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| DRCO > SEC Filings for DRCO > Form 10-Q on 10-Nov-2008 | All Recent SEC Filings |
10-Nov-2008
Quarterly Report
The following discussion should be read in conjunction with our condensed consolidated financial statements and the related notes. Unless the context otherwise requires, references in this Form 10-Q to "DRC", "we", "us" or "our" refer to Dynamics Research Corporation and its subsidiaries.
The following discussion also contains non-GAAP financial measures. In evaluating our operating performance, management uses certain non-GAAP financial measures to supplement the consolidated financial statements prepared under generally accepted accounting principles in the United States ("GAAP").
More specifically, we use the following non-GAAP financial measures: non-GAAP operating profit, non-GAAP income before income taxes, non-GAAP provision for income taxes, non-GAAP net income and non-GAAP earnings per share.
Management believes these non-GAAP measures help indicate our operating performance before charges that are considered by management to be outside our ongoing operating results. Accordingly, management uses these non-GAAP measures to gain a better understanding of our comparative operating performance from period-to-period and as a basis for planning and forecasting future periods. Management believes these non-GAAP measures, when read in conjunction with our GAAP financials, provide useful information to investors by offering:
• the ability to make more meaningful period-to-period comparisons of our ongoing operating results;
• the ability to better identify trends in our underlying business and perform related trend analysis;
• a higher degree of transparency for certain expenses (particularly when a specific charge impacts multiple line items);
• a better understanding of how management plans and measures our underlying business; and
• an easier way to compare our most recent results of operations against investor and analyst financial models.
The non-GAAP measures we use exclude the provision for litigation charge and its related tax effect that management believes is unusual and outside of our ongoing operations for the periods presented.
These non-GAAP measures have limitations, however, because they do not include all items of expense that impact our operations. Management compensates for these limitations by also considering our GAAP results. The non-GAAP financial measures we use are not prepared in accordance with, and should not be considered an alternative to, measurements required by GAAP, such as operating loss, net loss and loss per share, and should not be considered measures of our liquidity. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the most directly comparable GAAP measures. In addition, these non-GAAP financial measures may not be comparable to similar measures reported by other companies.
OVERVIEW
Dynamics Research Corporation, headquartered in Andover, Massachusetts, is a leading, innovative provider of solutions and services to federal, state and local governments. We provide support to our customers in the primary mission areas of IT, Logistics and Readiness, Systems Integration and Technical Services, C4ISR (Command, Control, Computers, Communication, Intelligence, Surveillance and Reconnaissance), Homeland Security, Health and Human Services and Intelligence/Space.
On August 1, 2008, DRC completed the acquisition of Kadix as more fully described in Note 3 of our Notes to Condensed Consolidated Financial Statements. The acquisition strengthens and expands our growth as a provider of high-end services and solutions in the homeland security and other federal civilian markets. The operating results of Kadix are included in DRC's results of operations within the Systems and Services segment for the period subsequent to the acquisition date.
We are cognizant of funding challenges facing the federal government and the
resulting increase in competitiveness in our industry. Customers are moving away
from General Services Administration and time and materials contracts toward
agency sponsored Indefinite Delivery/Indefinite Quantity contract vehicles and
fixed price contracts and task orders. The DoD seeks to reduce spending on
contracted program advisory and assistance services and often is setting this
work aside for small businesses. Concurrently, there is increasing demand from
federal customers for engineering, training, business transformation, lean six
sigma, information technology and business intelligence solutions and services.
Many federal customers are seeking to streamline their procurement activities
by consolidating work under large contract vehicles. Our competitive strategy
is intended to align with these trends.
Operating income (loss) for the three months ended September 30, 2008 and 2007 was $(2.3) million and $3.4 million, respectively. Excluding the provision for litigation, operating income for the three months ended September 30, 2008 was $3.7 million and the operating margin was 5.9% of total revenue, compared to 5.8% of total revenue for the three months ended September 30, 2007.
Operating income (loss) for the nine months ended September 30, 2008 and 2007 was $(5.7) million and $8.6 million, respectively. Excluding the provision for litigation, operating income for the nine month periods ended September 30, 2008 and 2007 was $9.1 million and $8.8 million, respectively, and the operating margin was 5.2% and 5.1% of total revenue, respectively.
