SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the year ended October 31, 2005 Commission file number 0-13880
ENGINEERED SUPPORT SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
Missouri 43-1313242
(State of Incorporation) (IRS Employer Identification No.)
201 Evans Lane, St. Louis, Missouri 63121
(Address of principal executive offices) (Zip Code)
Registrant's telephone number including area code: (314) 553-4000
Securities registered pursuant to Section 12(b) of the Securities Exchange
Act of 1934: None
Securities registered pursuant to Section 12(g) of the Securities Exchange
Act of 1934:
Title of each class
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Common stock, $.01 par value
Indicate by check mark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act. Yes [ ]. No [X].
Indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ]. No [X].
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 requirement for the past 90 days. Yes [X]. No [ ].
Indicate by check mark if disclosure of delinquent filers pursuant
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the Registrant's knowledge, in the 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 an accelerated
filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes [X]. No [ ].
Indicate by check mark whether the registrant is a shell company
(as defined in Rule 12b-2 of the Exchange Act). Yes [ ]. No [X].
Based on the closing price on April 30, 2005, the aggregate market
value of the voting stock held by non-affiliates of the Registrant was
approximately $1,420,768,494.
The number of shares of the Registrant's common stock, $.01 par
value, outstanding at December 20, 2005 was 41,960,035.
DOCUMENTS INCORPORATED BY REFERENCE
None.
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PART I
ITEM 1. BUSINESS
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Engineered Support Systems, Inc. (ESSI) is a holding company for 14
wholly-owned operating subsidiaries. These subsidiaries are organized within
ESSI's two business segments: Support Systems and Support Services. The
Support Systems segment includes the operations of Systems & Electronics
Inc. (SEI), Keco Industries, Inc. (Keco), Engineered Air Systems, Inc.
(Engineered Air), Engineered Coil Company, d/b/a Marlo Coil (Marlo Coil),
Engineered Electric Company, d/b/a Fermont (Fermont), Universal Power
Systems, Inc. (UPSI), Engineered Environments, Inc. (EEi), Pivotal Power
Inc. (Pivotal Power), Prospective Computer Analysts Incorporated (PCA) and
Mobilized Systems, Inc. (Mobilized Systems). The Support Services segment
includes the operations of Technical and Management Services Corporation
(TAMSCO), Radian, Inc. (Radian), Spacelink International, LLC (Spacelink)
and ESSIbuy.com, Inc. (ESSIbuy). Substantially all revenues within these two
segments are directly or indirectly derived from contracts with the U.S.
Department of Defense (DoD) and certain foreign militaries.
Engineered Air was incorporated under the laws of the State of
Missouri in December 1981 and acquired the assets of the Defense Systems
Division of Allis-Chalmers Corporation in March 1982. ESSI was incorporated
under the laws of the State of Missouri in December 1983, and exchanged all
of its outstanding common stock for two-thirds of the common stock of
Engineered Air held by ESSI's founders. ESSI purchased the remaining
one-third of the common stock of Engineered Air in January 1984. ESSI
effected its initial public offering in August 1985. In March 1993, ESSI
purchased all of the outstanding stock of Associated Products, Inc.
(subsequently changed to Engineered Specialty Plastics, Inc. (ESP)).
Effective February 1998, Engineered Coil Company acquired substantially all
of the net assets of Nuclear Cooling, Inc., d/b/a Marlo Coil. In June 1998,
ESSI acquired all of the outstanding common stock of Keco. In February 1999,
Engineered Electric Company acquired substantially all of the net assets of
the Fermont Division of Dynamics Corporation of America, d/b/a Fermont. In
September 1999, ESSI acquired all of the outstanding common stock of SEI. In
May 2002, ESSI acquired all the outstanding common stock of Radian. In June
2002, ESSI acquired all the outstanding stock of UPSI. In May 2003, ESSI
acquired all of the outstanding stock of TAMSCO. In September 2003, ESSI
acquired all of the outstanding stock of EEi. In December 2003, ESSI
acquired all of the outstanding stock of Pivotal Power. In January 2005,
ESSI acquired all of the outstanding stock of PCA. In February 2005, ESSI
acquired all the outstanding membership interests of Spacelink. In May 2005,
ESSI acquired all the outstanding equity of Mobilized Systems.
On September 21, 2005, ESSI and DRS Technologies, Inc. (DRS)
entered into a definitive agreement which provides for the acquisition by
DRS of all the outstanding common stock of ESSI for approximately $1.9
billion, or $43.00 per share (subject to possible adjustment), through a
combination of cash and DRS common stock. Pending customary regulatory
approvals and other closing conditions, including approval by ESSI and DRS
shareholders, the transaction is expected to close on or about January 31,
2006.
PRODUCTS AND SERVICES
As described above, ESSI's operations currently are organized into
two business segments: Support Systems and Support Services. The Support
Systems segment designs, engineers and manufactures integrated military
electronics and other military support equipment primarily for the DoD, as
well as related heat transfer and air handling equipment for domestic
commercial and industrial users. The Support Services segment provides
engineering services, logistics and training services, advanced technology
services, asset protection systems and services, telecommunication systems
integration and information technology services primarily for the DoD. The
Support Services segment also provides certain power generation and
distribution equipment and vehicle armor installation to the DoD.
For financial information regarding ESSI's business segments, see
"Management Discussion and Analysis of Financial Condition and Results of
Operations," and Note L to the Consolidated Financial Statements for the
year ended October 31, 2005 included elsewhere within this Annual Report on
Form 10-K.
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ENGINEERING AND DESIGN
As ESSI has grown both internally and through acquisition, it
significantly has increased its engineering capabilities. As of October 31,
2005, ESSI has 1,165 people engaged in engineering activities that encompass
advanced development, engineering research and development, product
improvement and evolution, new product development, productionization,
logistic and life-cycle support, product re-engineering and support
services. ESSI believes its depth of engineering capabilities allows it to
cover all phases of a project from conception to full-life cycle support.
The majority of ESSI's development activities are conducted under,
and funded directly or indirectly through, DoD contracts in response to
designated performance specifications. ESSI's expenditures on internal
research and development (IRAD) were approximately $4.6 million, $4.3
million and $2.9 million for the years ended October 31, 2005, 2004 and
2003, respectively.
ESSI's engineering expertise is complementary to the military
markets it serves, primarily the environmental control, power, electronics,
heavy mechanical and material handling, security, communications, service
and logistical support markets. ESSI has engineering capabilities in the
areas of system design and analysis, electronic signal processing, power
electronics, software, firmware, mechanical design, control,
electro-mechanical, electro-optical, electro-chemical, acoustics,
thermodynamics, fluid and air flow, fluid pumping, HVAC, liquid fuel
combustion, chemical and biological hardened environmental control,
filtration and decontamination, power system analysis, environmental control
system analysis, stress analysis, water treatment analysis, water
purification technology, radar, target acquisition systems, automatic test
equipment, communication system analysis and all the logistic support
disciplines to include reliability, maintainability, embedded diagnostics
and prognostics, training and the development of web-based interactive
electronic technical manuals. ESSI's subsidiaries within the Support
Services segment have engineering expertise in fields such as re-engineering
obsolete mechanical and electronic products, nano-hardened products,
security system design, fuel cells and super critical reformation. ESSI's
engineering expertise has significant overlap throughout its operating
subsidiaries, allowing it to leverage engineering personnel and
technologies, and to function as an integrated team.
ESSI's design and development of new products is enhanced by a
number of computer-aided design and manufacturing (CAD/CAM) systems as well
as a number of automated system design and analysis tools. CAD/CAM tools are
used by both engineers and draftsmen to design and validate complex products
and component parts. ESSI utilizes both two- and three-dimensional CAD/CAM
tools, providing both design and production engineers an interactive
environment with which to view the final product and all the relevant
interfaces. These tools are compatible across all of ESSI's operating
subsidiaries, allowing for virtual design and development without regard to
geographical location. ESSI's engineering technologies and expertise provide
it with the ability to adapt its production processes to new product needs
on a timely basis. ESSI also has the capability to provide complete
technical data support for the products it manufactures to include
integrated logistics support, spare parts provisioning and preparation of
technical manuals.
ESSI intends to leverage its engineering and design capabilities to
continue to develop and evolve differentiated products and services that
address both the current and future needs of the DoD for rapid deployment,
smaller, lighter and more efficient equipment, and for innovative,
value-added service offerings.
MARKETING AND BUSINESS DEVELOPMENT
ESSI's business development efforts are undertaken at two
functional levels. ESSI's corporate operation focuses on long-term strategic
planning, policy development, best practice identification and
dissemination, and on major programs which require the bundling of products
and services across traditional subsidiary lines. In addition, ESSI's
corporate Washington D.C. operations interface with service staffs within
the Pentagon and liaisons with key
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Congressional delegations. At the subsidiary level, a sales force is engaged
to identify and pursue programs with specific customers in a variety of
markets. With increased emphasis on ESSI's vision for the future, efforts
have begun to strengthen the long-term strategic planning process.
Market-based peer groups enable experts throughout ESSI to share knowledge
and collectively recommend direction and strategy. These peer groups also
evaluate market intelligence, customer knowledge and core competencies to
refine ESSI's growth strategies.
ESSI's Business Development Organization meets on a regular basis
to identify and disseminate best practices in the areas of proposal
development and market presence. The sales force shares customer and market
intelligence, identifies key opportunities and assesses campaign strategies.
ESSI gathers information from primary sources such as the DoD budget and its
supporting documents, and military requirements documents such as Initial
Capabilities Documents, along with direct interface with its customers. ESSI
analyzes this data and then determines whether or not to bid on specific
projects based upon determinations of potential profitability and the
likelihood of award.
PURCHASED COMPONENTS AND RAW MATERIALS
ESSI's products require a wide variety of components and materials.
