10-K 1 h10050817x1_10k.htm 10-K

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2017

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

For the transition period from     to

Commission file number 001-37975

L3 TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)

Delaware
13-3937436
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
   
 
600 Third Avenue, New York, NY
10016
(Address of principal executive offices)
(Zip Code)

(212) 697-1111
(Registrant’s telephone number, including area code)

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

Title of each class
Name of each exchange on which registered:
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 registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
☒ Yes o No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
o Yes No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. ☒ Yes o No

Indicate by check mark whether the registrant has submitted electronically and posted on the corporate Web site, 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 registrant was required to submit and post such files). ☒ Yes o No

Indicate by check mark if disclosure of the delinquent filer 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 registrant’s 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 registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer ☒
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
Emerging growth company o
 
 
(Do not check if a smaller reporting company)
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

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

The aggregate market value of the registrant’s voting stock held by non-affiliates as of June 30, 2017, based upon the closing price of the stock on the New York Stock Exchange, was approximately $12.9 billion. For purposes of this calculation, the registrant has assumed that the directors and executive officers are affiliates.

There were 78,223,953 shares of the registrant’s common stock with a par value of $0.01 outstanding as of the close of business on February 16, 2018.

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 registrant’s Annual Meeting of Shareholders, to be held on May 7, 2018, 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 registrant’s fiscal year ended December 31, 2017.

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PART I

For convenience purposes in this filing on Form 10-K, references to “L3”, “Company”, “we”, “us” and “our” refer to L3 Technologies, Inc. and its subsidiaries.

Item 1. Business

Overview

L3 Technologies, Inc. (L3 Technologies, Inc. and, together with our subsidiaries, referred to herein as L3) is a prime contractor in Intelligence, Surveillance and Reconnaissance (ISR) systems, aircraft sustainment (including modifications and fleet management of special mission aircraft), simulation and training, night vision and image intensification equipment, and security and detection systems. L3 is also a leading provider of a broad range of communication, electronic and sensor systems used on military, homeland security 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), foreign governments, and domestic and foreign commercial customers.

For the year ended December 31, 2017, we generated sales of $9,573 million, operating income of $1,020 million and cash from continuing operations of $985 million. The table below presents a summary of our 2017 sales by major category of end customer. For a more detailed presentation of our sales by end customer, see “Major Customers” within this Business section.

 
2017 Sales
% of
Total Sales
 
(in millions)
 
DoD
$
6,329
 
 
66
%
Other U.S. Government
 
368
 
 
4
 
Total U.S. Government
 
6,697
 
 
70
 
Foreign governments
 
1,420
 
 
15
 
Commercial — foreign
 
809
 
 
8
 
Commercial — domestic
 
647
 
 
7
 
Total sales
$
9,573
 
 
100
%

We have the following four reportable segments: (1) Electronic Systems, (2) Aerospace Systems, (3) Communication Systems and (4) Sensor 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 21 to our audited consolidated financial statements.

On October 16, 2017, our Board of Directors approved a plan to explore strategic alternatives to sell or otherwise divest the Vertex Aerospace business. We expect to complete a sale in 2018. The divestiture of the Vertex Aerospace business represents a strategic shift by us to exit the logistics solution and maintenance services business for military aircraft where we do not provide complex ISR systems integration and modification. The Vertex Aerospace business generated sales of $1.4 billion in 2017, $1.3 billion in 2016 and $1.2 billion in 2015. The assets and liabilities and results of operations of the Vertex Aerospace business are reported as discontinued operations for all periods presented.

All references made to financial data in this Annual Report on Form 10-K are to L3’s continuing operations, unless otherwise specifically noted.

Business Strategy

Our goal is to build on our strong aerospace & defense company in a focused and disciplined way. We aspire to become a non-traditional sixth prime through teaming arrangements, joint ventures and integrating our capabilities to compete for larger and higher value contracts. The key elements of our growth strategy are summarized in the paragraphs below. Our business is centered around serving our customers’ needs through innovation, quality, dependability and reliability. We believe in and operate under the principles that there are no short cuts to hard work, integrity, accountability and excellence. We believe these principles drive sustainable shareholder value over the long term. We continually evaluate ways to improve our positioning in core markets within Electronic Systems, Aerospace

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Systems, Communication Systems and Sensor Systems. We intend to leverage our excellent customer relationships and pursue adjacent market opportunities including, international and commercial markets, through greater cross segment collaboration and integration across the enterprise. We intend to gain market share with innovative and affordable solutions and by building on the trust that results from demonstrated past performance that addresses customer needs. We expect that we will continue to focus our business portfolio around products and systems in core attractive markets, namely defense electronics, ISR and Communications. Financially, our emphasis is to grow sales, operating income, earnings per share and cash flow, as well as increase operating margins. In addition to striving for organic growth, we pursue select acquisitions and divestitures. We also intend to continue to seek new and existing routes for efficiencies through L365 (L3’s operational excellence program) and other cost reduction efforts, in order to streamline our organization for greater agility and adaptability. We believe that these focused actions will enable us to both grow the company and return cash to our shareholders in a balanced and disciplined manner. Our strategy includes the elements discussed below.

Maintain an Innovative, Agile and Adaptable Culture of Continuous Improvement Focused on Excellence, Integrity and Accountability. A key part of L3’s strategy is an agile, adaptable, and results-driven culture that focuses on meeting or exceeding our customers’ needs. L3 is a unique aerospace and defense company, a federation of highly entrepreneurial businesses, with driven and diverse people providing creative, innovative and affordable solutions in an environment that fosters teamwork and collaboration across the enterprise. Operating with integrity and a commitment to the highest standards of ethical conduct and maintaining strong internal controls are foundational elements of our success. We endeavor to build and maintain the trust of our customers, our shareholders, our employees, suppliers and communities where we live and work every day.

Strengthen and Expand Our Market Positions and Unique Capabilities. We intend to use our existing prime contractor and supplier positions and internal investments to increase our market share, grow sales and continue to build upon our strong businesses with durable discriminators that have leading market positions as we strive to continue to move up the value chain. We intend to expand our prime contractor roles in select business areas where we have domain expertise, including special operations forces and U.S. Government classified business. We expect to benefit from and expand our supplier positions to multiple bidders by leveraging customer relationships, pursuing adjacent market opportunities and expanding content on Original Equipment Manufacturer (OEM) platforms. 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 mature programs and participating in new programs. Teaming arrangements with other prime contractors and platform OEMs is one way we intend to pursue select new business opportunities and expand our content on select platforms. We plan to maintain our diversified and broad business mix with limited reliance on any single contract, follow-on or new business opportunity. While sales to the U.S. Government, especially the DoD, will remain an integral part of L3’s business, we also intend to continue to increase our sales to foreign governments and domestic and international commercial businesses. We expect to continue to supplement our organic sales growth by acquiring, on a select basis, businesses that provide attractive returns on investment and add new products, technologies, programs and contracts, or provide access to select DoD, other U.S. Government, international and/or commercial customers.

Collaborate to Increase Growth Opportunities through Innovation. We intend to deepen the collaboration among our diversified businesses to develop new business opportunities, combine our leading technologies and deliver the right solutions to our customers quickly. 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 to focus on innovation and research and development, which will allow us to enhance our existing products and to create new and more affordable solutions and products for our customers.

Leverage Our Excellent Customer Relationships. We intend to maintain and expand our excellent customer relationships. We also intend to continue to leverage our customer relationships and our capabilities, including proprietary technologies, to expand the scope of our products to existing and new customers. We also intend to continue to align our products, services, investments in research and development and business acquisitions to proactively address customer priorities and requirements and invest in growth areas such as aerospace systems, sensor systems, pilot training, U.S. Government classified business and special operations.

Increase Margins by Proactively Managing Our Cost Structure and Optimizing Our Business Portfolio. We intend to increase our operating margin by improving productivity and reducing direct contract costs and overhead costs, including general and administrative costs through streamlining and consolidation activities within our organization. Our effective management of labor, material, subcontractor and other direct costs is also an important

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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 operating margin and to also selectively invest in new product development, business acquisitions, bids and proposals and other business development activities to win new business. We intend to continue to evaluate our portfolio of businesses to address the needs of a dynamic and demanding market place and to strengthen our core business through select business acquisitions or divestitures.

Achieve Outstanding Program Performance. We believe that outstanding performance on our existing programs and contracts, in terms of on-budget, on-schedule and satisfying and exceeding technical and other contractual performance requirements, is the foundation for expanding L3’s prime contractor and supplier positions and winning new business. We believe that a prerequisite for growing and winning new business is to retain our existing business by successfully meeting or exceeding the performance criteria included in our contracts. We will continue to focus on delivering superior contract performance with affordable prices 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 Divestitures

During the years ended December 31, 2017, 2016 and 2015, we used net cash of $316 million, $388 million and $320 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 Divestitures” for additional information regarding our business acquisitions and divestitures.

Products and Services

Our four reportable segments provide a wide range of products and services to various customers and are described below. See “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Reportable Segment Results of Operations” and Note 21 to our audited consolidated financial statements for financial information about each segment.

Electronic Systems Reportable Segment

In 2017, Electronic Systems had net sales of $3,024 million, representing 32% 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. These products and services serve niche markets such as, aircraft simulation and training, power and distribution, cockpit avionics, airport security and precision weapons. The table below provides a summary of the segment’s business areas and the percentage that each contributed to Electronic Systems’ net sales in 2017.

Business Area
% of 2017
Segment Sales
Total Training Solutions
 
30
%
Power & Propulsion Systems
 
24
 
Aviation Products
 
17
 
Precision Engagement Systems
 
15
 
Security & Detection Systems
 
14
 
Total Electronic Systems
 
100
%

Total Training Solutions (TTS) is a leading supplier of military and commercial aircraft flight simulators and advanced flight simulation technologies. In addition, TTS provides flight training services for both rotary and fixed wing aircraft and support and maintenance services. Key customers include DoD and foreign militaries, commercial airlines and aircraft OEMs.