RECONCILIATION OF NON-GAAP MEASURES
Three Months Ended
September 30,
2008 2007
(in millions) $ (1) % (2) $ (1) % (2)
GAAP operating income (loss) $ (2.3 ) (3.6 )% $ 3.4 5.8 %
Provision for litigation 6.0 9.5 % - -
Non-GAAP operating income $ 3.7 5.9 % $ 3.4 5.8 %
GAAP income (loss) before provision for
income taxes $ (2.7 ) (4.2 )% $ 3.3 5.7 %
Provision for litigation 6.0 9.5 % - -
Non-GAAP income before provision for
income taxes $ 3.3 5.2 % $ 3.3 5.7 %
GAAP provision (benefit) for income
taxes (3) $ (2.4 ) 91.3 % $ 1.4 42.6 %
Tax benefit for provision for litigation
(3) 3.6 60.6 % - -
Non-GAAP provision for income taxes (3) $ 1.2 35.9 % $ 1.4 42.6 %
GAAP net income (loss) $ (0.2 ) (0.4 )% $ 1.9 3.3 %
Provision for litigation, net of tax
benefit 2.4 3.7 % - -
Non-GAAP net income $ 2.1 3.4 % $ 1.9 3.3 %
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Nine Months Ended
September 30,
2008 2007
(in millions) $ (1) % (2) $ (1) % (2)
GAAP operating income (loss) $ (5.7 ) (3.3 )% $ 8.6 5.0 %
Provision for litigation 14.8 8.5 % 0.2 0.1 %
Non-GAAP operating income $ 9.1 5.2 % $ 8.8 5.1 %
GAAP income (loss) before provision for
income taxes $ (6.2 ) (3.5 )% $ 7.9 4.6 %
Provision for litigation 14.8 8.5 % 0.2 0.1 %
Non-GAAP income before provision for
income taxes $ 8.6 4.9 % $ 8.1 4.7 %
GAAP provision (benefit) for income
taxes (3) $ (2.3 ) 37.8 % $ 3.3 42.2 %
Tax benefit for provision for litigation
(3) 5.8 38.8 % 0.1 39.8 %
Non-GAAP provision for income taxes (3) $ 3.4 39.6 % $ 3.4 42.1 %
GAAP net income (loss) $ (3.9 ) (2.2 )% $ 4.6 2.6 %
Provision for litigation, net of tax
benefit 9.1 5.2 % 0.1 0.1 %
Non-GAAP net income $ 5.2 3.0 % $ 4.7 2.7 %
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(1) Totals may not add due to rounding.
(2) Represents a percentage of total revenue of $175.3 million and $173.1 million in the nine months ended September 30, 2008 and 2007, excluding the percentages for provision for income taxes and the tax benefit for provision for litigation.
(3) The percent amounts represent a percentage of GAAP income (loss) before provision for income taxes, provision for litigation and non-GAAP income before provision for income taxes, respectively.
We have two reportable business segments: Systems and Services and Metrigraphics. The Systems and Services segment accounted for approximately 97% of total revenue and the Metrigraphics segment accounted for approximately 3% of total revenue for the nine months ended September 30, 2008.