Although ESSI has multiple sources of supply for most of its material
requirements, sole-source vendors supply certain components, and ESSI's
ability to perform certain contracts depends on their performance. In the
past, these required raw materials and various purchased components
generally have been available in sufficient quantities.
GOVERNMENT CONTRACTING
ESSI's government contracts are obtained through the DoD
procurement process as governed by the Federal Acquisition Regulations and
related regulations and agency supplements, and are typically fixed-price
contracts. This means that the price is agreed upon before the contract is
awarded and ESSI assumes complete responsibility for any difference between
estimated and actual costs. For the fiscal year ended October 31, 2005,
approximately 64% of ESSI's revenues were derived from fixed-price contracts.
Under the Truth in Negotiations Act of 1962 (Negotiations Act), the
U.S. government has the right for three years after final payment on certain
negotiated contracts, subcontracts and modifications, to determine whether
ESSI furnished the U.S. government with complete, accurate and current cost
or pricing data as defined by the Negotiations Act. If ESSI fails to satisfy
this requirement, the U.S. government has the right to adjust a contract or
subcontract price by the amount of any overstatement as defined by the
Negotiations Act.
U.S. government contracts permit the U.S. government to
unilaterally terminate these contracts at its convenience. In the event of
such termination, ESSI is entitled to reimbursement for certain expenditures
and overhead as provided for in applicable U.S. government procurement
regulations. Generally, this results in the contractor being reasonably
compensated for work actually done, but not for anticipated profits. The
U.S. government also may terminate contracts for cause if ESSI fails to
perform in strict accordance with contract terms. Termination of, or
elimination of appropriation for, a significant government contract could
have a material adverse effect on ESSI's business, financial condition and
results of operations in subsequent periods. Similarly, U.S. government
contracts typically permit the U.S. government to change, alter or modify
the contract at its discretion. If the U.S. government were to exercise this
right, ESSI could be entitled to reimbursement of all allowable and
allocable costs incurred in making the change plus a reasonable profit.
For manufactured items, the U.S. government typically finances a
substantial portion of ESSI's contract costs through progress payments. In
each such case, ESSI receives progress payments in accordance with DoD
contract terms which provide progress payments at 75% to 90% of costs
incurred.
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INTELLECTUAL PROPERTY
ESSI owns various patents and other forms of intellectual property.
From time to time, ESSI develops proprietary information and trade secrets
regarding the design and manufacture of various products. ESSI considers its
proprietary information and intellectual property to be valuable assets.
However, ESSI's business is not materially dependent on their protection.
COMPETITION
The markets for all of ESSI's products and services are highly
competitive. In order to obtain U.S. government contracts, ESSI must comply
with detailed and complex procurement procedures adopted by the DoD pursuant
to regulations promulgated by the U.S. government. ESSI believes the
regulations and procurement procedures are adopted to promote competitive
bidding. In addition, ESSI competes with a large number of suppliers to
commercial and industrial air handling customers. In all phases of its
operations, ESSI competes in both performance and price with companies, some
of which are considerably larger, more diversified and have greater
financial resources than ESSI.
BACKLOG
ESSI records its backlog as either funded or unfunded backlog.
ESSI's funded backlog was $689.8 million and $588.1 million as of October
31, 2005 and 2004, respectively. ESSI's funded backlog is subject to
fluctuations and is not necessarily indicative of future revenues. Funded
backlog represents products or services that the customer has committed by
contract to purchase from ESSI. Unfunded backlog includes products or
services that the customer has the option to purchase under contract with
ESSI, including, with respect to contracts which include a maximum amount
purchasable by the customer thereunder, such maximum amount, and with
respect to contracts without a specified maximum amount, ESSI's estimate of
the amount it expects the customer to purchase using the Best Estimated
Quantity (BEQ) as a guide where a BEQ is specified. There are no commitments
by the customer to purchase products or services included in unfunded
backlog and there can be no assurance that any or all amounts included
therein will generate revenue for ESSI. Moreover, cancellations of purchase
orders or reductions of product quantities or levels of service to be
provided in existing contracts could substantially reduce ESSI's funded
backlog and, consequently, future net revenues. Failure of ESSI to replace
canceled or reduced backlog, whether funded or unfunded, could have a
material adverse effect on ESSI's business, financial condition and results
of operations in subsequent periods.
The following table summarizes funded and unfunded defense backlog
(in millions) as of the indicated dates:
Funded Unfunded
Defense Backlog Defense Backlog
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October 31, 2005 $689.8 $1,487.1
October 31, 2004 588.1 849.2
October 31, 2003 533.4 922.8
October 31, 2002 350.1 868.6
October 31, 2001 291.7 681.8
EMPLOYEES
As of October 31, 2005, ESSI employed 3,673 persons, of which 1,196
were engaged in manufacturing activities, 1,165 in engineering activities
and 1,312 in services activities, office administration and management
functions. District No. 9 of the International Association of Machinists and
Aerospace Workers (AFL-CIO) represents 287 employees under a collective
bargaining agreement, which expires March 21, 2008.
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ESSI considers its overall employee relations to be satisfactory.
GEOGRAPHIC AREAS
The following table summarizes (in thousands) ESSI's net revenues
attributed to the United States and to foreign countries:
Year Ended United Foreign Total
October 31 States Countries Revenues
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2005 $993,288 $25,085 $1,018,373
2004 853,286 30,344 883,630
2003 556,809 15,892 572,701
ESSI attributes foreign net revenues based on the domicile of the
purchaser of the product or service.
Of the $702.2 million of ESSI's total assets as of October 31,
2005, $13.9 million were located in countries other than the United States.
FILING OF PERIODIC REPORTS
ESSI regularly files periodic reports with the Securities and
Exchange Commission (SEC), including annual reports on Form 10-K and
quarterly reports on Form 10-Q, as well as, from time to time, current
reports on Form 8-K and amendments to those reports. These filings are
available free of charge on ESSI's website at www.engineeredsupport.com, as
soon as reasonably practicable after their electronic filing with the SEC.
ITEM 1A RISK FACTORS
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In addition to historical information, this Annual Report on Form
10-K contains or may contain certain forward-looking statements, within the
safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Generally, the words "will," "may," "should," "continue," "believes,"
"expects," "intends," "anticipates," "estimates" or similar expressions
identify forward-looking statements, These forward-looking statements
involve certain risks and uncertainties. Factors that could cause actual
results to differ materially from those contemplated by the forward-looking
statements include, among others, the risks and uncertainties identified
below.
THE OBLIGATIONS OF ESSI AND DRS TO COMPLETE THE PROPOSED MERGER ARE
SUBJECT TO THE SATISFACTION OR WAIVER OF CERTAIN CONDITIONS. THE FAILURE TO
SATISFY THESE CONDITIONS COULD RESULT IN TERMINATION OF THE MERGER
AGREEMENT, WHICH WOULD HAVE A MATERIAL ADVERSE EFFECT ON ESSI.
A number of conditions must be satisfied before the proposed merger
between ESSI and DRS will be completed. These include among others:
o the receipt of the approval of the issuance of shares of DRS
common stock in the merger by DRS stockholders and the approval of
the merger agreement and the transactions contemplated by the
merger agreement by ESSI shareholders;
o the absence of any legal restraints or prohibitions preventing the
completion of the merger, or making such completion illegal;
o the receipt of all governmental and regulatory authorizations,
consents, waivers, orders, approvals, or declarations required to
consummate the merger, except as would not be reasonably expected
to result in a material adverse effect on ESSI;
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o the representations and warranties of each party contained in the
merger agreement being true and correct in all material respects;
o each party must have performed, in all material respects, all of
its obligations under the merger agreement at or prior to the
effective time of the merger agreement; and
o the absence of events or developments since the date of the merger
agreement that would reasonably be expected to have a material
adverse effect with respect to either party.
ESSI can give no assurance that all of the conditions to the merger
will be either satisfied or waived or that the merger will occur. The failure
to satisfy these conditions could result in termination of the merger
agreement, which would have a material adverse effect on ESSI. The proposed
merger between DRS and ESSI is discussed in Note P to the Consolidated
Financial Statements included elsewhere in this Annual Report on Form 10-K.
THE MERGER AGREEMENT MAY BE TERMINATED PRIOR TO COMPLETION OF THE
MERGER, WHICH WOULD HAVE A MATERIAL ADVERSE EFFECT ON ESSI.
DRS and ESSI mutually may agree in writing, at any time before the
effective time of the merger, to terminate the merger agreement. Also,
either DRS or ESSI may terminate the merger agreement in a number of
circumstances, including if:
o the merger is not consummated by June 30, 2006 through no fault
of the party seeking to terminate the merger agreement;
o there is a final, non-appealable injunction, judgment or other
order, or law which prohibits the merger;
o the ESSI board of directors authorizes ESSI to enter into an
agreement with respect to a superior proposal;
o ESSI shareholders fail to approve the merger agreement and the
transactions contemplated by the merger agreement at the ESSI
special meeting or at an adjournment of that meeting;
o DRS stockholders fail to approve the issuance of shares of DRS
common stock in the merger at the DRS special meeting or at an
adjournment of that meeting; or
o the party seeking termination is not in material breach of the
merger agreement and the other party has materially breached a
representation, warranty, covenant or agreement of that party
contained in the merger agreement and such breach has not been
cured within 15 days of notice of the breach.
ESSI may terminate the merger agreement to accept an acquisition
proposal that is more favorable to ESSI and ESSI's shareholders from a
financial point of view than the proposed merger with DRS. ESSI must pay DRS
a termination fee of $60.0 million, plus up to $10.0 million in costs and
expenses of DRS in connection with the transactions contemplated by the
merger agreement, if the merger agreement is terminated due to ESSI's board
of directors authorizing ESSI to enter into an acquisition agreement with a
third party or if DRS terminates the merger agreement due to ESSI's board of
directors withdrawing its approval or recommendation of the proposed merger,
modifying its recommendation of the merger agreement in a manner adverse to
DRS or failing to recommend against any tender or exchange offer that
constitutes an alternative proposal. ESSI also must pay these fees and
expenses if ESSI or DRS terminates the merger agreement because the merger
has not been completed by the outside date or ESSI shareholders fail to
approve the merger agreement, an alternative proposal with respect to ESSI
shall have been publicly announced prior to such termination and ESSI enters
into or completes any merger or extraordinary transaction within twelve
months of the termination.