Power & Propulsion Systems (PPS) is a provider of maritime power and distribution solutions. Offerings include electric propulsion, conversion, distribution and protection for naval submarines, surface ships and aircraft carriers.

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In addition, PPS provides integrated bridge equipment including Command, Control, Communications, Computers and Navigation (C4N) systems, as well as combat vehicle engines and transmissions. Key customers include the U.S. Navy (USN), the U.S. Coast Guard (USCG), U.S. Army, foreign ministries of defense, foreign navies and commercial ship owners.

Aviation Products is a provider of cockpit and mission displays, airborne traffic and collision avoidance systems, terrain awareness warning systems, advanced cockpit avionics and solid state voice and flight data recorders. Key customers include various commercial transport, business, regional and military aircraft manufacturers.

Precision Engagement Systems (PES) is a prime and component provider of precision weapon systems including fuzing and ordinance systems, unmanned systems and radar-based sensors and systems. In addition, PES provides global positioning system receivers for guided projectiles and precision munitions as well as navigation systems for fire control systems. Key customers include DoD, U.S. Government and foreign militaries.

Security & Detection Systems (SDS) is a leading provider of integrated security solutions for airports, ports, border crossings and other critical infrastructure. Offerings include airport security screening solutions, explosive detection systems and whole body scanning systems as well as non-intrusive systems for threat and contraband detection. Key customers include the U.S. Transportation Security Administration, domestic and international airports, the U.S. Customs and Border Protection agency and international equivalents, and domestic and international port operators.

Aerospace Systems Reportable Segment

In 2017, Aerospace Systems had net sales of $2,773 million, representing 29% of our total net sales. The businesses in this reportable segment provide products and services for the global ISR and Command, Control and Communications (C3) markets, specializing in signals intelligence (SIGINT) and multi-intelligence platforms, including engineering, modernization and sustainment solutions for military and various government aircraft, ground support equipment and other platforms. These strategic and tactical products and services provide warfighters with the ability to detect, collect, identify, analyze and disseminate information from command centers, communication nodes and air defense systems for real-time situational awareness and response. The table below provides a summary of the segment’s business areas and the percentage that each contributed to Aerospace Systems’ net sales in 2017.

Business Area
% of 2017
Segment Sales
Mission Integration
 
87
%
MAS
 
6
 
Aerostructures
 
4
 
Advanced Systems
 
3
 
Total Aerospace Systems
 
100
%

Mission Integration is a systems integration organization specializing in complex ISR capabilities including fleet management support services, procurement, systems integration, sensor development, modifications and periodic depot maintenance for ISR and special mission aircraft and airborne systems. These products and services are critical elements for a substantial number of major C3 and intelligence gathering systems. Key customers include DoD, and classified customers within the U.S. Government, U.K. Ministry of Defence (MoD) and select foreign militaries.

MAS is a provider of modernization and life extension maintenance upgrade and support services for military aircraft, which include structural modifications and inspections, installation of mission equipment, navigation and avionics products and interior modifications. Key customers include the Canadian Department of National Defence, USN, U.S. Air Force (USAF) and select foreign militaries.

Aerostructures provide aircraft fabrication and assembly of fixed and rotary wing aerostructures as well as avionics hardware and software systems to address mission critical needs. Key customers include DoD, U.S Special Operations Command (USSOCOM), commercial customers and aircraft OEMs.

Advanced Systems is a provider of prime mission systems integration and sensor development for military ISR aircraft platforms and ground systems. Key customers include DoD and USAF.

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Communication Systems Reportable Segment

In 2017, Communication Systems had net sales of $2,229 million, representing 23% of our total net sales. The businesses in this reportable segment provide network and communication systems, secure communications products, radio frequency (RF) components, satellite communication terminals and space, microwave and telemetry products. These products include secure data links that are used to connect a variety of space, airborne, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring and dissemination functions of these communication systems. The table below provides a summary of the segment’s business areas and the percentage that each contributed to Communication Systems’ net sales in 2017.

Business Area
% of 2017
Segment Sales
Broadband Communication Systems
 
66
%
Space & Power Systems
 
19
 
Advanced Communications
 
15
 
Total Communication Systems
 
100
%

Broadband Communication Systems is focused on the development, design, manufacturing and integration of secure networked communications equipment. Offerings include airborne, space and surface data link terminals, ground stations, and transportable tactical satellite communications (SATCOM) systems used on manned aircraft, unmanned aerial vehicles (UAVs) and naval ships. In addition, Broadband Communication Systems provides managed communications security (COMSEC) satellite networks and integrated remote very small aperture terminals (VSAT) satellite systems. Key customers include DoD, USSOCOM, USAF, U.S. Army, U.S. intelligence agencies and commercial customers.

Space & Power Systems is a provider of traveling wave tube amplifiers, telemetry and instrumentation systems, and low-power SATCOM products. Offerings include microwave vacuum electron devices and power modules for unmanned and manned platforms, including satellites, radar systems, communication systems, UAVs, various missile programs and commercial broadcast. Additional offerings include spacecraft telemetry tracking and control encryption as well as high data rate transmitters and tactical intelligence receivers. Key customers include DoD, foreign militaries, commercial customers and aircraft and satellite OEMs.

Advanced Communications is a provider of secure communications terminals and equipment, secure network encryption products, shipboard communications systems, advance radar antennas and radomes. Offerings include secure and non-secure voice, data and video communication for office, battlefield and secure internet protocol (IP) network applications, and surveillance and radar detection. Key customers include USN, USCG and foreign navies.

Sensor Systems Segment

In 2017, Sensor Systems had net sales of $1,547 million, representing 16% of our total net sales. The businesses in this reportable segment provide a broad range of multi-domain ISR mission solutions from seabed to space for DoD, intelligence community, international, federal, civil and commercial customers. Major capabilities and mission solutions include networked warfighter systems, integrated ISR and targeting systems, space avionics and imaging payloads, Counter Unmanned Aircraft Systems (CUAS) mission solutions, integrated maritime mission solutions, directed energy, cyber and electronic warfare, special mission command & control, lightweight unmanned undersea vehicles, modeling & simulation and life cycle support. The table below provides a summary of the segment’s business areas and the percentage that each contributed to Sensor Systems’ net sales in 2017.

Business Area
% of 2017
Segment Sales
Space & Sensor Systems
 
23
%
Airborne Sensor Systems
 
23
 
Warrior Sensor Systems
 
22
 
Maritime Sensor Systems
 
21
 
Intelligence & Mission Systems
 
7
 
Advanced Programs
 
4
 
Total Sensor Systems
 
100
%

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Space & Sensor Systems provides avionics, payloads and exploitation systems for DoD, intelligence and commercial space exploration, including space launch vehicle avionics, space imaging and information systems, and tactical imaging systems. Key customers include National Aeronautics Space Administration (NASA), DoD and commercial space companies.

Airborne Sensor Systems provides multi-spectral and multi-intelligence ISR and targeting sensor systems designed for manned and unmanned platforms for ISR military, law enforcement and government missions. Key customers include DoD, foreign ministries of defense, intelligence and security agencies and law enforcement agencies.

Warrior Sensor Systems provides multi-domain warfighter mission integration including networked augmented reality systems, advanced night vision and electro-optical technology and systems, weapon sights, integrated information systems and rangefinding systems. Key customers include DoD, federal agencies, law enforcement agencies, foreign militaries, commercial hunting and professional shooting communities.

Maritime Sensor Systems provides integrated maritime mission solutions for surface and undersea acoustic, imaging and detection systems, including surface electro-optical/infrared systems for surface ships and submarines, dipping sonar systems, towed arrays, maritime command and control systems, undersea platforms and ranges, directed energy, cabled ocean systems, undersea warfare and anti-submarine systems, and integrated, multi-intelligence autonomous undersea vehicles. Key customers include USN, allied navies, and other military customers.

Intelligence & Mission Systems provides solutions that gather and protect intelligence to deliver successful mission outcomes including cyber and electronic warfare solutions, situational awareness for border security and maritime surveillance, and the protection of the most sensitive of information with leading-edge, government grade cyber security. Key customers include U.K. MoD, Australian Defence Force, other international military and security agencies and commercial customers.

Advanced Programs provides advanced ISR and special mission capabilities, directed energy, special mission command and control, modeling & simulation, networked system of system capabilities, unmanned systems and CUAS, lightweight unmanned undersea vehicles and geospatial application technology programs for cueing system software, hardware and wide-area sensor integration solutions. Key customers include USAF, USSOCOM, USN and other DoD agencies.

Funded 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, percentage of funded backlog at December 31, 2017 expected to be recorded as sales in 2018 and funded orders for each of our reportable segments and on a consolidated basis.

 
   
   
Funded Backlog at
December 31,
Percentage of
Funded Backlog at
December 31, 2017
Expected to be
Recorded as
Sales in 2018
   
   
Funded Orders
 
2017
2016
2017
2016
 
(in millions)
 
(in millions)
Reportable Segment:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Electronic Systems
$
2,905
 
$
2,708
 
55%
$
3,201
 
$
2,956
 
Aerospace Systems
 
2,140
 
 
2,218
 
72%
 
2,673
 
 
2,768
 
Communication Systems
 
1,825
 
 
1,932
 
70%
 
2,120
 
 
1,967
 
Sensor Systems
 
2,009
 
 
1,522
 
56%
 
2,002
 
 
1,829
 
Consolidated
$
8,879
 
$
8,380
 
62%
$
9,996
 
$
9,520
 

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

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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 sales by end customer and the percent contributed by each to our total sales. For additional information regarding domestic and international sales, see Note 21 to our audited consolidated financial statements.

