Goodwill impairment charge

     (0.3 )%               
  

 

 

   

 

 

   

 

 

 

Consolidated operating margin

     10.5     11.2     10.6
  

 

 

   

 

 

   

 

 

 

 

(1) 

As a result of re-alignments of business units in the Company’s management and organizational structure as discussed in Note 2 to our audited consolidated financial statements, sales of $113 million and $141 million were reclassified from the Government Services segment to the Electronic Systems segment and sales of $76 million and $78 million were reclassified from the C3ISR segment to the Government Services segment for the years ended December 31, 2010 and 2009, respectively. In addition, operating income of $7 million and $16 million was reclassified from the Government Services segment to the Electronic Systems segment and operating income of $4 million and $5 million was reclassified from the C3ISR segment to the Government Services segment for the years ended December 31, 2010 and 2009, respectively.

 

(2) 

Net sales are after intercompany eliminations.

 

54


Table of Contents

C3ISR

 

      Year Ended December 31,     Increase/
    (decrease)    
    Year Ended December 31,         
      2011     2010       2010     2009         Increase      
      (dollars in millions)  

Net sales

   $     3,568.2      $     3,322.8      $     245.4      $     3,322.8      $     3,015.9      $     306.9   

Operating income

     409.1        391.2        17.9        391.2        338.9        52.3   

Operating margin

     11.5     11.8     (30)  bpts      11.8     11.2     60  bpts 

2011 Compared with 2010

C3ISR net sales for the year ended December 31, 2011 increased by $245 million, or 7%, compared to the year ended December 31, 2010. This increase was primarily due to increased volume and new business for networked communication systems for manned and unmanned platforms, airborne ISR logistics support and fleet management services to the DoD, and international airborne ISR platforms. These increases were partially offset primarily by lower sales for airborne ISR platforms to the DoD and force protection products to foreign ministries of defense.

C3ISR operating income for the year ended December 31, 2011 increased by $18 million, or 5%, compared to the year ended December 31, 2010. Operating margin decreased by 30 basis points primarily due to lower margin sales mix for networked communication systems and a $6 million loss on a contract termination recorded in 2011.

2010 Compared with 2009

C3ISR net sales for the year ended December 31, 2010 increased by 10% compared to the year ended December 31, 2009 primarily due to demand for airborne ISR logistics support and fleet management services and networked communications systems for manned and unmanned platforms.

C3ISR operating income for the year ended December 31, 2010 increased by 15% compared to the year ended December 31, 2009. Operating margin increased by 60 basis points. Higher sales volume and improved contract performance increased operating margin by 60 basis points and lower pension expense of $6 million increased operating margin by 20 basis points. These increases were partially offset by higher lower margin services sales, which reduced operating margin by 20 basis points.

Government Services

 

      Year Ended December 31,            Year Ended December 31,         
          2011             2010           Decrease           2010             2009           Decrease    
      (dollars in millions)  

Net sales

   $     3,621.4      $     3,926.4      $     (305.0)      $     3,926.4      $     4,030.9      $     (104.5)   

Operating income

     279.8        341.7        (61.9)        341.7        383.3        (41.6)   

Operating margin

     7.7     8.7     (100)  bpts      8.7     9.5     (80)  bpts 

2011 Compared with 2010

Government Services net sales for the year ended December 31, 2011 decreased by $305 million, or 8%, compared to the year ended December 31, 2010. The decrease in sales was due to: (1) $124 million primarily related to the loss of the Afghanistan MoD support contract and the FAA IT support services contract, (2) $118 million in lower linguist services, training, intelligence support, and logistics support services for the U.S. Army due to the drawdown of U.S. military forces from Iraq, (3) $75 million in reduced SSES pass-through volume, (4) $51 million of lower sales related to the SBInet program for the U.S. Department of Homeland Security and an international maritime security enhancement program, and (5) $42 million for IT support services for the U.S.

 

55


Table of Contents

Special Operations Command due to fewer task orders received because of more competitors on the current contract. These decreases were partially offset by $105 million in higher sales due to increased demand for intelligence and information technology support services for U.S. Government agencies.

Government Services operating income for the year ended December 31, 2011 decreased by $62 million, or 18%, compared to the year ended December 31, 2010. Operating margin decreased by 100 basis points. Lower contract profit rates on select new business and re-competitions of existing business due to competitive price pressures and higher business development costs for cyber security initiatives decreased operating margin by 60 basis points. Transaction costs of $9 million for the Engility spin-off and severance charges of $5 million reduced operating margin by 40 basis points.