DRS may terminate the merger agreement if the financing contemplated
by the merger agreement is not available on substantially the terms and
conditions identified in DRS's financing commitment letter, or on other
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terms or pursuant to other financing arrangements reasonably acceptable to
DRS, but DRS will not have the right to terminate for this reason if its
failure to fulfill its obligations to obtain financing is the cause of the
failure of financing to become available. ESSI may terminate the merger
agreement if DRS's financing contemplated in the merger agreement is not
available and DRS fails to enter into a substitute commitment letter or
alternate arrangements with other financing sources within 20 business days
of advising ESSI of the unavailability of such financing or substitute
financing. Under the merger agreement, DRS must pay ESSI $20.0 million in
liquidated damages upon such termination by DRS or ESSI.
ESSI can give no assurance that the merger agreement will not be
terminated prior to completion of the merger or that the merger will occur.
Termination of the merger agreement, other than in respect of a superior
transaction that actually closes, would have a material adverse effect on
ESSI operations.
DRS MAY NOT BE ABLE TO OBTAIN FINANCING TO PAY THE CASH PORTION OF
THE MERGER CONSIDERATION.
In addition to the issuance of common stock, DRS intends to finance
the merger using a portion of available cash on hand, borrowings provided
for under the commitment letter issued by Bear, Stearns & Co. Inc. and
its affiliates (Bear Stearns) and Wachovia Capital Markets, LLC and its
affiliates (Wachovia) for a $706.9 million senior secured credit facility
consisting of a $356.9 million seven-year term loan and a $350.0 million
six-year revolving credit facility and through the issuance of a combination
of senior fixed-rate notes, senior floating-rate notes, senior subordinated
notes and/or convertible notes in an aggregate principal amount of $950.0
million. DRS has entered into a commitment with Bear Stearns and Wachovia
for the term loan and revolving credit facility. DRS also has entered into a
separate commitment letter with each of Bear Stearns and Wachovia for up to
a $950.0 million interim credit facility, if the placement of the permanent
debt financing cannot be consummated by the effective time of the merger.
Each of the commitment letters and the availability of the term loan,
revolving credit facility and interim facility, if necessary, is subject to
certain conditions precedent, including, among other things, that there be
no material adverse effect on ESSI. Therefore, ESSI can give no assurance
that the financing pursuant to the commitment letters will be available.
DRS's proposed offerings of notes pursuant to the permanent debt financing
is subject to market and other customary conditions, including, but not
limited to, general global and U.S. economic conditions, the market for
similar securities, and delivery of customary documents, officer
certifications and representations prior to, or at the time of, the closing
of the notes offering. There can be no assurance that DRS will be able to
complete the notes offering or enter into the term loan, the revolving
credit facility or the interim facility, if necessary, on commercially
reasonable terms, or at all.
As of September 30, 2005, DRS's cash and cash equivalents were
approximately $257.3 million. DRS will not be able to complete the merger if
it is unable to obtain financing. DRS may terminate the merger agreement if
funding to consummate the merger pursuant to financing arrangements on
substantially the terms expected or other terms reasonably acceptable to DRS
shall not have become available. However, DRS will not have this termination
right if the failure to fulfill its obligations under the merger agreement
to obtain such financing is the cause of such financing not becoming
available. ESSI may terminate the merger agreement if DRS's financing
contemplated in the merger agreement is not available and DRS fails to
obtain substitute financing within 20 business days of advising ESSI of the
unavailability of such financing or substitute financing. Under certain
circumstances pursuant to the merger agreement, DRS must pay ESSI $20.0
million in liquidated damages upon such termination by DRS or ESSI.
ESSI CURRENTLY IS SUBJECT TO AN SEC INVESTIGATION THAT COULD
REQUIRE SIGNIFICANT MANAGEMENT ATTENTION AND LEGAL RESOURCES AND COULD HAVE
A MATERIAL ADVERSE EFFECT ON ESSI OR THE COMBINED COMPANY.
In December 2004, ESSI was notified by the Enforcement Division of
the SEC of the issuance of a formal order directing a private investigation
captioned In the Matter of Engineered Support Systems, Inc. and in September
2005, ESSI received notice that the SEC staff had expanded the scope of its
investigation. The investigation is discussed in greater detail under "Item
3--Legal Proceedings" of this Annual Report on Form 10-K. In connection with
the investigation, ESSI and certain of its directors and officers have
received subpoenas and provided information and testimony to the SEC and one
former director and officer who currently is a consultant has received a
so-called Wells notice. ESSI continues to furnish information required by
the SEC and otherwise to cooperate in connection with the
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investigation. ESSI is unable to determine at this time the impact, if any,
which the investigation could have on ESSI or the combined company following
ESSI's proposed merger with DRS as discussed in Note P to the Consolidated
Financial Statements included elsewhere in this Annual Report on Form 10-K.
If ESSI is unable to resolve the SEC investigation before completion of the
merger, it could require significant management attention and legal
resources and could have a material adverse effect on the combined company.
THE VALUE OF THE STOCK COMPONENT OF THE MERGER CONSIDERATION COULD
VARY BASED UPON THE PRICE OF DRS COMMON STOCK.
The merger consideration to be received by ESSI's shareholders in
exchange for each share of ESSI common stock includes $30.10 in cash and a
fraction of a share of DRS common stock to be determined based upon the
average closing sale price of DRS common stock for the ten consecutive
trading day period ending with the second complete trading day before the
closing of the merger. The merger agreement provides that such fraction will
be fixed at 0.2255 if the average price is $57.20 or greater and 0.2756 if
the average price is $46.80 or less. If such average price is less than
$57.20 and greater than $46.80, such fraction will be equal to $12.90
divided by the average price. If the average price is between $57.20 and
$46.80 per share, the total consideration per share of ESSI common stock as
of the date will be valued at $43.00; if the average price is less than
$46.80, the value of the per-share consideration will be less than $43.00,
and if the average price is greater than $57.20, the value of the
consideration per share of ESSI common stock will be greater than $43.00.
Accordingly, ESSI shareholders will not know the value of the stock
component of the merger consideration until after the closing date.
THE REVENUES OF THE COMBINED COMPANY DEPEND ON DRS'S AND ESSI'S
ABILITY TO MAINTAIN LEVELS OF GOVERNMENT BUSINESS. THE LOSS OF CONTRACTS
WITH DOMESTIC AND NON-U.S. GOVERNMENT AGENCIES COULD ADVERSELY AFFECT THE
COMBINED COMPANY'S REVENUES.
Both DRS and ESSI derive the substantial majority of their revenues
from contracts or subcontracts with domestic and non-U.S. government
agencies. A significant reduction in the purchase of products by these
agencies would have a material adverse effect on the businesses of DRS and
ESSI. For fiscal years ended October 31, 2005, 2004 and 2003, approximately
96%, 94% and 95%, respectively, of ESSI's revenues were derived directly or
indirectly from defense industry contracts with the U.S. government and its
agencies. In addition, in each of the fiscal years ended October 31, 2005,
2004 and 2003, approximately 3% of ESSI's revenues were derived directly or
indirectly from sales to foreign governments. Additionally, for fiscal years
ended March 31, 2005, 2004 and 2003, approximately 84%, 85% and 81%,
respectively, of DRS's revenues were derived directly or indirectly from
defense-industry contracts with the U.S. government and its agencies. In
addition, in each of the fiscal years ended March 31, 2005, 2004 and 2003,
less than 14% of DRS's revenues were derived directly or indirectly from
sales to foreign governments. Therefore, the development of the combined
company's business in the future will depend upon the continued willingness
of the U.S. government and its prime contractors to commit substantial
resources to defense programs and, in particular, upon the continued
purchase of ESSI's and DRS's products and other products which incorporate
their respective products, by the U.S. government. In particular, the
current funding demands on the U.S. government combined with a potential
reduction of forces in Iraq, may lead to lower levels of government defense
spending.
The risk that governmental purchases of products may decline stems
from the nature of ESSI's and DRS's business with the U.S. government, in
which the U.S. government may:
o terminate contracts at its convenience;
o terminate, reduce or modify contracts or subcontracts if its
requirements or budgetary constraints change;
o cancel multi-year contracts and related orders if funds become
unavailable;
o shift its spending priorities;
10
o adjust contract costs and fees on the basis of audits done by its
agencies; and
o inquire about and investigate business practices and audit
compliance with applicable rules and regulations.
In addition, as defense businesses, DRS and ESSI are subject to the
following risks in connection with government contracts:
o the frequent need to bid on programs prior to completing the
necessary design, which may result in unforeseen technological
difficulties and/or cost overruns;
o the difficulty in forecasting long-term costs and schedules and
the potential obsolescence of products related to long-term
fixed-price contracts;
o the risk of fluctuations or a decline in government expenditures
due to any changes in the DoD budget or appropriation of funds;
o when DRS or ESSI acts as a subcontractor, the failure or inability
of the primary contractor to perform its prime contract may result
in an inability to obtain payment of fees and contract costs;
o restriction or potential prohibition on the export of products
based on licensing requirements; and
o government contract wins can be contested by other contractors.
THE PRICE OF DRS COMMON STOCK MAY BE AFFECTED BY FACTORS DIFFERENT
FROM THOSE AFFECTING THE PRICE OF ESSI COMMON STOCK.