RESULTS OF OPERATIONS
Operating results expressed as a percentage of segment and total revenue are as
follows:
Three Months Ended September 30,
2008 2007
(in millions) $ (1) % $ (1) %
Contract revenue $ 62.3 98.1 % $ 57.2 98.0 %
Product sales 1.2 1.9 1.1 2.0
Total revenue $ 63.5 100.0 % $ 58.3 100.0 %
Gross profit on contract revenue (2) $ 10.0 16.1 % $ 9.4 16.4 %
Gross profit (loss) on product sales (2) (0.1 ) (6.7 )% (0.1 ) (5.6 )%
Total gross profit (2) 10.0 15.7 % 9.3 16.0 %
Selling, general and administrative 5.5 8.7 % 5.3 9.0 %
Provision for litigation 6.0 9.5 % - -
Amortization of intangible assets 0.7 1.1 % 0.7 1.1 %
Operating income (2.3 ) (3.6 )% 3.4 5.8 %
Interest expense, net (0.4 ) (0.7 )% (0.4 ) (0.6 )%
Other income, net 0.0 0.1 % 0.3 0.6 %
Provision (benefit) for income taxes (3) (2.4 ) 91.3 % 1.4 42.6 %
Net income $ (0.2 ) (0.4 )% $ 1.9 3.3 %
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Nine months Ended September 30,
2008 2007
(in millions) $ (1) % $ (1) %
Contract revenue $ 170.8 97.4 % $ 170.1 98.3 %
Product sales 4.5 2.6 3.0 1.7
Total revenue $ 175.3 100.0 % $ 173.1 100.0 %
Gross profit on contract revenue (2) $ 26.7 15.6 % $ 27.9 16.4 %
Gross profit (loss) on product sales (2) 0.2 4.7 % (0.6 ) (18.8 )%
Total gross profit (2) 26.9 15.4 % 27.4 15.8 %
Selling, general and administrative 16.1 9.2 % 16.6 9.6 %
Provision for litigation 14.8 8.5 % 0.2 0.1 %
Amortization of intangible assets 1.7 1.0 % 2.0 1.1 %
Operating income (loss) (5.7 ) (3.3 )% 8.6 5.0 %
Interest expense, net (0.7 ) (0.4 )% (1.3 ) (0.8 )%
Other income, net 0.2 0.1 % 0.6 0.3 %
Provision (benefit) for income taxes (3) (2.3 ) 37.8 % 3.3 42.2 %
Net income (loss) $ (3.9 ) (2.2 )% $ 4.6 2.6 %
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(1) Totals may not add due to rounding.
(2) The percent amounts represent a percentage of contract revenues, product sales and total revenues, respectively.
(3) The percentage of provision for income taxes relates to a percentage of income (loss) before income taxes.
Revenues
Total revenues were $63.5 million for the third quarter of 2008 compared with $58.3 million for the same period in 2007, up 8.9% on a reported basis. The organic growth rate for the quarter was 1.5%, calculated by including the August and September 2007 Kadix revenues of $4.2 million in the base period. Our revenues for the nine months ended September 30, 2008 and 2007 were $175.3 million and $173.1 million, respectively, representing an increase of $2.2 million or 1.2% from the same period in 2007.
Contract Revenues
Contract revenues in our Systems and Services segment were earned from the
following sectors:
Three Months Ended September 30,
2008 2007
(in millions) $ (1) % (1) $ (1) % (1)
National defense and intelligence agencies $ 39.9 64.0 % $ 45.3 79.2 %
Federal civilian agencies 9.6 15.4 7.2 12.6
Homeland security 6.1 9.8 0.9 1.6
State and local government agencies 6.2 10.0 3.5 6.2
Other 0.5 0.8 0.2 0.4
Total contract revenue $ 62.3 100.0 % $ 57.2 100.0 %
Nine months Ended September 30,
2008 2007
(in millions) $ (1) % (1) $ (1) % (1)
National defense and intelligence agencies $ 118.0 69.1 % $ 134.8 79.3 %
Federal civilian agencies 23.0 13.5 21.4 12.6
Homeland security 9.1 5.3 2.5 1.5
State and local government agencies 18.8 11.0 10.8 6.4
Other 1.9 1.1 0.5 0.3
Total contract revenue $ 170.8 100.0 % $ 170.1 100.0 %
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(1) Totals may not add due to rounding.
The decrease in revenues from national defense and intelligence agencies in the three and nine months ended September 30, 2008 compared to the same periods in 2007 was due to decreased revenues derived from the U.S. Air Force ASC small business set-aside CAPS contract and the transition from the U.S. Air Force Electronic Systems Center ("ESC") full and open ITSP II contract to the small business set-aside PASS contract.
Revenues derived from the CAPS contract during the three and nine months ended September 30, 2008 were $4.9 million and $14.3 million, respectively, compared to $5.7 million and $18.2 million for the three and nine months ended September 30, 2007, respectively.