 
2017
2016
 
Sales
% of
Total Sales
Sales
% of
Total Sales
 
(in millions)
 
(in millions)
 
Air Force
$
3,173
 
 
33
%
$
2,873
 
 
31
%
Navy/Marines
 
1,324
 
 
14
 
 
1,367
 
 
15
 
Army
 
1,071
 
 
11
 
 
1,034
 
 
11
 
Other Defense
 
761
 
 
8
 
 
824
 
 
9
 
Total DoD
 
6,329
 
 
66
 
 
6,098
 
 
66
 
Other U.S. Government
 
368
 
 
4
 
 
301
 
 
3
 
Total U.S. Government
 
6,697
 
 
70
 
 
6,399
 
 
69
 
Foreign governments
 
1,420
 
 
15
 
 
1,531
 
 
17
 
Commercial — foreign
 
809
 
 
8
 
 
732
 
 
8
 
Commercial — domestic
 
647
 
 
7
 
 
548
 
 
6
 
Total sales
$
9,573
 
 
100
%
$
9,210
 
 
100
%

Direct sales to the end customer represented approximately 64% of our consolidated 2017 sales, and sales as a subcontractor or supplier represented the remaining 36%.

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, 2017, our five largest contracts (revenue arrangements) generated 14% of our consolidated sales.

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. At December 31, 2017, we employed approximately 7,000 engineers, substantially all of whom hold advanced degrees, 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 our U.S. Government businesses and our commercial businesses.

 
Year Ended December 31,
 
2017
2016
2015
 
(in millions)
Company-Sponsored Research and Development Costs:
 
 
 
 
 
 
 
 
 
U.S. Government Contractor Businesses
$
224
 
$
204
 
$
176
 
Commercial Businesses
 
63
 
 
54
 
 
52
 
Total
$
287
 
$
258
 
$
228
 

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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 our research and development efforts.

Competition

While 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 businesses generally encounter significant competition.

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 superior program performance at an affordable and competitive cost;
historical, technical, cost and schedule performance;
our ability to attain supplier positions on contracts;
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.

L3 is an aerospace and defense contractor with a broad and diverse portfolio of products and services. We have prime contractor and 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 and defense 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 prohibit us from preventing the use of our patents in most DoD work performed by other companies for the U.S. Government.

Raw Materials

Although we generated 70% of our 2017 sales from products and systems, our businesses are generally engaged in limited manufacturing activities and have minimal exposure to fluctuations in the supply of raw materials. For those businesses that manufacture and sell products and systems, 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

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 due to the greater levels of risk we assume on a fixed-price type contract.

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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 for: (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. Award and incentive fees earned were not material to our results of operations for 2017, 2016 and 2015.

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.

Substantially all of our cost-plus type contracts and time-and-material type contracts are with U.S. Government customers, while sales to commercial customers are generally transacted under fixed-price sales arrangements and are included in our fixed-price contract type sales. The table below presents the percentage of our total sales generated from each contract type.

 
Year Ended December 31,
Contract Type
2017
2016
2015
Fixed-price(1)
 
73
%
 
76
%
 
78
%
Cost-plus(2)
 
24
 
 
21
 
 
19
 
Time-and-material
 
3
 
 
3
 
 
3
 
Total sales
 
100
%
 
100
%
 
100
%
(1) Includes fixed-price incentive fee type contracts, which contributed approximately 1% to our total sales for each of the years ended December 31, 2017, 2016 and 2015.
(2) Includes cost-plus award and incentive fee type contracts, which contributed approximately 5% to our total sales for each of the years ended December 31, 2017 and 2016 and 4% for the year ended December 31, 2015.

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” 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

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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.

In 2017, sales under foreign military sales (FMS) agreements, which are included in the international (foreign governments) category in the “Major Customers” table above, were $372 million, or 4% of our total consolidated sales. FMS agreements are made directly between the U.S. Government and 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 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 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.

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

At December 31, 2017, we employed approximately 31,000 full-time and part-time employees (excluding employees of discontinued operations), 82% of whom were located in the United States. Of these employees, approximately 10% are covered by approximately 47 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. Historically, we have renegotiated labor agreements without significant disruptions to operating activities, and we believe that relations with our employees are positive.

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 Securities and Exchange Commission 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, NE, Washington, DC 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.

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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.L3T.com.

We also have a Corporate Governance webpage. You can access our Corporate Governance Guidelines and charters for the audit and ethics, compensation and nominating/corporate governance committees of our Board of Directors through our website, http://www.L3T.com, by clicking on the “Corporate Governance” link under the heading “Investor Relations.” You can access our Code of Ethics and Business Conduct by clicking on the “Code of Ethics and Business Conduct” link under the heading “Code of Ethics.” Our Code of Ethics and Business Conduct applies to all directors, officers and employees, including our chief executive officer and president, 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 or accessible through our website is not incorporated by reference into this report.

To learn more about L3, please visit our website at http://www.L3T.com. From time to time, we use our website as a channel of distribution of material company information. Financial and other material information regarding L3 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 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 funds are normally committed to the contract by the procuring agency only as appropriations are made by Congress in future fiscal years. DoD budgets are determined by 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, geopolitical 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.

The total DoD budget for FY 2016 was $581 billion, an increase of 4% compared to FY 2015. The increase was due to a higher base budget of $522 billion, representing an increase of $25 billion compared to FY 2015. The FY 2016 Overseas Contingency Operations (OCO) budget declined slightly to $59 billion compared to $63 billion for FY 2015.

On May 4, 2017, Congress passed the FY 2017 Appropriations Bill, which provides for a $606 billion total FY 2017 DoD Budget ($523 billion base budget, $83 billion OCO), an increase of 4% compared to the appropriated FY 2016 DoD budget. President Trump signed the FY 2017 Appropriations Bill into law on May 5, 2017.

On May 23, 2017, the Trump Administration submitted its FY 2018 DoD budget request (Budget Request) to Congress. The Budget Request included a $574 billion base budget and a $65 billion OCO budget for a total FY 2018 DoD budget of $639 billion, an increase of 5% compared to the total FY 2017 DoD Budget. On July 14, 2017, the House of Representatives and, seperately on September 18, 2017, the Senate each passed their own versions of the National Defense Authorization Act (NDAA). Both the House and Senate versions of the FY 2018 NDAA included authorization spending levels higher than the Budget Request, and such authorized spending would represent an increase of at least 10% compared to the total FY 2017 DoD Budget. The FY 2018 Budget Request and both the

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House and Senate versions of the FY 2018 NDAA exceed the statutory budget cap for defense spending as specified by the Budget Control Act of 2011 (BCA), which mandates a DoD base budget of approximately $522 billion for FY 2018. Accordingly, in order to appropriate funds as submitted by the Budget Request or House and Senate versions of the FY 2018 NDAA, Congress must provide relief from the BCA spending caps through law enacted by Congress. The House and Senate versions of the FY 2018 NDAA were reconciled via the conference process and signed into law by the President on December 12, 2017. The enacted FY 2018 NDAA authorizes a total of $699.9 billion for all Defense spending, including a $634.2 billion base budget and an additional $65.7 billion for OCO.

Because the FY 2018 DoD Appropriations bill was not enacted into law prior to start of fiscal year 2018 (October 1, 2017), DoD’s FY 2018 funding was addressed through a series of Continuing Resolutions (CR), the latest of which is due to expire on March 23, 2018. However, on February 9, 2018, President Trump signed into law the Bipartisan Budget Act of 2018 (BBA), a bipartisan two-year budget and debt ceiling agreement that provides a level of stability in the U.S. Government budget process over the next two fiscal years (FYs 2018 and 2019). The BBA included a short-term CR extension to March 23, 2018, to allow for completion of the FY 2018 appropriations process (including enactment of the FY 2018 DoD Appropriations bill). While 2018 BBA does raise the spending caps for FY 2018 and FY 2019 previously constrained by the BCA and temporarily suspends the statutory debt ceiling through March 1, 2019, it does not modify the BCA’s spending caps or sequestration mechanism beyond FY 2019.

Future DoD budgets and spending levels are difficult to predict as the U.S. Government’s overall fiscal challenges remain. A significant decline in or redirection of U.S. military expenditures in the future, or the loss or significant reduction in U.S. Government funding of a large program in which we participate, could have a material adverse effect on our financial position, results of operations and cash flows.

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 70%, or $6.7 billion, of our sales for the year ended December 31, 2017 were made directly or indirectly to U.S. Government agencies, including 66% to the DoD. Aggregate sales for our five largest contracts (revenue arrangements) amounted to approximately $1.3 billion, or 14% of our consolidated sales for the year ended December 31, 2017.

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;
geopolitical developments that affect demand for our products and services;
our ability to hire and retain personnel to meet demand for our services; and
technological developments that impact purchasing decisions or our competitive position.

The DoD’s wide-ranging efficiency and better buying power initiatives, which target 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.

Since 2010, the DoD has implemented efficiency initiatives and other best practices for procurement that are intended to reduce prices, ensure adequate competition and control costs throughout the acquisition cycle. In addition, under the Better Buying Power 3.0 initiative, the DoD has focused on technology innovation, incentive-based cost-plus and fixed-price contracts and Company-sponsored independent research and development efforts. The U.S.

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Government may continue to implement changes to its procurement practices that change the way contracts are solicited, negotiated and managed, which may impact our future sales, earnings and cash flows, and could affect whether, and how we pursue opportunities to provide our products and services to the U.S. Government, including the terms and conditions under which we do so.

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 has adjusted, and may in the future 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.

At December 31, 2017, we had a backlog of funded orders, primarily under contracts with the U.S. Government, totaling $8,879 million. 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 have a material adverse effect on our future sales, results of operations and cash flows.

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

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Intense competition and bid protests may adversely affect 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 from other providers 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. For more information concerning the factors that affect our ability to compete, see “Part I — Item 1 — Business — Competition.”

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. As discussed in Note 18 to our audited consolidated financial statements, we are currently cooperating with the U.S. Government on several investigations. Under U.S. Government regulations, an indictment of L3 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, which could have a material adverse effect on our results of operations and cash flows. 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, which could have a material adverse effect on our results of operations and cash flows.

Our commercial aviation products and services businesses are affected by global demand and economic factors that could negatively impact our financial results.