Holders of ESSI common stock will be entitled to receive cash and
DRS common stock in the merger and thus will become holders of DRS common
stock. DRS's business is different in certain ways from that of ESSI, and
DRS's results of operations, as well as the price of DRS common stock, may
be affected by factors different from those affecting ESSI's results of
operations and the price of ESSI common stock. The price of DRS common stock
may fluctuate significantly following the merger, including as a result of
factors over which DRS has no control. For a discussion of ESSI's businesses
and certain factors to consider in connection with such businesses, see
"Business" and "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
Factors affecting DRS's business include:
o DRS's revenues are dependent on its ability to maintain its government
business;
o DRS's revenues will be adversely affected if it fails to receive
renewal of follow-on contracts;
o DRS's failure to anticipate technical problems, estimate costs
accurately or control costs with respect to the performance of
fixed-price contracts may reduce its profit or cause a loss;
o DRS may experience production delays if its suppliers fail to deliver
materials to it;
o DRS's backlog is subject to reduction and cancellation;
o competition;
o military conflict, war or terrorism;
o government regulation;
11
o technological change; and
o DRS's ability to use and safeguard intellectual property.
THE MARKET PRICE OF DRS COMMON STOCK MAY DECREASE AS A RESULT OF THE
MERGER.
In the merger, ESSI shareholders will receive consideration that
includes DRS common stock. A number of factors may cause the market price of
such DRS common stock to fluctuate significantly after the merger,
including:
o the success of the integration of DRS's and ESSI's operations;
o DRS's realization of expected business opportunities and growth
prospects from the merger;
o short-term selling pressure on the market price of DRS common
stock resulting from sales of DRS shares received by ESSI's
shareholders in the merger;
o DRS's operating results and those of defense companies in general;
o the public's reaction to DRS's press releases, announcements and
filings with the SEC;
o changes in earnings estimates or recommendations by research
analysts;
o DRS's ability to reduce the indebtedness undertaken in connection
with the acquisition of ESSI;
o changes in general conditions in the U.S. economy, financial
markets, global climate or defense industry;
o natural disasters, terrorist attacks or acts of war;
o other developments affecting DRS or its competitors; and
o additional issuances of DRS common stock.
INTEGRATION OF DRS'S AND ESSI'S OPERATIONS WILL BE COMPLEX,
TIME-CONSUMING AND EXPENSIVE AND MAY ADVERSELY AFFECT THE RESULTS OF
OPERATIONS OF DRS AFTER THE MERGER.
The anticipated benefits of the merger will depend in part on
whether DRS and ESSI can integrate their operations in an efficient, timely
and effective manner. Integrating DRS and ESSI will be a complex,
time-consuming and expensive process. ESSI will represent DRS's largest and
most significant acquisition to date. Successful integration will require,
among other things, combining the companies':
o business development efforts;
o key personnel;
o geographically separate facilities; and
o business and executive cultures.
DRS and ESSI may not accomplish this integration successfully and
may not realize the benefits contemplated by combining the operations of
both companies. The diversion of management's attention to the integration
effort and any difficulty encountered in combining operations could cause
the interruption of, or a loss of momentum in, the activities of either or
both of the companies' businesses.
12
IF DRS IS UNABLE TO SUCCESSFULLY INTEGRATE ESSI INTO DRS'S
OPERATIONS ON A TIMELY BASIS, DRS'S PROFITABILITY COULD BE NEGATIVELY
AFFECTED.
DRS expects that the acquisition of ESSI will result in certain
business opportunities and growth prospects. DRS, however, may never realize
these expected business opportunities and growth prospects. DRS may
experience increased competition that limits its ability to expand its
business, DRS's assumptions underlying estimates of expected cost savings
may be inaccurate or general industry and business conditions may
deteriorate. The acquisition involves numerous risks, including, but not
limited to:
o difficulties in assimilating and integrating the operations,
technologies and products of ESSI;
o the diversion of DRS's management's attention from other business
concerns;
o DRS's current operating and financial systems and controls may be
inadequate to deal with the combined company's operations;
o the risk that the combined company will be unable to maintain or
renew any of ESSI's government contracts;
o the risks of DRS entering markets in which it has limited or no
experience; and
o the loss of key employees.
If these factors limit DRS's ability to integrate the operations of
ESSI successfully or on a timely basis, DRS's expectations of future results
of operations may not be met. In addition, DRS's growth and operating
strategies for ESSI's business may be different from the strategies that
ESSI currently is pursuing. If DRS's strategies are not the proper
strategies for ESSI, it could have a material adverse effect on the
business, financial condition and results of operations of the combined
company. Further, there can be no assurance that DRS will be able to
maintain or enhance the profitability of ESSI or consolidate the combined
company's operations to achieve cost savings.
DRS'S LEVEL OF INDEBTEDNESS FOLLOWING THE MERGER COULD LIMIT CASH
FLOW AVAILABLE AND COULD ADVERSELY AFFECT ITS OPERATIONS OR ITS ABILITY TO
OBTAIN ADDITIONAL FINANCING, IF NECESSARY. DRS MAY INCUR SUBSTANTIAL
ADDITIONAL INDEBTEDNESS IN THE FUTURE.
DRS's total debt outstanding as of September 30, 2005 was
approximately $708.4 million. DRS's pro forma indebtedness as of September
30, 2005, after giving effect to the merger and related financing would have
been approximately $1.9 billion. As a result of the increase in debt,
demands on the cash resources of DRS will increase after the merger, which
could have important effects on an investment in DRS common stock. For
example, increased levels of indebtedness could, among other things:
o limit the ability of the combined company to obtain additional
financing for working capital, capital expenditures, acquisitions
and general corporate purposes or make such financing more costly;
o require the combined company to dedicate all or a substantial
portion of its cash flow to service debt, which will reduce funds
available for other business purposes, such as capital
expenditures, research and development, dividends or acquisitions;
o limit flexibility in planning for or reacting to changes in the
markets in which the combined company will compete;
o place the combined company at a competitive disadvantage relative
to its competitors with less indebtedness;
o render the combined company more vulnerable to general adverse
economic and industry conditions; and
o make it more difficult to satisfy financial obligations, including
those relating to the financing of the merger.
13
The terms of DRS's new financing agreements will include covenants
restricting the activities of DRS and will require repayment of the debt in
certain circumstances. In addition, following the merger, DRS may not be
able to incur substantial additional indebtedness in the future. If DRS adds
new debt, the related risks that it currently faces could intensify.
If DRS is unable to consummate permanent debt financing of at least
$950.0 million, DRS may enter into a new interim credit facility of up to
$950.0 million that is likely to be on terms substantially more restrictive
and is likely to be more costly than the terms of the contemplated permanent
financing. If any interim loan under the interim facility is not repaid
within one year of the closing of the interim facility, the principal amount
of such loan and any interest on the loan automatically will be exchanged
for senior exchange notes which will bear a higher rate of interest and may
contain other more restrictive terms than the interim credit facility.
Additionally, if the interim facility has not been repaid within 90 days of
the closing of the interim facility, Bear Stearns, in consultation with
Wachovia, may demand that DRS issue and sell senior notes or senior
subordinated notes in an amount sufficient to refinance the interim loans.
THE MERGER MAY ADVERSELY AFFECT THE COMBINED COMPANY'S ABILITY TO
ATTRACT AND RETAIN KEY ESSI EMPLOYEES.
ESSI employees may experience uncertainty about their future roles
after the merger. In addition, ESSI employees, including key executives and
members of ESSI's senior management, may determine that they do not desire
to work for DRS for a variety of reasons and may seek early retirement or
other employment opportunities. These factors may adversely affect the
combined company's ability to attract and retain key management,
engineering, sales, marketing and other personnel. There is a continuing
demand for qualified technical personnel and DRS's future growth and success
will depend in part upon its ability to attract, train and retain such
personnel. Competition for personnel in the defense industry is intense. An
inability to attract and maintain a sufficient number of technical
personnel, including ESSI personnel, could have a material adverse effect on
DRS's contract performance and ability to capitalize on market
opportunities.
A number of senior executive officers of ESSI have agreements
requiring payments in the event of a change in control of ESSI. (See "Item
11 --Executive Compensation--Employment Agreements" and "Item 11--Executive
Compensation--Consulting Agreements"). Moreover, several of these executives
have indicated their desire to retire from ESSI upon completion of the
merger. Departing key employees may be difficult to replace, and their loss
may have a material adverse effect on the combined company's operations.
14
ITEM 2. PROPERTIES
------- ----------
ESSI conducts its business from 45 manufacturing, warehouse and
office facilities.
Location Description Square Footage
-------- ----------- --------------
West Plains, Missouri (1) Manufacturing/Office 391,000
Florence, Kentucky (1) Manufacturing/Office 265,000
St. Louis County, Missouri (1) Subassembly/Office 263,000
High Ridge, Missouri (1) Manufacturing/Office 214,000
Bridgeport, Connecticut (1) Manufacturing/Office 135,000
Cincinnati, Ohio (2) Manufacturing/Office 134,000
Elizabeth City, North Carolina (1) Hangar - under construction 80,000
Bridgeport, Connecticut (2) Warehouse 45,000
Alexandria, Virginia (2) Office 44,000
Halifax, Nova Scotia, Canada (1) Manufacturing/Office 40,000
Cincinnati, Ohio (1) Manufacturing/Office 27,000
Elizabeth City, North Carolina (2) Office 21,000
Polson, Montana (2) Manufacturing/Office 20,000
Troy, Michigan (2) Office 20,000
Calverton, Maryland (2) Office 19,000
Chantilly, Virginia (2) Office 16,000
Melbourne, Florida (2) Manufacturing/Office 16,000
Tinton Falls, New Jersey (2) Manufacturing/Office 15,000
Dulles, Virginia (2) Office 15,000
St. Louis County, Missouri (2) Manufacturing 14,000
St. Louis County, Missouri (2) Warehouse 13,000
Warner Robins, Georgia (2) Office 13,000
Fairborn, Ohio (2) Office 13,000
West Plains, Missouri (2) Warehouse 13,000
Willoughby, Ohio (2) Office 12,000
Bridgeton, Missouri (2) Manufacturing/Office 11,000
Warner Robins, Georgia (1) Office 11,000
Warner Robins, Georgia (2) Manufacturing/Office 11,000
Polson, Montana (2) Manufacturing/Office 10,000
West Long, New Jersey (2) Office 9,000
Huntsville, Alabama (2) Office 8,000
Lorton, Virginia (2) Office 6,000
Cincinnati, Ohio (2) Warehouse 5,000
Petersburg, Virginia (2) Office 4,000
Augusta, Georgia (2) Manufacturing/Office 3,000
Arlington, Virginia (2) Office 3,000
Garden City, New York (2) Office 3,000
Abington, Maryland (2) Office 2,000
Coronado, California (2) Office 1,000
Layton, Utah (2) Office 1,000
San Diego, California (2) Office 1,000
Shrewsbury, New Jersey (2) Office 1,000
Anchorage, Alaska (2) Office 1,000
Oklahoma City, Oklahoma (2) Office 1,000
Fredericksburg, Virginia (2) Office 1,000
(1) - Owned
(2) - Leased
ESSI also leases certain other small product support and service
facilities located throughout the United States and abroad. ESSI believes
that its current facilities are sufficient for the conduct of its current
level of operations.