2010 Compared with 2009

Government Services net sales for the year ended December 31, 2010 decreased by 3% compared to the year ended December 31, 2009. The decrease was primarily due to: (1) reduced subcontractor pass-through sales volume of $154 million related to reduced SSES pass through volume, (2) $46 million of lower sales volume from the loss of an Afghanistan MoD support contract, and (3) $27 million of lower sales volume from reduced tasking for Iraq training work. These decreases were partially offset by increases of $109 million primarily for increased logistics and law enforcement support services for the U.S. Army due to higher volume for Afghanistan, and information technology support services for SOCOM and other U.S. Government agencies. The increase in net sales from acquired businesses was $13 million.

Government Services operating income for the year ended December 31, 2010 decreased by 11% compared to the year ended December 31, 2009. Operating margin decreased by 80 basis points. Operating margin was reduced by 110 basis points primarily due to lower sales volume and lower margins on select contract renewals and new contracts. These decreases were partially offset by a decline in lower margin subcontractor pass-through sales, which increased operating margin by 30 basis points.

Aircraft Modernization and Maintenance (AM&M)

 

        Year Ended December 31,       Increase/
  (decrease)  
      Year Ended December 31,         Decrease    
          2011             2010               2010             2009        
      (dollars in millions)  

Net sales

   $     2,439.5      $     2,780.9      $     (341.4)      $     2,780.9      $     2,827.8      $     (46.9)   

Operating income

     231.8        229.1        2.7        229.1        242.7        (13.6)   

Operating margin

     9.5     8.2     130  bpts      8.2     8.6     (40)  bpts 

2011 Compared with 2010

AM&M net sales for the year ended December 31, 2011 decreased by $341 million, or 12%, compared to the year ended December 31, 2010. The decrease was primarily the result of $332 million from the SOFSA contract loss, $75 million from lower JCA volume, and $35 million due to lower sales for MHP, partially offset by increased CLS services for U.S. Army C-12 aircraft.

AM&M operating income for the year ended December 31, 2011 increased by $3 million, or 1%, compared to the year ended December 31, 2010. Operating margin increased by 130 basis points. The increase in operating margin was due to: (1) improved contract performance for rotary wing cabin assemblies and special mission aircraft, which increased operating margin by 100 basis points, (2) the sales decline on the lower margin SOFSA contract, which increased operating margin by 60 basis points, and (3) a 2011 first quarter favorable price adjustment of $10 million for an international aircraft modernization contract, which increased operating margin by 40 basis points. These margin increases were partially offset by a 70 basis point decrease in operating margin primarily due to JCA for higher costs and reduced aircraft order quantities.

 

56


Table of Contents

2010 Compared with 2009

AM&M net sales for the year ended December 31, 2010 decreased by 2% compared to the year ended December 31, 2009. The decrease was primarily due to sales volume declines of $123 million from SOFSA and $45 million from the loss of an aircraft maintenance contract with the U.S. Customs and Border Patrol in 2009. These decreases were partially offset by $121 million in sales increases primarily for higher volume for JCA, rotary wing cabin assemblies, and the Canadian Maritime Helicopter Program.

AM&M operating income for the year ended December 31, 2010 decreased by 6% compared to the year ended December 31, 2009. Operating margin decreased by 40 basis points. The decrease in operating margin was primarily due to lower volume and prices for systems field support services and lower margin sales mix, primarily related to higher JCA volume, which has lower margins than the overall AM&M segment.

Electronic Systems

 

        Year Ended December 31,           Decrease           Year Ended December 31,       Increase/
  (decrease)  
 
          2011             2010               2010             2009        
      (dollars in millions)  

Net sales

   $     5,539.6      $     5,649.5      $     (109.9)      $     5,649.5      $     5,740.1      $     (90.6)   

Operating income

     719.9        788.1        (68.2)        788.1        691.3        96.8   

Operating margin

     13.0     13.9     (90)  bpts      13.9     12.0     190  bpts 

2011 Compared with 2010

Electronic Systems net sales for the year ended December 31, 2011 decreased by $110 million, or 2%, compared to the year ended December 31, 2010, reflecting lower sales of: (1) $376 million due to declining DoD demand for night vision products, combat propulsion systems, mobile satellite communication systems and simulation & training devices, (2) $40 million due to lower manufacturing yields for power devices for satellite communications systems, and (3) $9 million from the sale of a general aviation product technology license in the 2010 fourth quarter that did not recur in the 2011 fourth quarter. These decreases were partially offset by sales from acquired businesses of $160 million, sales volume increases of $122 million for integrated sensor systems to the U.S. Army and U.S. Air Force, and higher sales for commercial shipbuilding products of $33 million, with a majority of the increase from commercial shipbuilding products due to the strengthening of the U.S. dollar against the Euro.

Electronic Systems operating income for the year ended December 31, 2011 decreased by $68 million, or 9%, compared to the year ended December 31, 2010. Operating margin decreased by 90 basis points. Unfavorable contract performance and lower sales primarily for warrior systems and simulation & training reduced operating margin by 150 basis points, and lower manufacturing yields for power devices for satellite communication systems reduced operating margin by 20 basis points. These decreases in operating margin were partially offset by 80 basis points due primarily to higher sales volume for integrated sensor systems.