The operating results of our commercial aviation products and services businesses may be adversely affected by downturns in the global demand for air travel which impacts new aircraft production and orders, and global flying hours, which impacts air transport, regional and business aircraft utilization rates and pilot training needs. The aviation industry is highly cyclical, and the level of demand for air travel is correlated to the strength of the U.S. and international economies and is impacted by long-term trends in airline passenger and cargo traffic. The results of our commercial aviation business also depend on other factors, including general economic growth, political stability in both developed and emerging markets, pricing pressures, trends in capital goods markets and changes in OEM production rates.

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

For the year ended December 31, 2017, sales to international customers, excluding our international sales made under FMS agreements directly between the U.S. Government and foreign governments, represented approximately 19% 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 international local business practices and cultural considerations;
sovereign government credit risk; and

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potential military conflicts and political risks.

Our international contracts may include industrial cooperation agreements requiring specific local purchases, manufacturing agreements or financial support obligations, known as offset obligations, and provide for penalties if we fail to meet such requirements. See “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contractual Obligations” for further discussion. While we have and will continue to adopt measures to reduce the potential impact of losses resulting from the risks of our international business, these measures may not be adequate.

We are subject to the risks of 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 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 18 to our audited consolidated financial statements.

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.

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 $6,615 million at December 31, 2017. 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 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.

Our annual impairment tests at November 30, 2017 and 2016 did not result in impairments to goodwill. The fair value of all of our reporting units exceeded the carrying value of the net assets of those reporting units by more than 20% at November 30, 2017, the date of our most recent annual impairment assessment. A decline in the estimated fair value of one or more of our reporting units could potentially trigger goodwill impairment charges and a material adverse effect on our results of operations. See “Part II — Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies — Goodwill and Identifiable Intangible Assets” for further discussion.

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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.” For information on the percentage of our total sales generated from each contract type, see “Item 1 —Business — Contracts.”

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 established 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 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 business could be negatively impacted by cybersecurity threats and other disruptions.

As a U.S. defense contractor, we have faced, and continue to face, various security threats, including, but not limited to, threats to the physical security of our facilities and employees, cybersecurity threats to our information technology infrastructure and attempts to gain access to our proprietary or classified information as well as the proprietary or classified information of our customers.

Although we utilize various procedures and controls to monitor, deter and mitigate these threats, these procedures and controls may not be sufficient to prevent disruptions in mission critical systems, the unauthorized release of confidential, sensitive or classified information and the corruption of data, systems or networks. Any significant operational delays, or any destruction, manipulation or improper use of our or our customers’ data, information systems or networks, could materially and adversely affect our financial results, damage the reputation of our products and services and require significant management attention and expense. In addition, our insurance coverage and/or indemnification arrangements that we enter into, if any, may not be adequate to cover all of the costs related to cybersecurity attacks or disruptions resulting from such events.

To date, cyber attacks directed at us have not had a material impact on our financial results. Due to the evolving nature and increased frequency of security threats, however, the impact of any future incident cannot be predicted. The threats we face vary from those common to most industries to more advanced and persistent, highly organized adversaries who target us because we operate in the defense industry and protect national security information. If we are unable to protect sensitive information, our customers or governmental authorities could question the adequacy of our threat mitigation and detection processes and procedures, which could result in us having to spend a significant amount of money to upgrade our networks and systems and could otherwise have a material adverse effect on our business, financial condition, results of operations and cash flows.

In the current environment, there are also numerous and evolving risks to cybersecurity and privacy, including the use of viruses, worms or other malicious software programs and threats involving criminal hackers,

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state-sponsored intrusions, terrorist attacks, industrial espionage, employee malfeasance, and human or technological error. As these risks develop and these attacks become more frequent and sophisticated, we may find it necessary to make significant further investments to protect data and infrastructure from cyber and other security attacks.

We must also rely on the safeguards put in place by customers, suppliers, vendors, subcontractors, venture partners or other third parties to minimize the impact of cyber threats, other security threats or business disruptions. These third parties may have varying levels of cybersecurity expertise and safeguards and their relationships with government contractors, such as L3, may increase the likelihood that they are targeted by the same cyber threats we face. In the event of a breach affecting these third parties, our business and financial results could suffer materially. With respect to our commercial arrangements with these third parties, we have processes designed to require that the third parties and their employees and agents agree to maintain certain standards for the storage, protection and transfer of confidential, personal and proprietary information. However, we remain at risk of a data breach due to the intentional or unintentional non-compliance by a third party’s employee or agent, the breakdown of a third party’s data protection processes, which may not be as sophisticated as ours, or a cyber attack on a third party’s information network and systems.

Pension expense and funding may fluctuate significantly because of changes in key estimates and assumptions, including discount rates and the assumed long-term rate of return on plan assets, as well as our actual investment returns and regulatory actions, which could negatively impact our results of operations, cash flows and financial condition.

Determining our pension expense requires significant judgment, particularly with respect to our discount rates, the assumed long-term rates of return on plan assets and other actuarial assumptions. If our assumptions change significantly due to changes in economic, legislative, demographic experience and/or circumstances, our pension expense, the funded status of our plans and our cash contributions to such plans would be impacted, which could negatively affect our results of operations, cash flows and financial condition. In addition, differences between our actual investment returns and our assumed long-term rate of return on plan assets could also impact our pension expense, the funded status of our plans and our required cash contributions to the plans. Further, our pension expense and the funded status of our plans, including required cash contributions to the plans, may be impacted by regulatory actions in any given year.

Additionally, pension plan cost recoveries under Cost Accounting Standards (CAS) for our U.S. Government contracts occur in different periods from when pension expense is recognized under accounting principles generally accepted in the U.S. or when cash contributions are made. Although CAS has been revised to better align the minimum required contributions under the Employee Retirement Income Security Act of 1974 (ERISA), as amended by the Pension Protection Act of 2006, with pension plan cost recoveries under CAS, timing differences could have a material adverse effect on our cash flow.

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.

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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 margin improvement. 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 capital 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. 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.

Our spin-off of Engility could result in substantial tax liability to us and our shareholders.

In connection with our spin-off of Engility in 2012, we received an Internal Revenue Service (IRS) Ruling stating that L3 and its shareholders would not recognize any taxable income, gain or loss for U.S. federal income tax purposes as a result of the transaction. In addition, we received an opinion of counsel that the spin-off satisfied certain requirements for tax-free treatment that are not covered in the IRS Ruling; however, 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 received shares of Engility would generally be treated as having received 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.

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Item 2. Properties

At December 31, 2017, we operated in 273 locations consisting of manufacturing facilities, administration, research and development and other properties throughout the United States and internationally. Of these, we owned 30 locations consisting of approximately 5.2 million square feet and leased space at 243 locations consisting of approximately 9.4 million square feet. Additionally, our Aerospace Systems segment utilized a facility consisting of approximately 3.3 million square feet through a land lease expiring in 2031 with the city of Greenville, Texas.

A summary of square footage by reportable segment at December 31, 2017, is presented below.

 
Leased
Owned
Government-
Owned
Total
 
(Square feet in millions)
Electronic Systems
 
3.4
 
 
2.0
 
 
 
 
5.4
 
Aerospace Systems
 
1.0
 
 
1.7
 
 
3.3
 
 
6.0
 
Communication Systems
 
3.3
 
 
0.4
 
 
 
 
3.7
 
Sensor Systems
 
1.5
 
 
1.1
 
 
 
 
2.6
 
Total
 
9.2
 
 
5.2
 
 
3.3
 
 
17.7
 

Our reportable segments have major operations at the following locations:

Electronic Systems — Phoenix, Arizona; Anaheim, San Diego and San Leandro, California; Pueblo, Colorado; Sanford, Sarasota and St. Petersburg, Florida; Woburn, Massachusetts; Grand Rapids and Muskegon, Michigan; Mount Olive, New Jersey; Kirkwood, New York; Cincinnati, Ohio; Tulsa, Oklahoma; Philadelphia, Pennsylvania; Arlington, Grand Prairie and Plano, Texas; Melbourne, Australia; Hamilton, New Zealand; and Bracknell, Crawley, Droitwich and Luton, U.K.
Aerospace Systems — Greenville, Rockwall and Waco, Texas; and Quebec and Ontario, Canada.
Communication Systems — San Diego, Simi Valley and Torrance, California; Ayer, Massachusetts; Camden, New Jersey; Hauppauge, New York; Williamsport, Pennsylvania; and Salt Lake City, Utah.
Sensor Systems — Tempe, Arizona; Sylmar, California; Orlando, Florida; Northampton and Wilmington, Massachusetts; Londonderry, New Hampshire; Mason, Ohio; Pittsburgh, Pennsylvania; Ontario, Canada; Bologna, Italy; and Tewkesbury, U.K.

Additionally, our Corporate staff occupies a total of 0.2 million square feet of office space in New York, New York and Arlington, Virginia. Management believes all of our properties have been well maintained, are in good condition and are adequate and suitable for our business as presently conducted.

Item 3. Legal Proceedings

The information required with respect to this item can be found in Note 18 to our audited consolidated financial statements and is incorporated by reference into this Item 3.

Item 4. Mine Safety Disclosures

None.

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PART II

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

The common stock of L3 is traded on the New York Stock Exchange (NYSE) under the symbol “LLL.” On February 16, 2018, the number of holders of L3’s common stock was approximately 197,000. On February 16, 2018, the closing price of L3’s stock, as reported by the NYSE, was $212.89 per share.

The table below sets forth the amount of dividends paid per share and the high and low closing price of L3’s common stock as reported on the NYSE during the past two calendar years.

 
Dividends Paid
Closing Price
(High-Low)
 
2017
2016
2017
2016
Common Stock — Dividends Paid and Market Prices
 
 
 
 
 
 
 
 
 
 
 
 
First Quarter
$
0.75
 
$
0.70
 
$170.81 — 145.71
$120.55 — 108.05
Second Quarter
 
0.75
 
 
0.70
 
 173.94 — 160.69
 147.90 — 118.50
Third Quarter
 
0.75
 
 
0.70
 
 190.32 — 168.99
 151.63 — 140.11
Fourth Quarter
 
0.75
 
 
0.70
 
 199.05 — 183.09
 161.56 — 134.05
Year Ended December 31
$
3.00
 
$
2.80
 
$199.05 — 145.71
$161.56 — 108.05

On February 12, 2018, L3 announced that its Board of Directors increased L3’s regular quarterly cash dividend from $0.75 per share to $0.80 per share, or 7%, payable on March 15, 2018, to shareholders of record at the close of business on March 1, 2018.