At October 31, 2005, ESSI also owned a 171,000 square foot facility
in St. Louis County, Missouri which it vacated during the year ended October
31, 2003. On November 22, 2005, ESSI completed the sale of this facility for
a sale price of approximately $3.0 million.
15
ITEM 3. LEGAL PROCEEDINGS
------- -----------------
In December 2004, ESSI was notified by the Enforcement Division of
the SEC of the issuance of a formal order directing a private investigation
captioned In the Matter of Engineered Support Systems, Inc. and that the SEC
had issued subpoenas to various individuals associated with ESSI to produce
certain documents. The SEC staff also requested that ESSI voluntarily
produce certain documents in connection with the investigation. The
subpoenas related to trading in ESSI stock around its earnings releases in
2003 and the adequacy of certain disclosures made by ESSI regarding
related-party transactions in 2002 and 2003 involving insurance policies
placed by ESSI through an insurance brokerage firm in which a director of
ESSI was a principal at the time of the transactions. On or about September
23, 2005, the SEC staff contacted ESSI's counsel and advised that it had
issued a subpoena directed to ESSI and expanded its investigation to include
ESSI's disclosure of a November 2004 stop-work order relating to ESSI's
Deployable Power Generation and Distribution Systems program for the U.S.
Air Force, and trading in ESSI's stock by certain individuals associated
with ESSI.
In connection with the foregoing SEC investigation, ESSI and
certain of its directors and officers have provided information and
testimony to the SEC. ESSI continues to furnish information requested by the
SEC. On November 14, 2005, ESSI was informed by the Enforcement Division
that one of ESSI's former directors and officers who is currently a
consultant to ESSI has been issued a so-called Wells notice informing him
that the staff of the SEC was considering recommending that the SEC bring a
civil injunctive action against the former officer and director in
connection with the SEC's investigation into trading in ESSI common stock in
2003. A Wells notice provides prospective defendants with an opportunity to
respond to the SEC staff members before the staff makes a formal
recommendation on whether the SEC should pursue disciplinary action against
them. ESSI has not received a Wells notice and continues to cooperate with
the investigation. ESSI is unable to determine at this time either the
timing of the investigation or the impact, if any, which the investigation
could have on ESSI or the combined company following ESSI's proposed merger
with DRS as discussed in Note P to the Consolidated Financial Statements
included elsewhere in this Annual Report on Form 10-K.
In addition, ESSI is from time to time party to various legal
proceedings, including environmental claims, arising out of its business.
ESSI's management believes that there are no such proceedings pending or
threatened against them which, if determined adversely, would have a
material adverse effect on the consolidated financial position, results of
operations or cash flows of ESSI.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SHAREHOLDERS
------- -----------------------------------------------
There were no matters submitted to a vote of shareholders during
the fourth quarter of the year ended October 31, 2005.
16
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER
------- ----------------------------------------------------------------
MATTERS
-------
ESSI's common stock trades on the Nasdaq Stock Market under the
symbol EASI. The number of holders of common stock as of December 20, 2005
was approximately 24,350, including 340 shareholders of record and an
estimated 24,010 persons or entities holding common stock in nominee name.
The following table sets forth the high and low stock prices for each
quarter as provided by the Nasdaq Stock Market, as adjusted to reflect a
three-for-two stock split effected by ESSI on April 15, 2005.
2005 2004
-------------- ---------------
High Low High Low
---- --- ---- ---
QUARTER ENDED:
January 31 $40.26 $31.87 $41.29 $30.01
April 30 42.63 33.83 36.99 30.33
July 31 39.10 31.60 40.01 29.57
October 31 41.47 32.25 38.26 24.22
ESSI has paid a dividend of $.018 per share on a semi-annual basis
during the last two fiscal years. ESSI's pending merger agreement with DRS
provides that ESSI may not declare, set aside or pay any dividend or make
any similar payment with respect its capital stock prior to the effective
date of the merger.
Effective February 1, 2005, ESSI acquired all of the membership
interests of Spacelink. A portion of the purchase price paid by ESSI at
closing consisted of the issuance by the ESSI of 342,438 shares of its
restricted common stock valued at approximately $13.2 million. ESSI issued
these shares of common stock to the sellers of Spacelink's membership
interests, Spacelink International LTD., a Delaware corporation, and
SatComSolutions LLC, a Delaware limited liability company. The common stock
was issued as a private placement of securities under Section 4(2) of the
Securities Act of 1933.
The following table provides information as of October 31, 2005
with respect to shares of the common stock that may be issued under ESSI's
existing equity compensation plans:
Number of shares
remaining
available for
Number future issuance
of shares under equity
to be compensation
issued upon Weighted- plans
exercise average (excluding
of exercise price of securities
outstanding outstanding reflected in
Plan category options Options column (a))
(a)(1) (b) (c)
-------------------------------------------------------------- --------- --------------------- -----------------------
Equity compensation plans approved by shareholders 4,422,058 $ 24.18 616,447
Equity compensation plan not approved by
shareholders (2) 288,562 $ 13.42 0
--------- -------
Total 4,710,620 $ 23.52 616,447
========= =======
--------
(1) All shares and per share amounts have been restated to reflect a
three-for-two stock split effected by ESSI on April 15, 2005.
(2) The equity compensation plan not approved by shareholders represents the
Engineered Support Systems, Inc. 2002 Non-Executive Stock Option Plan under
which ESSI has issued 1,012,500 stock options to non-executive employees.
17
Item 6. SELECTED FINANCIAL DATA
------- -----------------------
Selected financial data for each of ESSI's last five fiscal years
is as follows:
Year Ended October 31 (in thousands, except per share amounts)
2005 2004 2003 2002 2001
--------------------------------------------------------------------------------------------------------
RESULTS OF OPERATIONS
Net revenues $1,018,373 $ 883,630 $ 572,701 $ 407,945 $365,198
==========================================================
Operating income from continuing operations $ 141,422 $ 123,296 $ 72,616 $ 48,599 $ 35,853
==========================================================
Net income from continuing operations $ 87,249 $ 75,909 $ 43,283 $ 27,666 $ 18,269
Discontinued operations (2,073) 125 (4,133) 307
----------------------------------------------------------
Net income $ 85,176 $ 75,909 $ 43,408 $ 23,533 $ 18,576
==========================================================
Diluted shares outstanding 43,232 41,799 38,757 36,471 34,236
==========================================================
Diluted earnings per share:
Continuing operations $ 2.02 $ 1.82 $ 1.12 $ 0.76 $ 0.53
==========================================================
Total $ 1.97 $ 1.82 $ 1.12 $ 0.65 $ 0.54
==========================================================
Cash dividends declared per share $ 0.03 $ 0.02 $ 0.02 $ 0.01 $ 0.01
==========================================================
FINANCIAL POSITION AT YEAR END
Total assets $ 702,157 $ 511,134 $ 421,446 $ 290,147 $240,435
Total debt 47,139 1,121 73,190 55,000 63,738
Shareholders' equity 473,309 336,956 197,167 134,857 109,392
----------------------------------------------------------
Funded backlog $ 689,796 $ 588,061 $ 533,439 $ 350,063 $291,745
Total backlog 2,176,923 1,437,218 1,456,174 1,218,706 973,552
In order to analyze the comparability of the information reflected
in the above selected financial data, see Notes B, D and E of the Notes to
Consolidated Financial Statements included elsewhere within this Annual
Report on Form 10-K.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
------- -----------------------------------------------------------
AND RESULTS OF OPERATIONS
-------------------------
CRITICAL ACCOUNTING POLICIES
Revenue Recognition
ESSI's revenues on long-term contracts, substantially all of which
are directly or indirectly with the U.S. Government, are recognized under
the percentage of completion method and include a proportion of the earnings
that are expected to be realized on the contract in the ratio that
production measures, primarily labor, incurred bear to the total estimated
production measures for the contract. Earnings expectations are based upon
estimates of contract values and costs at completion. Contracts in process
are reviewed on a periodic basis. Adjustments to revenues and earnings are
made in the current accounting period based upon revisions in contract
values and estimated costs at completion. Amounts representing contract
change orders, claims and other items are included in revenues, as
recognized under the percentage of completion method, only when these
amounts can be reliably estimated and
18
realization is probable. Provisions for estimated losses on contracts are
recorded when identified. Substantially all other revenues are recognized
when title passes to the customer. Actual results could differ from ESSI's
estimates and assumptions.
Retirement Obligations
The determination of ESSI's obligation and expense for pension
and other postretirement benefits is dependent on certain assumptions
developed by ESSI and used by actuaries in calculating such amounts.