2010 Compared with 2009

Electronic Systems net sales for the year ended December 31, 2010 decreased by 2% compared to the year ended December 31, 2009, reflecting lower sales volume of: (1) $113 million for combat propulsion systems due to a reduction in DoD funding for Bradley Fighting Vehicles, (2) $107 million due to reduced demand for commercial ship building products, and (3) $168 million from precision engagement, marine services, training & simulation, and displays due to contracts nearing completion. These decreases were partially offset by $94 million of sales volume increases due primarily to higher demand for integrated sensor systems products to the U.S. Army, microwave products and security & detection systems, and $9 million from the sale of a technology license. Acquired businesses, primarily Insight and 3Di, contributed $194 million to net sales.

 

57


Table of Contents

Electronic Systems operating income for the year ended December 31, 2010 increased by 14% compared to the year ended December 31, 2009. Operating margin increased by 190 basis points. Favorable sales mix across several businesses, primarily integrated sensor systems products, increased operating margin by 150 basis points. Additionally, three items comprised of: (1) the sale of a technology license for $9 million, (2) a volume price adjustment on a supply contract of $6 million, and (3) a favorable contract modification for precision engagement of $5 million, collectively increased operating income by $20 million and operating margin by 40 basis points compared to the year ended December 31, 2009. Lower pension expense of $10 million increased operating margin by 20 basis points. These increases were partially offset by severance charges of $11 million, which reduced operating margin by 20 basis points.

Liquidity and Capital Resources

Anticipated Sources and Uses of Cash Flow

At December 31, 2011, we had total cash and cash equivalents of $764 million. While no amounts of the cash and cash equivalents are considered restricted, $208 million was held by the Company’s foreign subsidiaries. The repatriation of cash held in non-U.S. jurisdictions is subject to local capital requirements, as well as income tax considerations. Our primary source of liquidity is cash flow generated from operations. We generated $1,484 million of cash from operating activities during the year ended December 31, 2011. Significant cash uses during the year ended December 31, 2011, included $958 million to repurchase shares of our common stock, and $188 million for dividends.

As of December 31, 2011, we also had $997 million of borrowings available under our Revolving Credit Facility, after reductions of $3 million for outstanding letters of credit, subject to certain conditions. On February 3, 2012, we amended and restated our Revolving Credit Facility (Amended and Restated Revolving Credit Facility), which also extended the expiration date to February 3, 2017. We currently believe that our cash from operating activities together with our cash on hand, and available borrowings under our Amended and Restated Revolving Credit Facility will be adequate for the foreseeable future to meet our anticipated requirements for working capital, capital expenditures, defined benefit plan contributions, commitments, contingencies, research and development expenditures, business acquisitions (depending on the size), contingent purchase price payments on previous business acquisitions, program and other discretionary investments, interest payments, income tax payments, L-3 Holdings’ dividends and share repurchases.

Our business may not continue to generate cash flow at current levels, and it is possible that currently anticipated improvements may not be achieved. If we are unable to generate sufficient cash flow from operations to service our debt, we may be required to reduce costs and expenses, sell assets, reduce capital expenditures, reduce dividend payments, refinance all or a portion of our existing debt or obtain additional financing, which we may not be able to do on a timely basis, on satisfactory terms, or at all. Our ability to make scheduled principal payments or to pay interest on or to refinance our indebtedness depends on our future performance and financial results, which, to a certain extent, are subject to general conditions in or affecting the U.S. defense industry and to general economic, political, financial, competitive, legislative and regulatory factors beyond our control.

For a discussion of our debt refinancing activities during 2011, which improved our debt maturity profile and reduced ongoing interest expense, see “Financing Activities-Debt” on page 62.

Balance Sheet

Billed receivables decreased by $59 million to $1,240 million at December 31, 2011 from $1,299 million at December 31, 2010 due to the timing of billings and collections primarily for government services, commercial shipbuilding, network communications, undersea warfare, microwave, and display systems. These decreases were partially offset by increases in integrated sensor systems and ISR services due to higher sales, and the timing of billings and collections for simulation & training and AM&M.

 

58


Table of Contents

Contracts in process increased by $81 million to $2,629 million at December 31, 2011 from $2,548 million at December 31, 2010 due to the following:

 

   

Increases of $18 million in unbilled contract receivables primarily due to sales exceeding billings for networked communications, secure communications, ISR services, and commercial shipbuilding, partially offset by decreases due to lower sales and billings for government services, and combat propulsion systems; and

 

   

Increases of $63 million in inventoried contract costs across several business areas, primarily AM&M for spare parts, integrated sensor systems and space & propulsion systems to support current and anticipated customer demand, and Government Services inventoried pre-contract costs in anticipation of a Q1 2012 award, offset by decreases in precision engagement due to product deliveries.