Issuer Purchases of Equity Securities

The following table provides information about repurchases of L3’s common stock made in the quarterly period ended December 31, 2017. Repurchases are made from time to time at management’s discretion in accordance with applicable federal securities laws. All share repurchases of L3’s common stock have been recorded as treasury shares.

Period
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 Plan
or Program(1)
 
 
 
 
(in millions)
September 30 — October 31, 2017
 
 
$
 
 
 
$
1,435
 
November 1 — 30, 2017
 
212,665
 
 
185.73
 
 
212,665
 
 
1,396
 
December 1 — 31, 2017
 
248,627
 
 
197.16
 
 
248,627
 
 
1,347
 
Total
 
461,292
 
 
191.89
 
 
461,292
 
 
 
 
(1) The share repurchases described in the table above were made pursuant to the $1.5 billion share repurchase program authorized by L3’s Board of Directors on May 8, 2017. The program became effective on July 1, 2017 and has no set expiration date.

From January 1, 2018 through February 16, 2018, L3 repurchased 433,039 shares of its common stock at an average price of $203.33 per share for an aggregate amount of approximately $88 million.

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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, 2012 to December 31, 2017. These figures assume that all dividends paid over the performance period were reinvested. On July 17, 2012, we completed the Engility spin-off. Our shareholders received one share of Engility common stock for every six shares of our common stock held on the record date (July 16, 2012). The effect of the spin-off is reflected in the cumulative total return as a reinvested dividend for the year ended December 31, 2012. The figures also assume that the starting value of each index and the investment in our common stock was $100 on December 31, 2012.

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 closing stock price on the NYSE of $76.62 per share on December 31, 2012. The graph is not, and is not intended to be, indicative of future performance of our common stock.


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Item 6. Selected Financial Data

The selected financial data presented below is derived from our audited consolidated financial statements.

 
Year Ended December 31,
 
2017
2016
2015(1)
2014
2013
 
(in millions, except per share data)
Statements of Operations Data:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net sales
$
9,573
 
$
9,210
 
$
9,231
 
$
9,691
 
$
10,104
 
Operating income
$
1,020
 
$
957
 
$
785
 
$
1,000
 
$
1,036
 
Goodwill impairment charges
 
 
 
 
 
46
 
 
 
 
 
Loss related to business divestitures
 
 
 
 
 
31
 
 
 
 
 
Segment operating income
$
1,020
 
$
957
 
$
862
 
$
1,000
 
$
1,036
 
Operating margin
 
10.7
%
 
10.4
%
 
8.5
%
 
10.3
%
 
10.3
%
Segment operating margin
 
10.7
%
 
10.4
%
 
9.3
%
 
10.3
%
 
10.3
%
Interest and other, net
$
(149
)
$
(153
)
$
(146
)
$
(129
)
$
(128
)
Income from continuing operations before income taxes
$
871
 
$
804
 
$
639
 
$
871
 
$
908
 
Provision for income taxes
 
(102
) (2)
 
(171
)
 
(132
)
 
(225
)
 
(236
)
Income from continuing operations
 
769
 
 
633
 
 
507
 
 
646
 
 
672
 
Net income from continuing operations attributable to noncontrolling interests
 
(16
)
 
(14
)
 
(15
)
 
(13
)
 
(9
)
Net income from continuing operations attributable to L3
$
753
 
$
619
 
$
492
 
$
633
 
$
663
 
Earnings per share from continuing operations allocable to L3 common shareholders:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
$
9.65
 
$
7.99
 
$
6.10
 
$
7.41
 
$
7.42
 
Diluted
$
9.46
 
$
7.86
 
$
6.01
 
$
7.21
 
$
7.28
 
L3 weighted average common shares outstanding:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
78.0
 
 
77.4
 
 
80.7
 
 
85.4
 
 
89.4
 
Diluted
 
79.6
 
 
78.8
 
 
81.9
 
 
87.8
 
 
91.1
 
Cash dividends declared per common share
$
3.00
 
$
2.80
 
$
2.60
 
$
2.40
 
$
2.20
 
(1) Income from continuing operations for the year ended December 31, 2015 includes: (1) non-cash goodwill impairment charge of $46 million ($44 million after income taxes), or $0.54 per diluted share, related to a business retained by L3 in connection with the sale of the National Security Solutions (NSS) business and (2) a pre-tax loss of $31 million ($20 million after income taxes), or $0.25 per diluted share, related to business divestitures.
(2) Provision for income taxes for the year ended December 31, 2017 includes estimated tax benefits of $79 million, or $0.99 per diluted share, related to the enactment of the U.S. Tax Cuts and Jobs Act (U.S. Tax Reform) in December 2017.

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Year Ended December 31,
 
2017
2016
2015
2014
2013
 
(in millions)
Balance Sheet Data (at year end):
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Working capital(1)
$
1,871
 
$
1,467
 
$
797
 
$
1,580
 
$
1,749
 
Total assets
 
12,729
 
 
11,865
 
 
12,069
 
 
13,692
 
 
13,849
 
Long-term debt, including current portion
 
3,330
 
 
3,325
 
 
3,626
 
 
3,916
 
 
3,611
 
Equity
 
5,151
 
 
4,624
 
 
4,429
 
 
5,360
 
 
6,056
 
Cash Flow Data:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net cash from operating activities from continuing operations
$
985
 
$
1,022
 
$
1,035
 
$
1,065
 
$
1,058
 
Net cash used in investing activities from continuing operations
 
(453
)
 
(10
)
 
(190
)
 
(218
)
 
(256
)
Net cash used in financing activities from continuing operations
 
(366
)
 
(856
)
 
(1,205
)
 
(893
)
 
(853
)
(1) Excludes net assets held for sale.

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

Overview and Outlook

L3’s Business

L3 is a prime contractor in Intelligence, Surveillance and Reconnaissance (ISR) systems, aircraft sustainment (including modifications and fleet management of special mission aircraft), simulation and training, night vision and image intensification equipment, and security and detection systems. L3 is also a leading provider of a broad range of communication, electronic and sensor systems used on military, homeland security 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), foreign governments, and domestic and foreign commercial customers.

We have the following four reportable segments: (1) Electronic Systems, (2) Aerospace Systems, (3) Communication Systems and (4) Sensor Systems. Financial information for our segments is included in Note 21 to our audited consolidated financial statements.

Electronic Systems provide a broad range of products and services, including components, products, subsystems, systems and related services to military and commercial customers. These products and services serve niche markets such as, aircraft simulation and training, power and distribution, cockpit avionics, airport security and precision weapons. The Electronic Systems business areas are Total Training Solutions, Power & Propulsion Systems, Aviation Products, Precision Engagement Systems and Security & Detection Systems.

Aerospace Systems provide products and services for the global ISR and Command, Control and Communications (C3) markets, specializing in signals intelligence (SIGINT) and multi-intelligence platforms, including engineering, modernization and sustainment solutions for military and various government aircraft, ground support equipment and other platforms. These strategic and tactical products and services provide warfighters with the ability to detect, collect, identify, analyze and disseminate information from command centers, communication nodes and air defense systems for real-time situational awareness and response. Aerospace Systems sells these products and services primarily to the DoD and select foreign governments. The Aerospace Systems business areas are Mission Integration, MAS, Aerostructures and Advanced Systems.

Communication Systems provide network and communication systems, secure communications products, radio frequency (RF) components, satellite communication terminals and space, microwave and telemetry products. These products include secure data links that are used to connect a variety of space, airborne, ground and sea-based communication systems and are used in transmission, processing, recording, monitoring and dissemination functions of these communication systems. Communication Systems sells these products and services primarily to the DoD and select foreign governments. The Communications Systems business areas are Broadband Communication Systems, Space & Power Systems and Advanced Communications.

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Sensor Systems provide a broad range of multi-domain ISR mission solutions from seabed to space for DoD, intelligence community, international, federal civil and commercial customers. Major capabilities and mission solutions include networked warfighter systems, integrated ISR and targeting systems, space avionics and imaging payloads, Counter Unmanned Aircraft Systems mission solutions, integrated maritime mission solutions, directed energy, cyber and electronic warfare, special mission command & control, lightweight unmanned undersea vehicles, modeling & simulation and life cycle support. Sensor Systems sells these products and services primarily to the DoD and select foreign governments. The Sensor Systems business areas are Space & Sensor Systems, Airborne Sensor Systems, Warrior Sensor Systems, Maritime Sensor Systems, Intelligence & Mission Systems and Advanced Programs.

On October 16, 2017, our Board of Directors approved a plan to explore strategic alternatives to sell or otherwise divest the Vertex Aerospace business. We expect to complete a sale in 2018. The divestiture of the Vertex Aerospace business represents a strategic shift by us to exit the logistics solution and maintenance services business for military aircraft where we do not provide complex ISR systems integration and modification. The Vertex Aerospace business generated sales of $1.4 billion in 2017, $1.3 billion in 2016 and $1.2 billion in 2015. The assets and liabilities and results of operations of the Vertex Aerospace business are reported as discontinued operations for all periods presented.

On December 7, 2015, we entered into a definitive agreement to sell our National Security Solutions (NSS) segment to CACI International Inc. The transaction was completed on February 1, 2016. NSS provided cybersecurity solutions, high-performance computing, enterprise IT services, analytics and intelligence analysis to the DoD, U.S. Government intelligence agencies, federal civilian agencies and foreign governments. The results of operations of NSS are reported as discontinued operations for all periods presented.

All references made to financial data in this Annual Report on Form 10-K are to L3’s continuing operations, unless specifically noted.