Assumptions include, among others, the discount rate and the expected
long-term rate of return on plan assets. Actual results that differ from
assumptions made are accumulated and amortized over future periods and,
therefore, generally affect ESSI's recognized expense and recorded
obligation in such future periods. Significant differences in actual
experience or significant changes in assumptions may materially affect
pension and other postretirement obligations.
Goodwill and Other Long-Lived Assets
ESSI's management annually reviews goodwill and other long-lived
assets with indefinite useful lives for impairment or whenever events or
changes in circumstances indicate the carrying amount may not be
recoverable. If ESSI determines that the carrying value of the long-lived
asset may not be recoverable, a permanent impairment charge is recorded for
the amount by which the carrying value of the long-lived asset exceeds its
fair value. Fair value is measured based on a discounted cash flow method
using a discount rate determined by management to be commensurate with the
risk inherent in ESSI's current business model. The estimates of cash flows
and discount rate are subject to change due to the economic environment,
including such factors as interest rates, expected market returns and
volatility of markets served. ESSI's management believes that the estimates
of future cash flows and fair value are reasonable; however, changes in
estimates could result in an impairment charge. Intangible assets with
estimated useful lives are amortized over these lives and reviewed for
impairment on a periodic basis.
The following analysis should be read in this context.
RECENT ACQUISITIONS
Over the past three years, ESSI's net revenues and net income have
increased substantially as a result of both internal growth and several
significant acquisitions.
During 2005, ESSI acquired three companies operating in the
defense industry. Effective May 1, 2005, ESSI acquired all of the
outstanding stock of Mobilized Systems, which designs, manufacturers and
tests highly specialized trailers, shelters and environmental control
systems, primarily for the defense industry. The purchase price was $17.5
million, net of cash acquired. Of the purchase price, $16.7 million has been
paid as of October 31, 2005. The remaining $0.8 million of consideration is
in the form of long-term promissory notes payable to the sellers. The
purchase price was financed with short-term borrowings under ESSI's
revolving credit facility. The fair value of assets acquired, including
goodwill of $12.7 million and customer-related intangibles of $3.2 million,
was $19.1 million and liabilities assumed totaled $1.6 million. Mobilized
Systems in included within ESSI's Support Systems business segment.
Effective February 1, 2005, ESSI acquired all of the outstanding
stock of Spacelink, which designs, integrates, operates and maintains
deployed satellite and wireless networks for the DoD, the U.S. intelligence
community and other forward deployed federal agencies and multinational
organizations worldwide. The purchase price, including transaction costs,
was $154.6 million, which included common stock of ESSI with a value of
$13.2 million. The cash consideration was financed with short-term
borrowings under ESSI's revolving credit facility. The purchase price was
net of $2.2 million of cash acquired. The purchase price is also subject to
a working capital adjustment of approximately $2.9 million, tax adjustments
pursuant to Section 338(h)(10) of the Internal Revenue Code of approximately
$2.3 million and certain contingent cash consideration based upon
Spacelink's earnings before
19
interest, taxes, depreciation and amortization, as defined, for each of the
twelve month periods ending January 31, 2006 and 2007. The fair value of
assets acquired, including goodwill of $128.0 million and acquired
customer-related intangibles of $13.8 million, was $165.7 million and
liabilities assumed totaled $11.1 million. Spacelink is included within
ESSI's Support Services business segment.
On January 7, 2005, ESSI acquired all of the outstanding stock of
PCA, which develops and manufactures electronic test and measurement
equipment provided for electronic warfare and avionics systems primarily to
military customers. The purchase price was $37.6 million and is subject to a
working capital adjustment. The purchase price was financed with ESSI's
existing cash balances. The fair value of assets acquired, including
goodwill of $24.1 million and acquired customer-related intangibles of $6.4
million, was $38.1 million and liabilities assumed totaled $0.5 million. PCA
is included within ESSI's Support Systems business segment.
During 2004, ESSI acquired one company operating in the defense
industry. Effective December 5, 2003, ESSI acquired all of the outstanding
stock of Pivotal Power, a supplier of high performance static power
conversion equipment primarily to military customers, for approximately
$10.1 million, net of cash acquired. The fair value of assets acquired,
including goodwill of $4.8 million and acquired customer-related intangibles
of $1.2 million, was $11.6 million and liabilities assumed totaled $1.5
million. The purchase price was financed with short-term borrowings under
ESSI's revolving credit facility. Pivotal Power is included within ESSI's
Support Systems business segment.
During 2003, ESSI acquired two companies operating in the defense
industry. Effective May 1, 2003, ESSI acquired all the capital stock of
TAMSCO, a provider of information technology logistics and digitization
services, and a designer and integrator of telecommunications systems
primarily for the DoD, for approximately $71.1 million in cash plus the
payoff of $14.9 million of TAMSCO indebtedness. The fair value of assets
acquired, including goodwill of $35.9 million and acquired customer-related
intangibles of $29.9 million, was $103.9 million and liabilities assumed
totaled $32.8 million. The purchase price was financed with short-term
borrowings under ESSI's revolving credit facility. TAMSCO is included in
ESSI's Support Services business segment.
Effective September 24, 2003, ESSI acquired all of the capital
stock of Engineered Environments, Inc. (EEi), a designer and manufacturer of
specialized environmental control units and heat transfer systems for
defense and industrial markets. The purchase of EEi, net of cash acquired,
totaled $16.7 million, which represents the $15.6 million purchase price
plus assumed indebtedness of $1.1 million. The fair value of assets
acquired, including goodwill of $11.6 million and acquired customer-related
intangibles of $2.9 million, was $19.9 million and liabilities assumed
totaled $4.3 million. The purchase price was financed with short-term
borrowings under ESSI's revolving credit facility. EEi is included in ESSI's
Support Systems business segment.
RESULTS OF CONTINUING OPERATIONS
The following discussion is with regard to ESSI's results of
continuing operations. The discontinued operations of ESSI's ESP subsidiary
are discussed later. The following table provides a comparative margin
analysis for continuing operations for the years ended October 31, 2005,
2004 and 2003.
Year Ended October 31 2005 2004 2003
---- ---- ----
Net revenues 100.0% 100.0% 100.0%
Cost of revenues 75.9 74.8 75.9
----- ----- -----
Gross profit 24.1 25.2 24.1
Selling, general and
administrative expense 10.2 11.1 11.1
Restructuring expense 0.3
Loss on sale of assets 0.1
----- ----- -----
Income from operations 13.9 14.0 12.7
Interest expense, net 0.2 0.1 0.3
----- ----- -----
Income before income taxes 13.7 13.9 12.4
Income tax provision 5.1 5.3 4.8
----- ----- -----
Net income 8.6% 8.6% 7.6%
===== ===== =====
20
BUSINESS SEGMENTS
ESSI operates in two business segments: Support Systems and Support
Services. The Support Systems segment engineers and manufactures integrated
military electronics and other military support equipment primarily for the
DoD, as well as related air handling and heat transfer equipment for
commercial and industrial users. Segment products include environmental
control systems, power generation, distribution and conditioning systems,
chemical and biological protection systems, petroleum and water distribution
systems, load management and transport systems, airborne radar systems,
reconnaissance, surveillance and target acquisition systems, avionics test
equipment and other multipurpose military support equipment. The Support
Services segment provides engineering, logistics and training services,
advanced technology services, asset protection systems and services,
telecommunication systems integration and information technology services
primarily for the DoD. The Support Services segment also provides certain
power generation and distribution equipment and vehicle armor installation
to the DoD.
The following table sets forth net revenues and income from
operations, in millions, for the years ended October 31, 2005, 2004 and 2003
for each of ESSI's business segments:
Year Ended October 31 2005 2004 2003
----------------- ----------------- ------------------
Net Revenues
Support Systems $ 501.0 49.2% $ 514.7 58.3% $ 389.3 68.0%
Support Services 592.7 58.2 442.8 50.1 210.7 36.8
Intersegment Revenues (75.3) (7.4) (73.9) (8.4) (27.3) (4.8)
-------- ----- -------- ----- -------- -----
Total $1,018.4 100.0% $ 883.6 100.0% $ 572.7 100.0%
======== ===== ======== ===== ======== =====
Income from Operations
Support Systems $ 87.5 61.9% $ 93.0 75.4% $ 54.2 74.7%
Support Services 53.9 38.1 30.3 24.6 18.4 25.3
======== ===== ======== ===== ======== =====
Total $ 141.4 100.0% $ 123.3 100.0% $ 72.6 100.0%
======== ===== ======== ===== ======== =====
2005 COMPARED TO 2004
Consolidated net revenues increased $134.8 million, or 15.2%, in
2005 to $1,018.4 million from $883.6 million in 2004. $85.1 million of this
increase was generated by ESSI's most recently acquired subsidiaries (PCA,
Spacelink and Mobilized Systems) since their respective acquisition dates in
2005. The remaining $49.7 million increase from existing operations included
additional revenues from refurbishment of M1000 Heavy Equipment Transporters
($29.7 million increase), the manufacture and installation of vehicle add-on
armor kits ($47.6 million increase), and additional telecommunications
support programs ($75.4 million increase). These revenue increases were
partially offset by reduced work on the 60-K Tunner Aircraft Cargo Loader
(Tunner), as the production phase of this long-term program ended in the
second quarter of 2005 ($36.5 million decrease), reduced deliveries of
Manportable Surveillance and Target Acquisition Radars (MSTAR) for which a
large military base perimeter security subcontract with Northrop Grumman was
completed in the fourth quarter of 2004 ($57.3 million decrease) and the
impact of temporary production delays on the Deployable Power Generation and
Distribution System (DPGDS), which had been encountering performance issues
on the primary power unit component of the program during 2005 ($41.0
million decrease). After the successful completion of intensive reliability
testing on the primary power unit component of the DPGDS program, the DPGDS
program was returned to full rate production status in the fourth quarter of
2005. Gross profit for 2005 increased $22.3 million, or 10.0%, to $245.0
million (24.1% of consolidated net revenues) from $222.7 million (25.2% of
consolidated net revenues) in 2004. Revenue growth was primarily responsible
for the increase in consolidated gross profit in 2005. However, slightly
reduced gross margins
21
for 2005 reflect a shift in overall business mix towards a greater amount of
Support Services segment revenues, as well as the impact of temporary
production delays and increased estimated costs resulting from performance
issues with the primary power unit component of the DPGDS program. Selling,
general and administrative expense increased $5.6 million, or 5.7%, in 2005
to $103.6 million (10.2% of consolidated net revenues) from $98.0 million
(11.1% of consolidated net revenues) in 2004. Incremental selling, general
and administrative expense for PCA, Spacelink and Mobilized Systems
accounted for $9.0 million of the increase. It should be noted that selling,
general and administrative expense in 2004 included a $5.0 million severance
charge ($4.2 million of which represented a non-cash charge) in connection
with the resignation of a former executive officer. Selling, general and
administrative expense also included amortization expense related to
acquired customer-related intangibles of $9.8 million and $6.7 million in
2005 and 2004, respectively. During 2004, ESSI completed the sales of its
Sanford, Florida and Blue Ash, Ohio facilities, which had been vacated in
conjunction with facility rationalization initiatives. Primarily as a result
of these disposals, ESSI incurred a $1.3 million loss on sale of assets in
2004. As a result of the above, operating income from continuing operations
increased by $18.1 million, or 14.7%, in 2005 to $141.4 million from $123.3
million in 2004.