L-3’s receivables days sales outstanding (DSO) was 73 at December 31, 2011, compared with 70 at December 31, 2010. The increase in DSO was primarily due to the decrease in our trailing 12 month pro forma sales, partially offset by the decrease in billed receivables. We calculate our DSO by dividing: (1) our aggregate end of period billed receivables and net unbilled contract receivables, by (2) our trailing 12 month sales adjusted, on a pro forma basis, to include sales from business acquisitions and exclude sales from business divestitures that we completed as of the end of the period, multiplied by the number of calendar days in the trailing 12 month period (365 days at both December 31, 2011 and December 31, 2010). Our trailing 12 month pro forma sales were $15,180 million at December 31, 2011 and $15,850 million at December 31, 2010.

The increase in inventories was primarily due to higher inventory for commercial shipbuilding to support demand, shipping delays for Warrior Systems, and $2 million of acquired inventories from business acquisitions. These increases were partially offset by lower microwave inventory.

The decrease in other current assets was primarily due to applying expected tax refunds, primarily for U.S. federal and state income taxes, to current year estimated tax payments.

The increase in net property, plant and equipment (PP&E) was principally due to capital expenditures, partially offset by depreciation expense.

Goodwill decreased by $33 million to $8,697 million at December 31, 2011 from $8,730 million at December 31, 2010.

The table below presents the changes in goodwill applicable to our reporting units in each reportable segment.

 

     C3ISR     Government
Services
    AM&M     Electronic
Systems
    Consolidated
Total
 
     (in millions)  

Balance at December 31, 2010

   $ 868      $ 2,285      $ 1,172      $ 4,405      $ 8,730   

Business acquisitions

     3               2        22        27   

Impairment losses

                          (43     (43

Foreign currency translation(1)

                   (5     (12     (17

Segment reclassification(2)

     (5     (94            99          
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

   $   866      $   2,191      $   1,169      $   4,471      $   8,697   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) 

The changes in goodwill from foreign currency translation adjustments are due to fluctuations in the U.S. dollar and foreign currency exchange rates. The decrease in goodwill presented in the AM&M and Electronic Systems segments during 2011 was primarily due to the strengthening of the U.S. dollar against the Canadian dollar and the Euro.

 

(2) 

As a result of re-alignments of business units in our management and organizational structure as discussed in Note 2, goodwill was reclassified on a relative fair value basis among the C3ISR, Government Services and Electronic Systems segments during the quarter ended April 1, 2011.

 

59


Table of Contents

The decrease in identifiable intangible assets was primarily due to amortization expense partially offset by the recognition of $5 million of intangible assets for the business acquisitions during 2011.

The fluctuation in accounts payable and accrued expenses were primarily due to the timing of when invoices for purchases from third-party vendors and subcontractors were received and payments were made. The decrease in accrued employment costs was due to the timing of payments and reductions in headcount for payroll taxes and salaries and wages, reduced incentive compensation and lower benefit costs.

The decrease in advance payments and billings in excess of costs incurred was primarily due to liquidations upon shipment and invoicing for certain microwave, security & detection systems, and power & control systems contracts, partially offset by increases in performance based billings for certain AM&M, C3ISR and undersea warfare contracts.

Non-current deferred income tax liabilities increased primarily due to amortization of certain goodwill and other identifiable intangible assets during 2011 for tax purposes. Other liabilities decreased primarily due to the reversal of previously accrued income tax expense related to tax years for which the statutes of limitations had expired.

Pension Plans

L-3 maintains defined benefit pension plans covering employees at certain of its businesses and approximately 22% of its employees. At December 31, 2011, L-3’s projected benefit obligation, which includes accumulated benefits plus the incremental benefits attributable to projected future salary increases for covered employees, was $2,679 million and exceeded the fair value of L-3’s pension plan assets of $1,712 million by $967 million. At December 31, 2010, L-3’s projected benefit obligation was $2,365 million and exceeded the fair value of L-3’s pension plan assets of $1,585 million by $780 million. The $187 million increase in our unfunded status was due to pension expense of $145 million for 2011, and a net increase of $218 million in accumulated other comprehensive loss comprised of $268 million primarily for net actuarial losses experienced in 2011 and $50 million of amortization of net actuarial losses and prior service costs as a component of pension expense in 2011, partially offset by employer pension contributions of $176 million.

The 2011 increase of $268 million in accumulated other comprehensive loss as noted above was primarily due to (i) the reduction in our weighted average discount rate from 5.57% at December 31, 2010 to 5.02% at December 31, 2011 and (ii) our actual 2011 pension plan asset return of approximately 4%, which was lower than our weighted average expected long-term rate of return assumption of 8.55%. The actuarial gains and losses that our pension plans experience are not recognized in pension expense in the year incurred, but rather are recorded as a component of accumulated other comprehensive income (loss) and amortized to pension expense in future periods over the estimated average remaining service periods of the covered employees. See Note 20 to our audited consolidated financial statements.