We generated sales of $9,573 million and $9,210 million for the years ended December 31, 2017 and 2016, respectively, and our primary customer was the DoD. See “Part I — Item 1 — Business — Major Customers” for additional information regarding a summary of our sales by end customer and the percent contributed by each to our total sales.

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.

Business Environment

U.S. Government Markets. Sales to U.S. Government customers represented 70% of our 2017 sales and were primarily to DoD customers, which comprised 66% of our sales. Therefore, our annual sales are generally highly correlated to changes in U.S. Government spending levels, especially DoD budget levels.

The total DoD budget for FY 2016 was $581 billion, an increase of 4% compared to FY 2015. The increase was due to a higher base budget of $522 billion, representing an increase of $25 billion compared to FY 2015. The FY 2016 OCO budget declined slightly to $59 billion compared to $63 billion for FY 2015.

On May 4, 2017, Congress passed the FY 2017 Appropriations Bill, which provides for a $606 billion total FY 2017 DoD Budget ($523 billion base budget, $83 billion OCO), an increase of 4% compared to the appropriated FY 2016 DoD budget. President Trump signed the FY 2017 Appropriations Bill into law on May 5, 2017.

On May 23, 2017, the Trump Administration submitted its FY 2018 DoD budget request (Budget Request) to Congress. The Budget Request included a $574 billion base budget and a $65 billion OCO budget for a total FY 2018 DoD budget of $639 billion, an increase of 5% compared to the total FY 2017 DoD Budget. On July 14, 2017, the House of Representatives and, separately on September 18, 2017, the Senate each passed their own versions of the National Defense Authorization Act (NDAA). Both the House and Senate versions of the FY 2018 NDAA included authorization spending levels higher than the Budget Request, and such authorized spending would represent an increase of at least 10% compared to the total FY 2017 DoD Budget. The FY 2018 Budget Request and both the

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House and Senate versions of the FY 2018 NDAA exceed the statutory budget cap for defense spending as specified by the Budget Control Act of 2011 (BCA), which mandates a DoD base budget of approximately $522 billion for FY 2018. Accordingly, in order to appropriate funds as submitted by the Budget Request or House and Senate versions of the FY 2018 NDAA, Congress must provide relief from the BCA spending caps through law enacted by Congress. The House and Senate versions of the FY 2018 NDAA were reconciled via the conference process and signed into law by the President on December 12, 2017. The enacted FY 2018 NDAA authorizes a total of $699.9 billion for all Defense spending, including a $634.2 billion base budget and an additional $65.7 billion for OCO.

Because the FY 2018 DoD Appropriations bill was not enacted into law prior to start of fiscal year 2018 (October 1, 2017), DoD’s FY 2018 funding was addressed through a series of Continuing Resolutions (CR), the latest of which is due to expire on March 23, 2018. However, on February 9, 2018, President Trump signed into law the Bipartisan Budget Act of 2018 (BBA), a bipartisan two-year budget and debt ceiling agreement that provides a level of stability in the U.S. Government budget process over the next two fiscal years (FYs 2018 and 2019). The BBA included a short-term CR extension to March 23, 2018, to allow for completion of the FY 2018 appropriations process (including enactment of the FY 2018 DoD Appropriations bill). While 2018 BBA does raise the spending caps for FY 2018 and FY 2019 previously constrained by the BCA and temporarily suspends the statutory debt ceiling through March 1, 2019, it does not modify the BCA’s spending caps or sequestration mechanism beyond FY 2019.

On February 12, 2018, the Trump Administration submitted its FY 2019 DoD budget request to Congress. The table below presents the FY 2011 through FY 2017 DoD enacted budgets and the FY 2018 Budget Request for DoD and the FY 2019 DoD Future Years Defense Plan (FYDP), as proposed within the FY 2019 DoD Budget Request.

 
DoD Budget
Annual
Total
Budget
Change
Fiscal Year (Ending September 30)
Base
OCO
Total
 
(in billions)
2012
$
530
 
$
115
 
$
645
 
 
-6
%
2013
$
496
 
$
82
 
$
578
 
 
-10
%
2014
$
496
 
$
85
 
$
581
 
 
+1
%
2015
$
497
 
$
63
 
$
560
 
 
-4
%
2016
$
522
 
$
59
 
$
581
 
 
+4
%
2017
$
524
 
$
82
 
$
606
 
 
+4
%
2018(1)
$
529
 
$
83
 
$
612
 
 
+1
%
2019
$
617
 
$
69
 
$
686
 
 
+12
%
2020
$
681
 
$
20
 
$
701
 
 
+2
%
2021
$
694
 
$
20
 
$
714
 
 
+2
%
2022
$
708
 
$
19
 
$
727
 
 
+2
%
2023
$
722
 
$
20
 
$
742
 
 
+2
%

Source: United States Department of Defense FY 2019 Budget Request.

(1) FY 2018 Base and OCO budget amounts presented above are presently being provided via a CR, which continues FY 2017 funding levels, with some limited exceptions, and expires March 23, 2018. We anticipate Congress to enact appropriations for an FY 2018 total DoD budget consistent with the FY 2018 BBA.

While the BBA provides a level of stability, future DoD budgets and spending levels are determined by a number of factors beyond our control, including changes to U.S. procurement policies, current and future domestic and international budget conditions, presidential administration priorities and changing national security and defense requirements. Furthermore, the U.S. Government’s overall fiscal challenges remain, including uncertainties regarding BCA sequestration cuts after FY 2019 and, therefore, future DoD budgets and spending levels are difficult to predict. Although, uncertainty exists, we believe that L3 will benefit from several of the DoD’s focus areas such as ISR, unmanned systems, undersea warfare, precision strike, secure communications, missile defense and space programs, electronic warfare, aircraft readiness and the ability to project power in denied environments. For more information on the risks and uncertainties related to our U.S. Government contracts, see “Part I — Item 1A — Risk Factors” in this Annual Report on Form 10-K.

International and Commercial Markets. Sales to end customers other than the U.S. Government represented 30% of our 2017 sales. We expect sales to international and commercial customers to continue to represent approximately 30% of our consolidated 2018 sales. These sales are generally affected by global economic conditions,

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geopolitical and security conditions and commodity prices, as well as our competitive success in winning new business and increasing our market share. We believe that L3 will benefit from a large addressable international market with sales directly to foreign allied governments and under Foreign Military Sales agreements between the U.S. Government and foreign governments. Although our international sales are experiencing near-term softness, we believe the focus of our international markets in areas such as ISR, simulators, communication systems, night vision products and sensors systems will benefit L3 in the long-term. We also believe that the commercial markets in which we participate such as aviation products, security and screening, simulation and training, and radio frequency microwave and power have long-term favorable fundamentals.

Key Performance Measures

The primary financial performance measures that we use to manage our businesses and monitor results of operations are (i) sales, (ii) operating income and (iii) net cash from operating activities (“Operating Cash Flow”). Management believes that these financial performance measures are the primary growth drivers for our earnings per share and cash flow per common share. Generally, in evaluating our businesses and contract performance, we focus on net sales, operating income, operating margin, which we define as operating income as a percentage of sales, and the financial performance measure of Operating Cash Flow, and not the type or amount of operating costs.

One of our primary business objectives is to increase sales organically and through select business acquisitions. We define organic sales as net sales excluding the sales impact of acquisitions and divestitures. Sales declines related to business divestitures are sales from divestitures that are included in our actual results for a twelve-month period prior to the divestitures. Sales increases related to acquired businesses are sales from acquisitions that are included in our actual results for less than a twelve-month period. We expect to supplement, strengthen and enhance our existing businesses 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. Another important financial performance measure that we use is operating margin, because sales growth combined with operating margin levels determine our operating income levels. Operating Cash Flow is also an important financial performance measure because Operating Cash Flow measures our ability to convert operating income into cash after paying income taxes and interest expenses and investing in working capital.

Sales Trends. For the year ended December 31, 2017, consolidated net sales of $9,573 million increased by 4%, compared to the year ended December 31, 2016. Organic sales increased $213 million, or 2%, and net sales from business acquisitions was $204 million, or 2%. These increases were partially offset by divestitures of $54 million, or 1%. Our average annual sales declined for the five years ended December 31, 2017 by 2% primarily due to a decline in average annual organic sales of approximately 1%. See “Results of Operations,” including segment results below for a further discussion of sales.

We derived approximately 66% of our 2017 sales from DoD customers; as a result, our sales are highly correlated to DoD budget levels. DoD budgets are a function of several factors and uncertainties beyond our control, including, but not limited to, changes in U.S. procurement policies, budget considerations, current and future economic conditions, presidential administration priorities, U.S. military engagements, changing national security and defense requirements, geo-political developments, actual fiscal year congressional appropriations for defense budgets, and sequestration and other DoD budget reductions. Any of these factors could result in a significant increase, decrease or redirection of DoD budgets and impact L3’s future results of operations, including our sales and operating income growth rates. Additionally, L3’s future results of operations will be affected by our ability to retain our existing business, including our revenue arrangements with DoD customers, and to successfully re-compete for existing business and compete for new business, which largely depends 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 and those with clearances of top-secret and above. We expect our 2018 consolidated sales to increase by approximately 4% compared to 2017, including an organic sales increase of 3%. We expect organic sales to the DoD and U.S. Government to increase by approximately 4% and organic international sales to decline by approximately 4% due to the completion of certain contracts with foreign governments. We expect organic commercial sales to increase by approximately 9%, primarily for commercial aviation products.

Operating Income and Margin Trends. For the year ended December 31, 2017, our operating income was $1,020 million, an increase of 7% from $957 million for the year ended December 31, 2016. Our operating margin

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was 10.7% for the year ended December 31, 2017, an increase of 30 basis points from 10.4% for the year ended December 31, 2016. See “Results of Operations”, including segment results below, for a further discussion of operating margin.