Net revenues in 2005 for the Support Systems segment totaled $501.0
million compared to $514.7 million (prior to the elimination of intersegment
revenues in each year) in 2004, a 2.7% decrease. The results for 2005
reflect the inclusion of a combined $23.8 million in net revenues of PCA and
Mobilized Systems since their respective acquisition dates in 2005. During
2005, the segment experienced a $36.5 million revenue reduction on the
Tunner program and a $57.3 million revenue reduction on the MSTAR program.
These decreases were offset by a $29.7 million increase from refurbishment
of M1000 Heavy Equipment Transporters and by a $20.3 million increase in
intersegment work performed for the Support Services segment, primarily
related to the production of vehicle add-on armor kits. Gross profit for the
segment decreased by $9.1 million, or 5.9%, in 2005 to $145.9 million (29.1%
of segment revenues) from $155.0 million (30.1% of segment revenues) in
2004, including a combined $6.9 million gross profit contribution from the
acquisitions of PCA and Mobilized Systems. Segment operating income for 2005
decreased to $87.5 million (17.5% of segment revenues) compared to $93.0
million (18.1% of segment revenues) in 2004 primarily as a result of
reduction in gross profit.
Net revenues in 2005 for the Support Services segment increased to
$592.7 million, an increase of $149.9 million, or 33.8%, compared to $442.8
million (prior to the elimination of intersegment revenues in each year) in
2004. The most significant year-over-year increases occurred in the
telecommunications support area ($75.4 million increase) and vehicle add-on
armor kit programs ($47.6 million increase). In addition, Spacelink added
$61.3 million of incremental revenues since its acquisition date in 2005.
Partially offsetting these increases were decreased revenues from the DPGDS
program of $41.0 million as previously discussed. Gross profit for the
segment increased by $31.4 million, or 46.4%, in 2005 to $99.1 million
(16.7% of segment revenues) from $67.7 million (15.3% of segment revenues)
in 2004 primarily as a result of increased revenues in 2005 including a
$10.8 million gross profit contribution from the acquisition of Spacelink.
Segment operating income for 2005 totaled $53.9 million (9.1% of segment
revenues) compared to $30.3 million (6.8% of segment revenues) in 2004. The
increase in segment revenues in 2005 provided significant gross profit
contributions which allowed for improved absorption of fixed overhead costs,
leading to the overall improved operating results for the Support Services
segment. However, segment profitability in 2005 was constrained by a
decrease in DPGDS-related revenues in comparison to 2004 as noted above.
Net interest expense totaled $1.8 million and $0.9 million in 2005
and 2004, respectively. This increase was a result of higher borrowing
levels in 2005 resulting, in large part, from a combined $190.5 million of
cash consideration paid in conjunction with the 2005 acquisitions. The
effective income tax rate was 37.5% for 2005 compared to 38.0% in 2004. This
reduction was primarily due to ESSI's state income tax reduction
initiatives. As a result of the foregoing, net income from continuing
operations increased by 14.9% to $87.2 million (8.6% of consolidated net
revenues) in 2005 compared to $75.9 million (8.6% of consolidated net
revenues) in 2004.
In the second quarter of 2003, ESSI completed the sale of ESP, a
wholly-owned subsidiary, to a private equity group (Buyer). The Buyer
subsequently alleged that ESSI breached certain representations made under
the related Stock Purchase Agreement (the ESP Agreement) and sought a claim
for associated damages under the binding arbitration provisions of the ESP
Agreement. During the second quarter of 2005, ESSI and the Buyer reached a
22
settlement on this claim, which included modification of ESSI's $3.2 million
note receivable from the Buyer to provide for suspension of interest charges
and payments through July 31, 2006, extension of the note's repayment term
to a balloon payment due in April 2009, and the release of the underlying
real estate collateral securing the note. Because of this settlement, ESSI
recorded a charge for the impairment of the note during the second quarter
of 2005 equal to $1.7 million, or $1.1 million net of income tax. In the
fourth quarter of 2005, ESSI was informed that the Buyer was insolvent. As a
result, ESSI recorded an additional non-cash charge totaling $1.6 million,
or $1.0 million net of income tax, for the impairment of the remainder of
the note in the fourth quarter of 2005. These charges are included within
the discontinued operations section of ESSI's Consolidated Statements of
Income for 2005.
2004 COMPARED TO 2003
Consolidated net revenues increased $310.9 million, or 54.3%, in
2004 to $883.6 million from $572.7 million in 2003. $181.3 million of this
increase represents an increase in net revenues contributed by TAMSCO, EEi
and Pivotal Power, since their respective acquisition dates in 2003 and
2004. Of the $129.6 million of net revenue growth from all other operating
subsidiaries, ESSI's programs for MSTAR, Field Deployable Environmental
Control Units (FDECU), DPGDS and vehicle add-on armor kits provided the most
significant revenue gains. Gross profit for 2004 increased $84.6 million, or
61.3%, to $222.7 million (25.2% of consolidated net revenues) from $138.1
million (24.1% of consolidated net revenues) in 2003. $23.1 million of this
increase represents an increase in gross profit contributed by TAMSCO, EEi
and Pivotal Power, which had gross profit for either a portion or none of
2003. Of the $61.5 million of gross profit growth from all other operating
subsidiaries, ESSI's programs for MSTAR, FDECU, DPGDS and vehicle add-on
armor kits provided the most significant increases. In addition, MSTAR,
FDECU and DPGDS have significantly higher margins than most of ESSI's
programs, which contributed to a more favorable product mix and a higher
overall gross margin in 2004. Selling, general and administrative expense
increased $34.2 million, or 53.6%, in 2004 to $98.0 million (or 11.1% of
consolidated net revenues) from $63.8 million (11.1% of consolidated net
revenues) in 2003. $21.2 million of this increase was due to an increase in
selling, general and administrative expenses from TAMSCO, EEi and Pivotal
Power. In addition, ESSI incurred a $5.0 million severance charge ($4.2
million of which represented a non-cash charge) in connection with the
resignation of a former executive officer of ESSI. Selling, general and
administrative expense also included amortization expense related to
acquired customer-related intangibles of $6.7 million and $2.8 million in
2004 and 2003, respectively. Under its facility rationalization plan, ESSI
incurred restructuring expense of $0.1 million and $1.8 million,
respectively, in 2004 and 2003 related to the write-down of fixed assets at
the affected facilities and to accrue for expected employee benefits costs.
During 2004, ESSI completed the sales of its Sanford, Florida and Blue Ash,
Ohio facilities, which had been vacated in conjunction with facility
rationalization initiatives. Primarily as a result of these disposals, ESSI
incurred a $1.3 million loss on sale of assets in 2004 compared to a $0.1
million gain on sale of assets in 2003. As a result of the above, operating
income from continuing operations increased by $50.7 million, or 69.8%, in
2004 to $123.3 million from $72.6 million in 2003.
Net revenues for the Support Systems segment increased by $125.4
million, or 32.2%, to $514.7 million in 2004 from $389.3 million (prior to
the elimination of intersegment revenues in each year) in 2003. The current
year increase was partially attributable to the incremental net revenues of
EEi and Pivotal Power of $11.5 million and $7.9 million, respectively,
during 2004. Programs with the largest revenue gains during 2004 included
the MSTAR, FDECU as well as intersegment work on the DPGDS and vehicle
add-on armor kits being performed for the Support Services segment. Segment
net revenues were partially offset by reduced work on the Tunner program as
production work on that contract ended in mid-2005. Gross profit for the
segment increased by $53.5 million, or 52.7%, to $155.0 million in 2004
(30.1% of segment revenues) from $101.5 million (26.1% of segment revenues)
in 2003. The increase in gross profit was attributable to incremental gross
profit from EEi and Pivotal Power of a combined $7.2 million coupled with
higher profits on MSTAR, FDECU as well as intersegment work on the DPGDS and
vehicle add-on armor kits due to increased revenues and production levels as
noted above. In addition, MSTAR and FDECU have significantly higher margins
than most of the segment's programs, which contributed to a more favorable
product mix and higher gross margins in 2004. Income from operations for the
segment increased by $38.8 million,
23
or 72.0%, in 2004 to $93.0 million from $54.2 million in 2003. The increase
was the result of higher gross profit partially offset by additional
selling, general and administrative expense in 2004.