Our pension expense for 2011 was $145 million. We currently expect pension expense for 2012 to increase $34 million to approximately $179 million primarily due to the reduction in our weighted average discount rate and a change in the expected long-term return on plan assets assumption for our U.S. pension plans to 8.25% in 2012 from 8.75% in 2011.

Our pension expense for 2012 may be different from our current expectations when finalized due to a number of factors, including the effect of any future business acquisitions for which we assume liabilities for pension benefits, changes in headcount at our businesses that sponsor pension plans, actual pension plan contributions and changes (if any) to our pension assumptions for 2012, including the discount rate, expected long-term return on plan assets and salary increases. The businesses that will comprise Engility do not have any employees who participate in our pension plans.

 

60


Table of Contents

Our contributions for 2011 were $176 million and we currently expect to contribute approximately $173 million to our pension plans in 2012. Actual 2012 pension contributions could be affected by changes in the funded status of our pension plans during 2012. A substantial portion of our pension plan contributions for L-3’s businesses that are U.S. Government contractors are recoverable as allowable indirect contract costs at amounts generally equal to the annual pension contributions.

Our projected benefit obligation and annual pension expense are significantly affected by our discount rate assumption. For example, a reduction to the discount rate of 25 basis points would increase our projected benefit obligation at December 31, 2011 by approximately $95 million and our estimated pension expense for 2012 by approximately $12 million. Conversely, an increase to the discount rate of 25 basis points would have decreased our projected benefit obligation at December 31, 2011 by approximately $91 million, and our estimated pension expense for 2012 by approximately $11 million.

Statement of Cash Flows

The table below provides a summary of our cash flows from operating, investing, and financing activities for the periods indicated.

 

     Year Ended December 31,  
     2011     2010     2009  
     (in millions)  

Net cash from operating activities

   $     1,484      $     1,461      $     1,407   

Net cash used in investing activities

     (203     (945     (272

Net cash used in financing activities

     (1,120     (918     (1,005

Operating Activities

2011 Compared with 2010. We generated $1,484 million of cash from operating activities during the year ended December 31, 2011, an increase of $23 million compared with $1,461 million generated during the year ended December 31, 2010. The increase was primarily due to lower tax payments.

2010 Compared with 2009. We generated $1,461 million of cash from operating activities during the year ended December 31, 2010, an increase of $54 million compared with $1,407 million generated during the year ended December 31, 2009. The increase was due to $55 million of higher net income and $51 million of higher non-cash expenses primarily for higher deferred income taxes and stock-based employee compensation. These increases were partially offset by $52 million of more net cash used for changes in operating assets and liabilities primarily for billed receivables and pension and postretirement benefits. The net cash from changes in operating assets and liabilities is further discussed above under “Liquidity and Capital Resources – Balance Sheet” beginning on page 58.

Interest Payments. Our cash from operating activities included interest payments on debt of $238 million for the year ended December 31, 2011, $233 million for the year ended December 31, 2010, and $237 million for the year ended December 31, 2009. Our interest expense also included amortization of deferred debt issue costs and bond discounts, which are non-cash items.

Investing Activities

During 2011, we used $203 million of cash primarily to: (1) acquire two businesses discussed under “Business Acquisitions and Dispositions” on page 40 and (2) pay $192 million for capital expenditures.

During 2010, we used $945 million of cash primarily to: (1) acquire four businesses discussed under “Business Acquisitions and Dispositions” on page 40, (2) pay $181 million for capital expenditures, and (3) invest $23 million in an unconsolidated subsidiary accounted for using the equity method.

 

61


Table of Contents

During 2009, we used $272 million of cash primarily to: (1) acquire a business and pay the remaining contractual purchase price for a business acquisition completed prior to January 1, 2009 for a total of $90 million, and (2) pay $186 million for capital expenditures.

Financing Activities

Debt

At December 31, 2011, total outstanding debt was $4,125 million, of which $2,938 million was senior debt and $1,187 million was subordinated debt and CODES, compared to $4,137 million at December 31, 2010, of which $1,794 million was senior debt and $2,343 million was subordinated debt and CODES. At December 31, 2011, borrowings available under our $1 billion Revolving Credit Facility were $997 million, after reduction for outstanding letters of credit of $3 million. We also had $407 million of other standby letters of credit at December 31, 2011, that may have been drawn upon in the event that we did not perform on certain of our contractual requirements. There were no borrowings outstanding under our Revolving Credit Facility at December 31, 2011. At December 31, 2011, our outstanding debt matures between October 15, 2015 and August 1, 2035. See Note 10 to our audited consolidated financial statements for the components of our debt at December 31, 2011.

Debt Issuances

The terms of each of the outstanding Senior Notes issued by L-3 Communications during the years ended December 31, 2011, 2010 and 2009 are presented in the table below.