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. While we continue to undertake cost management actions, such as reducing our indirect costs, curtailing pension benefits for salaried employees, resizing select business units and improving our productivity and contract performance in an effort to maintain or even increase operating margin, these efforts may not be successful and may be partially or fully offset by other cost increases. Furthermore, as a U.S. Government contractor, we do not retain the benefit of all cost management actions, particularly on cost-plus type contracts or on contracts where we are the sole-source provider. Although we expect our 2018 annual consolidated and segment operating margin to increase as compared to 2017, changes in the competitive environment and DoD procurement practices and changes in annual pension expense, including related assumptions such as the benefit obligation discount rates, among other factors, could result in lower operating margin. Furthermore, select business acquisitions and new business, including contract renewals and new contracts, could have lower future operating margins compared to our operating margins on existing contracts and could reduce future operating margins.

Operating Cash Flow Trends. For the year ended December 31, 2017, Operating Cash Flow was $985 million, a decrease of 4%, compared to the year ended December 31, 2016. The decrease in Operating Cash Flow was primarily driven by higher income tax payments.

U.S. Tax Reform

On December 22, 2017, the U.S. Government enacted the U.S. Tax Cuts and Jobs Act (U.S. Tax Reform), which made significant changes to the U.S. tax system. Significant changes under U.S. Tax Reform include, among other things, the reduction of the U.S. corporate income tax rate from 35% to 21%, the implementation of a modified territorial tax system, and the imposition of a one-time repatriation tax on deemed repatriated earnings and profits of U.S. owned foreign subsidiaries (Toll Charge).

We recognized the income tax effects of U.S. Tax Reform in accordance with the Securities and Exchange Commission Staff Accounting Bulletin No. 118, Income Tax Accounting Implication of the Tax Cuts and Job Act (SAB 118), in our consolidated financial statements for the year ended December 31, 2017. SAB 118 provides guidance for the application of income tax accounting standards related to U.S. Tax Reform. Accordingly, our consolidated financial statements reflect the income tax effects of U.S. Tax Reform for which the accounting is incomplete but a reasonable estimate could be determined. We recorded an estimated tax benefit of $79 million from U.S. Tax Reform, which includes a $101 million estimated tax benefit related to the remeasurement of deferred taxes partially offset by an estimated tax provision of $22 million related to the Toll Charge. The preliminary net tax benefit recorded may differ in the future due principally to changes to the interpretations of U.S. Tax Reform, legislative action to clarify the interpretation of U.S. Tax Reform and changes to estimates we have utilized to calculate the tax benefit. We expect to finalize the tax benefit from U.S. Tax Reform with the filing of our tax return and record the difference between the final benefit and the provisional benefit recorded in the 2018 fourth quarter, if any, at that time.

Discontinued Operations

Vertex Aerospace. On October 16, 2017, our Board of Directors approved a plan to explore strategic alternatives to sell or otherwise divest the Vertex Aerospace business. We expect to complete a sale in 2018. The divestiture of the Vertex Aerospace business represents a strategic shift by us to exit the logistics solution and maintenance services business for military aircraft where we do not provide complex ISR systems integration and modification. The Vertex Aerospace business generated sales of $1.4 billion in 2017, $1.3 billion in 2016 and $1.2 billion in 2015. The assets and liabilities and results of operations of the Vertex Aerospace business are reported as discontinued operations for all periods presented.

National Security Solutions (NSS). On February 1, 2016, we completed the sale of our NSS segment to CACI International Inc. for a sales price of $547 million.

See Note 3 to the audited consolidated financial statements for additional information.

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The table below presents the statements of operations data for Vertex Aerospace and NSS. The amounts presented in discontinued operations include allocated interest expenses for debt not directly attributable or related to L3’s other operations. Interest expense was allocated in accordance with the accounting standards for discontinued operations and were based on the ratio of their net assets to the sum of: (1) total L3 consolidated net assets and (2) L3 consolidated total debt.

 
Year Ended December 31,
 
2017
2016
2015
 
(in millions)
Net sales
$
1,429
 
$
1,402
 
$
2,334
 
Cost of sales
 
(1,342
)
 
(1,357
)
 
(2,259
)
(Loss) gain related to business divestiture(1)
 
(1
)
 
64
 
 
 
Goodwill impairment charges(2)
 
(187
)
 
 
 
(909
)
Operating (loss) income from discontinued operations
 
(101
)
 
109
 
 
(834
)
Interest expense allocated to discontinued operations
 
(2
)
 
(5
)
 
(26
)
(Loss) income from discontinued operations before income taxes
 
(103
)
 
104
 
 
(860
)
Income tax benefit (expense)
 
27
 
 
(13
)
 
128
 
(Loss) income from discontinued operations net of income taxes
$
(76
)
$
91
 
$
(732
)
(1) For the year ended December 31, 2017, we recognized $1 million of trailing expenses related to the sale of NSS. The year ended December 31, 2016 included a gain of $64 million (before and after income taxes) on the sale of NSS.
(2) Due to a decline in estimated fair value, we recorded goodwill impairment charges for the years ended December 31, 2017 and 2015. The impairment charge of $187 million recorded during 2017 relates to Vertex Aerospace. The impairment charge of $909 million recorded during 2015 consists of: (i) $571 million related to NSS and (ii) $338 million related to Vertex Aerospace.

Business Acquisitions and Divestitures

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 L3. Our business acquisitions, depending on their contract-type, sales mix or other factors, could reduce L3’s consolidated operating margin while still increasing L3’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 L3’s overall business strategy and we are able to receive an attractive price.

Acquisitions. We regularly evaluate potential business acquisitions. The table below summarizes the acquisitions that we have completed during the years ended December 31, 2015, 2016 and 2017 referred to herein as business acquisitions. See Note 3 to our audited consolidated financial statements for further information regarding our business acquisitions. During the year ended December 31, 2017, we used net cash of $316 million for business acquisitions.

Business Acquisitions
Date Acquired
Segment
Purchase Price(1)
 
 
 
(in millions)
2015
 
 
 
 
 
 
 
 
 
MITEQ, Inc.
January 21, 2015
Communication Systems
$
41
 
CTC Aviation Group (L3 CTC)
May 27, 2015
Electronic Systems
 
236
 
ForceX, Inc. (L3 ForceX)
October 13, 2015
Sensor Systems
 
61
 
Total 2015
 
 
$
338
 
2016
 
 
 
 
 
Advanced Technical Materials, Inc. (ATM)
January 22, 2016
Communication Systems
$
27
 
Micreo Limited (Micreo) and Flight Training Acquisitions LLC (Aerosim)
September 30, 2016
Sensor Systems and
Electronic Systems
 
86
 
MacDonald Humfrey (Automation) Limited (MacH)
November 22, 2016
Electronic Systems
 
327
(2) 
Total 2016
 
 
$
440
 

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Business Acquisitions
Date Acquired
Segment
Purchase Price(1)
 
 
 
(in millions)
2017
 
 
 
 
 
 
 
 
 
Explosive Trace Detection business of Implant Sciences (ETD business)
January 5, 2017
Electronic Systems
$
118
 
OceanServer Technology, Inc. (OceanServer),
Open Water Power, Inc. (Open Water Power), and Doss Aviation, Inc. (Doss Aviation)
March 17, 2017
May 19, 2017
September 12, 2017
Sensor Systems and
Electronic Systems
 
147
(3) 
Adaptive Methods, Inc. (Adaptive Methods)
September 8, 2017
Sensor Systems
 
33
 
Escola De Aviacao Aerocondor, S.A. (G-Air)
October 27, 2017
Electronic Systems
 
13
 
Kigre, Inc. (Kigre)
December 18, 2017
Sensor Systems
 
13
 
Total 2017
 
 
$
324
 
(1) The purchase price represents the contractual consideration for the acquired business, excluding adjustments for net cash acquired and acquisition transaction costs.
(2) Excludes additional purchase price, not to exceed £30 million (approximately $38 million), which is contingent upon the post-acquisition financial performance of MacH for the three-year period ending December 31, 2019.
(3) Excludes additional purchase price, not to exceed $17 million, which is contingent upon the post-acquisition milestone achievements of Open Water Power for the four-year period ending December 31, 2021.

All of our business acquisitions are included in our consolidated results of operations from their dates of acquisition.

Divestitures. We regularly evaluate potential business divestitures. Below summarizes the divestitures that we have completed during the years ended December 31, 2017, 2016 and 2015. See Note 3 to our audited consolidated financial statements for further information regarding our business divestitures.

2017 Divestitures

During the year ended December 31, 2017, we completed the sales of the CTC Aviation Jet Services Limited (Aviation Jet Services) business, the L3 Coleman Aerospace (Coleman) business and the Display Product Line. The table below presents pre-tax (loss) gain recognized, the proceeds received and net sales included in continuing operations from these divestitures.

 
Year Ended December 31, 2017
 
Pre-Tax
(Loss) gain
Proceeds
Received
Net Sales
 
(in millions)
Aviation Jet Services divestiture
$
(5
)
$
1
 
$
1
 
Coleman divestiture
 
(3
)
 
17
 
 
9
 
Display Product Line divestiture
 
4
 
 
7
 
 
 
Total
$
(4
)
$
25
 
$
10
 

Aviation Jet Services Divestiture. On March 1, 2017, we divested our Aviation Jet Services business for a sales price of £1 million (approximately $1 million). Aviation Jet Services provided non-core aircraft management and operational services as part of commercial training solutions based in the United Kingdom and was included in the Electronic Systems segment.

Coleman Divestiture. On February 24, 2017, we divested our Coleman business for a sales price of $15 million. Coleman provided air-launch ballistic missile targets and was included in the Electronic Systems segment.

Display Product Line Divestiture. On February 23, 2017, we divested our Display Product Line for a sales price of $7 million. The Display Product Line provided cockpits to various military aircraft and was included in the Electronic Systems segment.

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2016 Business Divestitures

NSS. On February 1, 2016, we completed the sale of our NSS segment to CACI International Inc. for a sales price of $547 million.