In January 2008, we purchased from THE CENTECH GROUP, Inc., a prime CAPS contract, on which minimal work was being performed. While awaiting the government's decision on approval of the contract novation, through the CENTECH contract we have won numerous task order re-competitions. We have received notification that the U.S. Air Force has denied CENTECH's request to novate their CAPS contract to DRC. CENTECH and we are currently considering avenues for reconsideration of this decision. Because we are able to continue to perform as a subcontractor on the CENTECH CAPS contract, our assessment is that this decision does not put our current work being performed under this contract at risk.
Revenues derived from ESC PASS contract and its predecessor ITSP II contract during the three and nine months ended September 30, 2008 were $1.2 million and $7.3 million, respectively, compared to $5.9 million and $18.2 million for the three and nine months ended September 30, 2007, respectively. Because the PASS contract was re-competed as a small business set-aside, and certain engineering work previously performed by the Company under ITSP II was directed to a new contract, for which the Company did not receive an award, the Company's revenues with the ESC in 2008 will be approximately $12 million lower than in 2007.
The increase in revenues from federal civilian agencies and Homeland Security in the three and nine months ended September 30, 2008 compared to the same periods in 2007 was primarily due to added revenues from Kadix and increased revenues from the Federal Deposit Insurance Corporation contract.
The increase in revenues from state and local government agencies in the three and nine months ended September 30, 2008 compared to the same period in 2007 was primarily due to additional change orders under the State of Ohio contract during 2007 and 2008. With the completion of the implementation phase of the Ohio project in October 2008, revenues derived from the project, which were $1.7 million and $9.7 million for the three and nine months ended September 30, 2008, and are anticipated at a reduced level for the last quarter of the year. Revenues for the State of Ohio in the three months and nine months ended September 30, 2007 were $2.1 million and $5.8 million, respectively. Concurrently, in the second quarter of this year we began a new child welfare system development project with the State of Tennessee, which generated $3.0 million and $4.3 million of revenues in the three and nine months ended September 30, 2008.
Revenues by contract type as a percentage of Systems and Services revenues were as follows:
Three Months Ended Nine months Ended
September 30, September 30,
2008 2007 2008 2007
Time and materials 49 % 59 % 50 % 57 %
Cost reimbursable 33 21 31 22
Fixed price, including service type contracts 18 20 19 21
100 % 100 % 100 % 100 %
Prime contract 68 % 51 % 61 % 52 %
Sub-contract 32 49 39 48
100 % 100 % 100 % 100 %
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Product Sales
Product sales for our Metrigraphics segment were $1.2 million and $1.1 million in the three months ended September 30, 2008 and 2007, respectively, and $4.5 million and $3.0 million, respectively, in the nine months then ended. The increase in product sales from the prior year comparable periods was primarily due to higher sales to a new medical device customer.
Funded Backlog
Our funded backlog was $148.4 million at September 30, 2008 compared to $116.5 million at December 31, 2007. We expect that substantially all of our backlog will generate revenue during the subsequent twelve month period.
Gross Profit
Total gross profit was $10.0 million and $9.3 million for the three months ended September 30, 2008 and 2007, respectively, resulting in a gross margin of 15.7% and 16.0% for the third quarters of 2008 and 2007, respectively. For the nine months ended September 30, 2008 and 2007, the total gross profit was $26.9 million and $27.4 million, respectively, resulting in a gross margin of 15.4% and 15.8%, respectively.
Our gross profit on contract revenue was $10.0 million and $9.4 million for the three months ended September 30, 2008 and 2007, respectively, and $26.7 million and $27.9 million for the respective nine months then ended. The change in gross profit on contract revenue resulted in a gross margin of 16.1% and 16.4% in the third quarters of 2008 and 2007, respectively, and 15.6% and 16.4% in the respective nine months then ended. The decrease in gross margin in both comparable periods was primarily attributable to costs associated with workforce reductions, partially offset by lower indirect cost.
During the first half of 2008, we learned that our work on the Navy's Trident Missile program would be curtailed significantly in the second half of 2008. The gross profit for the nine months ended September 30, 2008 includes a provision of $753 for such work force reduction caused by this curtailment.
Our gross loss on product sales was $0.1 million in the third quarters of 2008 and 2007, and $0.6 in the nine month period in 2007. Our gross margin on product sales was $0.2 million for the nine months ended September 30, 2008. The increase in gross profit in the comparable nine month periods was primarily attributable to higher medical device sales.