 

Note

  Date of Issuance     Amount
Issued
    Discount     Net
Cash
Proceeds
    Effective
Interest
Rate
    Redemption at
Treasury  Rate+
 
          (in millions)              

3.95% Senior Notes due November 15, 2016

    November 22, 2011      $ 500      $   4      $ 491        4.11     50 bps   

5.20% Senior Notes due October 15, 2019

    October 2, 2009      $ 1,000      $ 4      $ 987        5.25     30 bps   

4.75% Senior Notes due July 15, 2020

    May 21, 2010      $ 800      $ 3      $ 790        4.79     25 bps   

4.95% Senior Notes due February 15, 2021

    February 7, 2011      $ 650      $ 4      $ 639        5.02     25 bps   

Debt Repayments

We used the net cash proceeds from the Senior Note issuances, together with cash on hand, to repay our outstanding $650 million term loan on October 7, 2009 and redeem certain of our outstanding Senior Subordinated Notes. Information on the Senior Subordinated Notes we redeemed during the years ended December 31, 2011, 2010 and 2009 is presented in the table below.

 

Note

   Redemption Date      Principal
Amount
Redeemed
     Debt
Retirement
Charge
     Redemption Price
% of Principal
 
            (in millions)         

63/8% Senior Subordinated Notes due October 15, 2015

     December 22, 2011       $   500       $   17         102.125

57/8% Senior Subordinated Notes due January 15, 2015

     March 9, 2011       $ 650       $ 18         101.958

61/8% Senior Subordinated Notes due January 15, 2014

     June 21, 2010       $ 400       $ 13         102.042

61/8% Senior Subordinated Notes due July 15, 2013

     July 15, 2010       $ 400       $ 5         101.021

75/8% Senior Subordinated Notes due June 15, 2012

     November 2, 2009       $ 750       $ 10         101.271

On February 2, 2011, we repurchased approximately $11 million of our CODES as a result of the exercise by the holders of their contractual right to require us to repurchase their CODES. The CODES are subject to redemption at the option of L-3 Holdings, in whole or in part, at a cash redemption price (plus accrued and unpaid interest, including contingent interest and additional interest, if any) equal to 100% of the principal amount of CODES. We may, from time to time, make open market purchases of our outstanding debt securities,

 

62


Table of Contents

including the CODES. Whether or not we repurchase any of our outstanding debt securities, including the CODES, the amount of any such repurchases will vary depending on numerous factors, including, without limitation, the trading price of our debt, other market conditions, our ongoing capital allocation planning, the levels of our cash and debt balances, other demands for cash, such as acquisition activity, and general economic conditions.

Debt Covenants and Other Provisions. The Amended and Restated Revolving Credit Facility, senior notes and senior subordinated notes contain financial and/or other restrictive covenants. See Note 10 to our audited consolidated financial statements for a description of our debt and related financial covenants, including dividend payment and share repurchase restrictions and cross default provisions. As of December 31, 2011, we were in compliance with our financial and other restrictive covenants.

Under select conditions, including if L-3 Holding’s common stock price is more than 120% (currently $115.78) of the then current conversion price (currently $96.48) for a specified period, the conversion feature of the CODES will require L-3 Holdings, upon conversion, to pay the holders of the CODES the principal amount in cash, and if the settlement amount exceeds the principal amount, the excess will be settled in cash or stock or a combination thereof, at our option. See Note 10 to our audited consolidated financial statements for additional information regarding the CODES, including conditions for conversion. L-3 Holdings’ closing stock price of February 28, 2012 was $70.28 per share.

Guarantees. The borrowings under the Amended and Restated Revolving Credit Facility are fully and unconditionally guaranteed by L-3 Holdings and by substantially all of the material wholly-owned domestic subsidiaries of L-3 Communications on an unsecured senior basis. The payment of principal and premium, if any, and interest on the senior notes are fully and unconditionally guaranteed, on an unsecured senior basis, jointly and severally, by L-3 Communications’ material wholly-owned domestic subsidiaries that guarantee any of its other indebtedness. The payment of principal and premium, if any, and interest on the senior subordinated notes are fully and unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by L-3 Communications’ wholly-owned domestic subsidiaries that guarantee any of its other indebtedness. The payment of principal and premium, if any, and interest on the CODES are fully and unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by L-3 Communications and its wholly-owned domestic subsidiaries that guarantee any of its other liabilities.

Subordination. The guarantees of the Amended and Restated Revolving Credit Facility and the senior notes rank senior to the guarantees of the senior subordinated notes and the CODES and rank pari passu with each other. The guarantees of the senior subordinated notes and CODES rank pari passu with each other and are junior to the guarantees of the Amended and Restated Revolving Credit Facility and senior notes.