2015 Business Divestitures

During the year ended December 31, 2015, we completed the sales of Marine Systems International (MSI), Broadcast Sports Inc. (BSI), the Tinsley Product Line and Klein Associates, Inc. (Klein). The table below presents pre-tax loss recognized, the proceeds received and net sales included in continuing operations from these business divestitures.

 
Year Ended December 31, 2015
 
Pre-Tax
Loss
Proceeds
Received
Net Sales
 
(in millions)
MSI divestiture
$
(17
)
$
318
 
$
185
 
BSI divestiture
 
(4
)
 
26
 
 
7
 
Tinsley Product Line divestiture
 
(8
)
 
4
 
 
9
 
Klein divestiture
 
(2
)
 
10
 
 
8
 
Total
$
(31
)
$
358
 
$
209
 

MSI Divestiture. On May 29, 2015, we completed the sale of our MSI business to Wärtsilä Corporation for a sales price of €295 million (approximately $318 million), in addition to the assumption by Wärtsilä Corporation of approximately €60 million of MSI employee pension-related liabilities. The sales price was finalized as of June 24, 2016, with no significant changes to preliminary amounts. MSI was a sector within our Electronic Systems segment, primarily selling to the commercial shipbuilding industry.

BSI Divestiture. On April 24, 2015, we divested our BSI business for a sales price of $26 million. BSI provided wireless technology and communications systems services for use in the field of sports television broadcasting and was included in the Sensor Systems segment.

Tinsley Product Line Divestiture. On July 27, 2015, we divested our Tinsley Product Line for a sales price of $4 million. Tinsley provided optical components, sub-assemblies and passive sub-systems and was included in the Sensor Systems segment.

Klein Divestiture. On December 31, 2015, we divested our Klein business for a sales price of $10 million. Klein provided side scan sonar equipment and waterside security and surveillance systems and was included in the Sensor Systems segment.

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 for L3 relate to contract revenue, profit and loss recognition, fair values of assets acquired and liabilities assumed in business combinations, pension and post-retirement benefit obligations, income taxes, including the valuations of deferred tax assets, litigation reserves, useful lives and valuation of recorded amounts of long-lived assets, identifiable intangible assets and goodwill. Changes in estimates are reflected in the periods during which they become known. Actual amounts may 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 require judgment 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.

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Contract Revenue Recognition and Contract Estimates. Approximately 59% 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 type and are covered by contract accounting standards. 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 contract accounting standards are substantially recognized using percentage-of-completion (POC) methods of accounting. Sales on such contracts represent approximately 49% 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 the 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.

Accounting for the sales and profits on these fixed-price contracts requires the preparation of estimates of the: (1) total contract revenue, (2) 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) 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.”

Revisions or 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, as facts and circumstances change and as new information is obtained, even though the scope of work required under the contract may not change. Revisions or adjustments may also be required if contract modifications occur. 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 impact of revisions in profit (loss) estimates for all types of contracts subject to POC accounting are recognized on a cumulative catch-up basis in the period in which the revisions are made. 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. Aggregate net changes in contract estimates amounted to increases of $184 million, or 18%, of consolidated operating income ($1.48 per diluted share) for the year ended December 31, 2017, increases of $149 million, or 16%, of consolidated operating income ($1.23 per diluted share) for the year ended December 31, 2016, and increases of $52 million, or 7%, of consolidated operating income ($0.45 per diluted share) for the year ended December 31, 2015.

Sales and profits on cost-plus type contracts that are covered by contract accounting standards 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

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profit on a cost-plus contract is fixed or variable based on the contractual fee arrangement types. Incentive and award fees are our primary variable fee contractual arrangement types. Incentive and award fees on cost-plus type contracts are included as an element of total estimated contract revenues and recorded as 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 the 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 all 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 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 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 objective evidence exists that the fees have been earned.

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 cost of sales 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.

In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2014-09, Revenue from Contracts with Customers, As Amended (commonly referred to as ASC 606), which will replace numerous requirements in U.S. GAAP, including industry-specific requirements, provides companies with a single revenue recognition model for recognizing revenue from contracts with customers and significantly expands the disclosure requirements for revenue arrangements. The new standard, as amended, will be effective for us for interim and annual reporting periods beginning on January 1, 2018. See Note 2 to our audited consolidated financial statements for discussion of our efforts to evaluate and implement the new standard along with our evaluation of the expected impact of the standard on our audited consolidated financial statements.

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). 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 separate intangible assets 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

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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 growth expectations and 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, 2017, we had goodwill of $6,615 million and identifiable intangible assets of $292 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 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. 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 also review and update our estimates of the duration of our customer contractual relationships, at least annually. 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 lives.

We review goodwill for impairment annually as of November 30 and whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The accounting standards for goodwill allow for the assessment of qualitative factors, such as macroeconomic conditions, industry and market conditions and entity relevant events or circumstances, to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. We did not utilize a qualitative assessment approach for the November 30, 2017 goodwill impairment test, as we chose instead to complete the quantitative testing process for each reporting unit.

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.

L3 had 13 reporting units at December 31, 2017 and at November 30, 2017 when our annual goodwill impairment assessment was completed. L3 had 9 reporting units at December 31, 2016. The change in reporting units was a result of the segment realignment; effective March 1, 2017, we realigned our Electronic Systems segment, which was separated into two segments named (1) Electronic Systems and (2) Sensor Systems. Our annual impairment tests at November 30, 2017 and 2016 did not result in impairments to goodwill. In addition, the fair value of all of our reporting units exceeded the carrying value of the net assets of those reporting units by more than 20% at November 30, 2017.

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L3’s aggregate balance of goodwill from continuing operations increased by $241 million to $6,615 million at December 31, 2017 from $6,374 million at December 31, 2016 due to increases of $200 million for business acquisitions, net of divestitures and $93 million for foreign currency translation adjustments, partially offset by $52 million reclassified to assets held for sale. The table below presents the number of reporting units and the associated goodwill at December 31, 2017 for each of our reportable segments.

Reportable Segment
Number of
Reporting Units
Aggregate
Goodwill
 
 
(in millions)
Electronic Systems
 
5
 
$
2,813
 
Aerospace Systems
 
1
 
 
1,146
 
Communication Systems
 
1
 
 
1,023
 
Sensor Systems
 
6
 
 
1,633
 
Total
 
13
 
$
6,615
 

To test goodwill for potential impairment, we compare the carrying value of the reporting unit to its fair value. To the extent the carrying value of a reporting unit exceeds its fair value, a goodwill impairment charge is recognized. Our methodology for determining the fair value of a reporting unit uses 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 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.

We performed an interim impairment test during the quarterly period ended September 29, 2017 for the Vertex Aerospace reporting unit and as a result of a decline in the estimated fair value, we recorded an impairment charge of $187 million ($133 million after income taxes) in 2017. The impairment charge is included in the Vertex Aerospace results of operations which are classified as discontinued operations. We performed an interim impairment test in 2015 for the NSS and the Vertex Aerospace reporting units and due to a decline in the estimated fair values we recorded aggregate goodwill impairment charges of $955 million ($46 million classified in continuing operations, for the retained businesses, and $909 million classified in discontinued operations).

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, 2017 were: (1) detailed three-year cash flow projections for each of our reporting units, (2) the expected long-term cash flow growth rates for each of our reporting units (commonly known as Terminal Growth Rates), which approximate the expected long-term nominal growth rate for the U.S. DoD budget, the U.S. economy and the respective industries in which the reporting units operate, expected inflation rates, and specific circumstances for each reporting unit, including contracts or programs ending and expected new business 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. There were no changes to the underlying methods used in 2017 as compared to the prior year DCF valuations of our reporting units.

The WACC for each reporting unit 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 L3’s reporting units (Market Participants), including a risk free rate of return of 2.65% on the 20-year U.S. Treasury Bond at November 30, 2017 (2.73% as of November 30, 2016) and an equity risk premium of 6% (unchanged compared to November 30, 2016), and (2) an after-tax rate of return on Market Participants’ debt, which was derived from a selected corporate bond index having a Baa debt rating, consistent with the credit rating of the Market Participants. Each of the estimated required rate of return on equity and the after-tax rate of return on Market Participants’ debt is weighted by the relative market value percentages of the 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 of Market Participants and the Standard & Poor’s 500 Index over the prior five-year period, (2) the risk free rate of return based on the prevailing market yield on the 20 year U.S. Treasury Bond, (3) the rate of return on corporate bonds having a debt rating consistent with the credit rating of the Market Participants and (4) the relative market value percentages of Market Participants’ equity and debt.

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TABLE OF CONTENTS

The table below presents the weighted average risk adjusted discount rate assumptions in the WACC used in our DCF valuation for each of our reportable segments for our goodwill impairment assessments at November 30, 2017 and 2016.

 
WACC
Reportable Segments
2017
2016
Electronic Systems(1)
 
7.35
%
 
7.44
%
Aerospace Systems
 
7.05
%
 
6.98
%
Communication Systems
 
7.27
%
 
7.21
%
Sensor Systems(2)
 
7.03
%
 
7.00
%
(1) The weighted average risk adjusted discount rate in WACC for the Electronic Systems reportable segment is comprised of separate discount rates for each reporting unit within the segment that range from 7.05% to 7.78% for 2017 and 6.98% to 8.06% for 2016.
(2) The weighted average risk adjusted discount rate in WACC for the Sensor Systems reportable segment is comprised of separate discount rates for each reporting unit within the segment that range from 7.05% to 8.31% for 2017 and 6.98% to 8.01% for 2016.

As presented in the table below, L3’s historical three-year average annual cash flow growth rates for 2017, 2016 and 2015 for our reportable segments ranged from a negative 9% to a positive 8%. The annual cash flows generated by each of our reporting units vary from year to year, and, therefore, the annual cash flow growth rates do not result in linear trends due to a number of factors, including, but 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), (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 2017 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 2017
Cash Flow(1)
Estimated Average Annual Cash Flow Growth Rate(1)
 
(in millions)
2017
2016
2015
3 Yr. Average
Electronic Systems(2)
$
342
 
 
10
%
 
7
%
 
7
%
 
8
%
Aerospace Systems(3)