Selling, general and administrative expenses
Selling, general and administrative expenses were $5.5 million and $5.3 million in the three months ended September 30, 2008 and 2007, respectively, and $16.1 million and $16.6 million for the respective nine months then ended. Selling, general and administrative expenses as a percent of total revenue in the third quarter of 2008 and 2007 were 8.7% and 9.0%, respectively, and 9.2% and 9.6% for the respective nine months then ended. Selling, general and administrative expenses were higher in the third quarter of 2008 compared to 2007 due to the addition of Kadix' selling, general and administrative expenses, partially offset by lower deferred compensation costs and stock compensation costs. Selling, general and administrative expenses were lower in the nine months ended September 30, 2008 compared to September 30, 2007 due to lower deferred compensation costs, legal costs and stock compensation costs, partially offset by the addition of Kadix' selling, general and administrative expenses.
At September 30, 2008, the market value of the pension plan assets was $55.3 million, a decline of $12.8 million since December 31, 2007. As a result, we are anticipating that the unfunded status will increase significantly at December 31, 2008 as compared to the funded status of $0.7 million recorded at December 31, 2007. In accordance with SFAS No. 87 and SFAS No. 158, at December 31, 2008 we will record an increase in plan liabilities and change accumulated other comprehensive income, a component of shareholders' equity, to reflect any increase in the difference between plan assets and plan liabilities. We also anticipate that the decline in the value of plan assets will likely result in net periodic pension expense in 2009 rather than the net periodic pension income recorded in 2008. The periodic pension expenses for 2009 will not be determined prior to December 31, 2008.
Provision for litigation
During the third quarter of 2008, we increased the accrual for litigation to $15.0 million from $9.0 million in the first quarter of 2008 and from $0.2 million in 2007 based on a tentative settlement agreement. Further discussion related to this ruling is referenced in Note 14 of our Notes to Condensed Consolidated Financial Statements.
Amortization of intangible assets
Amortization expense was $0.7 million in the third quarters of 2008 and 2007,
and $1.7 million and $2.0 million for the respective nine months then
ended. Amortization expense of $0.2 million relates to intangible assets
acquired in our acquisition of Kadix and the remaining amount relates to
intangible assets acquired in our 2004 acquisition of Impact Innovations Group
LLC. The remaining amortization expense for the last quarter of 2008 related to
both acquisitions is expected to be approximately $0.8 million.
Interest expense, net
We incurred interest expense of $0.4 million in the third quarters of 2008 and 2007, and $0.7 million and $1.3 million for the respective nine months then ended. The increase in interest expense in the third quarter of 2008 compared to prior 2008 quarters was due to the addition of the $40 million term loan used to finance the Kadix acquisition. We anticipate interest expense on the term loan to be approximately $0.5 million in the fourth quarter of 2008.
Other income (expense), net
We recorded $0.2 million and $0.6 million of other income in the first nine months of 2008 and 2007, respectively. In the first quarter of 2008, we recorded $0.1 million of realized gains resulting from the sale of shares of common stock of an actively traded public entity. Other income also includes recognition of our portion of earnings in HMRTech. Our earnings related to this equity investment were $0.4 million in both nine month periods of 2008 and 2007.
Income tax provision
For the nine months ended September 30, 2008, the effective income tax rate excluding the $14.8 million litigation provision was 39.6%. We have estimated the tax benefits associated with the litigation provision at $5.8 million. The effective income tax rate for the comparable prior year period excluding the litigation provision recorded in the nine months ended September 30, 2007 was 42.1%. The pool of excess tax benefits has been depleted and as a result any future SFAS 123(R) tax deficiencies will be recorded directly to earnings. The effective tax rate for the year ended December 31, 2007 was 39.7%, reflecting adjustments to tax accruals and reserves plus favorable effects of tax credits and state tax audits.
LIQUIDITY AND CAPITAL RESOURCES
The following discussion analyzes liquidity and capital resources by operating, investing and financing activities as presented in our Condensed Consolidated Statements of Cash Flows. Our principal sources of liquidity are cash flows from operations and borrowings from our revolver.
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