Equity

During 2011 and 2010, L-3 Holdings’ Board of Directors authorized the following quarterly cash dividends:

 

Date Declared

       Record Date        Cash
Dividends

Per Share
         Date Paid        Total
Dividends

Paid
 
                      (in millions)  

2011

           

February 8

   March 1    $   0.45       March 15    $   49   

April 26

   May 17    $ 0.45       June 15    $ 48   

July 12

   August 18    $ 0.45       September 15    $ 46   

October 11

   November 17    $ 0.45       December 15    $ 45   

2010

           

February 2

   March 1    $ 0.40       March 15    $ 47   

April 27

   May 17    $ 0.40       June 15    $ 46   

July 13

   August 17    $ 0.40       September 15    $ 46   

October 26

   November 17    $ 0.40       December 15    $ 45   

 

63


Table of Contents

On February 7, 2012, L-3 Holdings announced that its Board of Directors had increased L-3 Holdings’ regular quarterly cash dividend by 11% to $0.50 per share, payable on March 15, 2012, to shareholders of record at the close of business on March 1, 2012.

On February 21, 2012, the number of holders of L-3 Holdings’ common stock was approximately 39,650. On February 28, 2012, the closing price of L-3 Holdings common stock, as reported by the NYSE, was $70.28 per share.

For the year ended December 31, 2011, L-3 Holdings repurchased $958 million, or 13.3 million shares, of its common stock compared to $834 million, or 11.0 million shares, of its common stock for the year ended December 31, 2010.

Contractual Obligations

The table below presents our estimated total contractual obligations at December 31, 2011, including the amounts expected to be paid or settled for each of the periods indicated below.

 

            Payments due by period  
     Total      Less than
1  year
    1 – 3 years      3 – 5 years      More than
5  years
 
     (in millions)  

Contractual Obligations

             

L-3 Communications long-term debt(1)

   $ 3,450       $      $       $ 1,000       $ 2,450   

L-3 Holdings long-term debt(1)(2)

     689                                689   

Interest payments(3)

     1,787         195        389         357         846   

Non-cancelable operating leases(4)

     620         173        225         119         103   

Notes payable and capital lease obligations

     10                1         8         1   

Purchase obligations(5)

     2,333         2,044        271         16         2   

Other long-term liabilities(6)

     323         186 (7)      81         7         49   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total(8)

   $   9,212       $   2,598      $   967       $   1,507       $   4,140   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

 

(1) 

Represents principal amount of long-term debt and only includes scheduled principal payments.

 

(2) 

The CODES are convertible into cash and shares of L-3 Holdings’ common stock based on a conversion rate of 10.3644 shares of L-3 Holdings common stock per one thousand dollars in principal amount of the CODES (equivalent to a current conversion price of $96.48 per share). The conversion feature of the CODES may require L-3 Holdings to settle the principal amount with the holders of the CODES if L-3 Holdings common stock price is more than 120% of the then current conversion price (currently $115.78) for a specified period, and if the settlement amount exceeds the principal amount, the excess will be settled in cash or stock or a combination thereof, at our option. Additionally, holders of the CODES may require L-3 Holdings to repurchase the CODES, in whole or in part, on February 1, 2016, February 1, 2021, February 1, 2026 and February 1, 2031 at a cash repurchase price equal to 100% of the principal amount of the CODES (plus accrued and unpaid interest, if any). See Note 10 to our audited consolidated financial statements for additional information regarding the CODES, including conditions for conversion and contingent interest features. L-3 Holdings stock price on February 28, 2012 was $70.28.

 

(3) 

Represents expected interest payments on L-3’s long-term debt balance as of December 31, 2011 using the stated interest rate on our fixed rate debt, assuming that current borrowings remain outstanding to the contractual maturity date.

 

(4) 

Non-cancelable operating leases are presented net of estimated sublease rental income.

 

(5) 

Represents open purchase orders at December 31, 2011 for amounts expected to be paid for goods or services that are legally binding.

 

(6) 

Other long-term liabilities primarily consist of workers compensation and deferred compensation for the years ending December 31, 2013 and thereafter and also include pension and postretirement benefit plan contributions that we expect to pay in 2012.

 

(7) 

Our pension and postretirement benefit plan funding policy is generally to contribute in accordance with cost accounting standards that affect government contractors, subject to the Internal Revenue Code and regulations thereon. For 2012, we expect to contribute approximately $173 million to our pension plans and approximately $13 million to our postretirement benefit plans. Due to the current uncertainty of the amounts used to compute our expected pension and postretirement benefit plan funding, we believe it is not practicable to reasonably estimate such future funding for periods in excess of one year and we may decide or be required to contribute more than we expect to our pension and postretirement plans.

 

(8) 

Excludes all income tax obligations, a portion of which represents unrecognized tax benefits in connection with uncertain tax positions taken, or expected to be taken on our income tax returns as of December 31, 2011 since we cannot determine the time period of future tax consequences. For additional information regarding income taxes, see Note 17 to our audited consolidated financial statements.

 

64


Table of Contents

Off Balance Sheet Arrangements

The table below presents our estimated total contingent commitments and other guarantees at December 31, 2011, including the amounts expected to be paid or settled for each of the periods indicated below.

 

          Payments due by period  
      Total         2012       2013-2014     2015-2016     2017 and
thereafter
 
    (in millions)  

Contingent Commitments

         

Standby letters of credit under our Revolving Credit Facility(1)

  $ 3      $ 3      $      $      $   

Other standby letters of credit(1)

    407        356        38        8        5   

Other guarantees(2)

    3                             3   

Contingent commitments for earnout payments on business acquisitions(3)

    21               16        5          
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total(4)

  $   434      $   359      $   54      $   13      $     8   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) 

Represents outstanding letters of credit with financial institutions covering performance and financial guarantees per contractual requirements with certain customers. These letters of credit may be drawn upon in the event of L-3’s nonperformance.

 

(2) 

Represents the minimum guarantees made by L-3 or the lessee under the purchase option for certain operating leases in which the lease renewal is not exercised (see Note 19 to our audited consolidated financial statements for a description of these guarantees).

 

(3) 

Represents potential additional contingent purchase payments for business acquisitions that are contingent upon the post-acquisition financial performance or certain other performance conditions of the acquired businesses in accordance with the contractual purchase agreement. At December 31, 2011, our consolidated balance sheet includes $16 million within the other liabilities caption for the fair value of these contingent purchase payments.

 

(4) 

The total amount does not include residual value guarantees for two real estate lease agreements that are accounted for as operating leases. We have the right to exercise options under the lease agreements to purchase both properties for $28 million on or before August 31, 2012. See Note 19 to our audited consolidated financial statements for a further description of these leases.

Legal Proceedings and Contingencies

We are engaged in providing products and services under contracts with the U.S. Government and, to a lesser degree, under foreign government contracts, some of which are funded by the U.S. Government. All such contracts are subject to extensive legal and regulatory requirements, and, periodically, agencies of the U.S. Government investigate whether such contracts were and are being conducted in accordance with these requirements. Under U.S. Government procurement regulations, an indictment by a federal grand jury, or an administrative finding against us as to our present responsibility to be a U.S. Government contractor or subcontractor, could result in the suspension for a period of time from eligibility for awards of new government contracts or task orders or in a loss of export privileges. A conviction, or an administrative finding that satisfies the requisite level of seriousness, could result in debarment from contracting with the federal government for a specified term. We are currently cooperating with the U.S. Government on several investigations, none of which we anticipate will have a material adverse effect on our consolidated financial position, results of operations or cash flows.

We continually assess our obligations with respect to applicable environmental protection laws. While it is difficult to determine the timing and ultimate cost that we will incur to comply with these laws, based upon available internal and external assessments, with respect to those environmental loss contingencies of which we are aware, we believe that even without considering potential insurance recoveries, if any, there are no environmental loss contingencies that, in the aggregate, would be material to our consolidated financial position, results of operations or cash flows. Also, we have been periodically subject to litigation, government investigations, proceedings, claims or assessments and various contingent liabilities incidental to our business. We accrue for these contingencies when it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. For a description of our legal proceedings and contingencies, see Note 19 to our audited consolidated financial statements.

 

65


Table of Contents

Derivative Financial Instruments and Other Market Risk

Included in our derivative financial instruments are foreign currency forward contracts. All of our derivative financial instruments that are sensitive to market risk are entered into for purposes other than trading.

Interest Rate Risk. Our Amended and Restated Revolving Credit Facility is subject to variable interest and is therefore sensitive to changes in interest rates. The interest rates on the Senior Notes, senior subordinated notes, and CODES are fixed-rate and are not affected by changes in interest rates. Additional data on our debt obligations and our applicable borrowing spreads included in the interest rates we would pay on borrowings under the Amended and Restated Revolving Credit Facility, if any, are provided in Note 10 to our audited consolidated financial statements.

Foreign Currency Exchange Risk. Our U.S. and foreign businesses enter into contracts with customers, subcontractors or vendors that are denominated in currencies other than their functional currencies. To protect the functional currency equivalent cash flows associated with certain of these contracts, we enter into foreign currency forward contracts, which are generally designated and accounted for as cash flow hedges. At December 31, 2011, the notional value of foreign currency forward contracts was $335 million and the net fair value of these contracts was an asset of $1 million. The notional values of our foreign currency forward contracts with maturities ranging through 2016 and thereafter are presented in the table below.

 

     Year of Maturity  
       2012          2013          2014          2015        2016 and thereafter  
     (in millions)  

Notional value

   $ 280       $ 27       $ 22       $ 6       $   

Accounting Standards Issued and Not Yet Implemented

For a discussion of accounting standards issued and not yet implemented, see Note 2 to our audited consolidated financial statements.

Inflation