Net revenues for the Support Services segment increased by $232.1
million, or 110.1%, in 2004 to $442.8 million from $210.7 million (prior to
the elimination of intersegment revenues) in 2003. The significant growth in
net revenues was primarily attributable to the inclusion of TAMSCO for a
full year in 2004 versus just six months of post-acquisition results in
2003. TAMSCO reported revenues of $232.0 million in 2004 and $70.1 million
in 2003. Significant revenue increases also were generated by the DPGDS
program and from vehicle add-on armor kits. Gross profit for the segment
increased by $31.1 million, or 85.1%, in 2004 to $67.7 million (15.3% of
segment revenues) from $36.6 million (17.4% of segment revenues) in 2003.
The increase in gross profit was attributable to the higher level of net
revenues in 2004 as discussed above. The decrease in gross margin for the
segment was primarily the result of a significant increase in revenues from
pass-through contract vehicles, such as the Rapid Response and FAST
programs, which generally provide lower than average profit margins. This
decrease was partially offset by revenues from the DPGDS and vehicle add-on
armor programs which provide comparatively higher margins. Income from
operations for the segment increased by $11.9 million in 2004 to $30.3
million from $18.4 million in 2003 as a result of the significant increases
in net revenues and gross profit as compared to the prior year.
Net interest expense decreased by $0.8 million to $0.9 million in
2004 compared to $1.7 million in 2003 primarily as a result of lower
outstanding borrowings throughout 2004. As of October 31, 2004, ESSI had
completely paid off borrowings against its revolving credit facility and had
cash and cash equivalents of $33.2 million.
ESSI's effective income tax rate was 38.0% and 39.0% for 2004 and
2003, respectively. The reduction in the effective income tax rate was
primarily the result of ESSI's state income tax reduction initiatives. As a
result of the foregoing, net income from continuing operations increased
75.4% to $75.9 million (8.6% of consolidated net revenues) in 2004 compared
to $43.3 million (7.6% of consolidated net revenues) in 2003.
During 2002, ESSI formally adopted a plan to dispose of ESP. ESP
was sold to a private equity group in 2003. As a result, ESP's financial
results were reclassified as a discontinued operation in the Consolidated
Financial Statements. Income from discontinued operations totaled $0.3
million, net of income tax, in 2003 and ESSI recorded after-tax losses of
$0.2 million in 2003 to reduce the carrying value of ESP's assets to their
estimated net realizable values less estimated selling costs. See Note E to
the Consolidated Financial Statements.
OUTLOOK FOR 2006 AND FUTURE
On September 21, 2005, ESSI and DRS entered into a definitive
agreement which provides for the acquisition by DRS of all the outstanding
common stock of ESSI for approximately $1.9 billion, or $43.00 per share
(subject to possible adjustment), through a combination of cash and DRS
common stock. Pending customary regulatory approvals and other closing
conditions, including approval by ESSI and DRS shareholders, the transaction
is expected to close before March 31, 2006.
ESSI continues to believe that significant growth opportunities
exist within the military support equipment, electronics and logistics
support segments of the defense industry in response to (1) the current
fragmentation within the industry; (2) the DoD's emphasis on awarding
contracts on the basis of "best value;" (3) the DoD's increasing outsourcing
of engineering, design and logistics services to contractors; (4) heightened
military operations around the globe; and, (5) overall increases in defense
spending by the DoD. In addition to supporting future merger integration
activities with DRS, ESSI's focus for 2006 includes the continued
rationalization of its existing defense operations in order to leverage its
infrastructure and achieve additional operational synergies.
LIQUIDITY AND CAPITAL RESOURCES
On January 27, 2005, ESSI and its banks entered into an Amended and
Restated Credit Agreement (Amended Credit Agreement). The Amended Credit
Agreement replaced ESSI's previous credit agreement dated April 23, 2003.
24
The Amended Credit Agreement, which expires January 27, 2010, provides for a
$200 million unsecured revolving credit facility. ESSI may request, subject
to certain conditions, an increase of up to $100 million in the amount of
the aggregate commitment under the Amended Credit Agreement.
Borrowings under the Amended Credit Agreement bear interest, at
ESSI's option, at either the Eurodollar rate plus an applicable margin, or
at the higher of the prime rate or the federal funds rate plus one-half of
one percent. The margin applicable to the Eurodollar rate varies from 0.625%
to 1.375% depending upon ESSI's ratio of total indebtedness to earnings
before interest, taxes, depreciation and amortization (leverage ratio). The
Amended Credit Agreement contains certain covenants, including maintaining
net worth of at least $265 million, plus 50% of the sum, to extent positive,
of ESSI's consolidated net income and other comprehensive income (loss)
reported after October 31, 2004, plus the net proceeds of all subsequent
equity offerings. ESSI also must comply with certain financial covenants,
including maintenance of a leverage ratio of no greater than 2.75 to 1. ESSI
is also subject to various other financial and operating covenants and
maintenance criteria, including restrictions on ESSI's ability to incur
additional indebtedness, make investments, pay dividends over a specified
amount, create liens, dispose of material assets and enter into merger
transactions and acquisitions. As of October 31, 2005, ESSI had $45 million
in borrowings against the Amended Credit Facility, and was in compliance
with all applicable covenants.
ESSI's working capital needs are generally funded through cash flow
from operations and the revolving credit facility. At October 31, 2005,
ESSI's working capital and ratio of current assets to current liabilities
were $71.9 million and 1.40 to 1, respectively, compared with $112.0 million
and 1.85 to 1 at October 31, 2004. During 2005, ESSI expended cash totaling
$190.5 million in conjunction with the acquisitions of PCA, Spacelink and
Mobilized Systems. ESSI financed these transactions with available cash
resources and short-term borrowings under its revolving credit facility. The
significant changes in working capital and the ratio of current assets to
current liabilities from October 31, 2004 were due to these acquisitions and
the related increase in short-term borrowings against ESSI's revolving
credit facility.
Net cash provided by operations totaled $101.9 million in 2005
compared to net cash provided by operations of $66.6 million in 2004. This
$35.3 million increase was a result of the significantly improved operating
results, as discussed above, as well as a $20.6 million reduction in working
capital growth in 2005 from the prior year. ESSI's investment in property,
plant and equipment totaled $12.1 million and $8.0 million in 2005 and 2004,
respectively. This $4.1 million increase was primarily due to the
construction of the Company's 80,000 square foot hanger to be used for
aircraft repair and maintenance. In 2004, ESSI realized $5.7 million in
proceeds primarily related to the sales of its Sanford, Florida and Blue
Ash, Ohio facilities. ESSI anticipates that capital expenditures in 2006
should not exceed $15.0 million. During 2005 and 2004, ESSI received
proceeds, including related income tax benefits, of $31.8 million and $56.5
million, respectively, related to the exercise of stock options, which are
classified as financing cash flows within the Consolidated Statements of
Cash Flow. ESSI management believes that cash flow generated from
operations, together with its revolving credit facility, will provide the
necessary resources to meet ESSI's needs for the foreseeable future.
COMMITTED AMOUNTS
Total contractual and contingent obligations, in thousands, as of
October 31, 2005 are as follows:
Payments / Expiration
Year Ended October 31 2006 2007 2008 2009 2010 Total
---- ---- ---- ---- ---- -----
Contractual Obligations:
Long-term debt $ 187 $ 198 $ 391 $ 533 $ $ 1,309
Operating leases 5,347 4,087 2,384 1,495 573 13,886
Unconditional purchase obligations 202,834 8,912 211,746
Contributions to pension and other
postretirement benefit plans 7,471 7,471 7,371 7,371 3,871 33,555
-------- ------- ------- ------ ------ --------
215,839 20,668 10,146 9,399 4,444 260,496
Contingent Obligations:
Letters of credit 1,840 1,840
-------- ------- ------- ------ ------ --------
Total Obligations $217,679 $20,668 $10,146 $9,399 $4,444 $262,336
======== ======= ======= ====== ====== ========
25
While contingent obligations are included in the table above, ESSI
does not expect to fund the full amounts indicated for letters of credit.
Lease expense totaled $5.9 million, $5.0 million and $4.2 million for the
years ended October 31, 2005, 2004 and 2003, respectively.
INFLATION
Since a significant portion of ESSI's contracts with the DoD are at
fixed prices, inflation can affect the ultimate profit to be realized on
them. Some contracts have price adjustment provisions that limit the impact
of inflation on profits. In addition, ESSI's volume purchasing and forward
purchasing policies serve to limit the effects of inflation. ESSI considers
potential inflation in preparation of contract proposals and bids. In
addition, ESSI's commercial and industrial products are predominantly
custom-made. Therefore, the impact of inflation on operating results
typically is not significant. ESSI attempts to alleviate inflationary
pressures on commercial and industrial products by increasing selling prices
to help offset rising costs (subject to competitive conditions), increasing
productivity and improving manufacturing techniques. Because of these
factors, management does not believe that inflation has had, or that
anticipated inflation will have, a significant effect on ESSI's operations.
BUSINESS AND MARKET CONSIDERATIONS
Approximately 96% of ESSI's consolidated net revenues for 2005 were
directly or indirectly derived from defense orders by the U.S. government or
its agencies. As of October 31, 2005, ESSI's funded backlog of orders
totaled $689.8 million, with related customer options of an additional
$1,487.1 million. These amounts compare to funded backlog of $588.1 million
and related customer options of an additional $849.2 million as of October
31, 2004.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In October 2004, the U.S. Congress passed the American Jobs
Creation Act of 2004 (the Jobs Creation Act). The Jobs Creation Act includes
numerous provisions that may materially affect business practices and
accounting for income taxes. For companies that pay U.S. income taxes on
manufacturing activities in the U.S., the Jobs Creation Act provides a
phased-in deduction from taxable income equal to a stipulated percentage of
qualified income from domestic production activities. In December 2004, the
Financial Accounting Standards Board (FASB) issued two FASB Staff Positions
(FSP) regarding the accounting implications of the Jobs Creation Act related
to (1) the deduction for qualified domestic production activities (FSP
109-1) and (2) the one-time tax benefit for the repatriation of foreign
earnings (FSP 109-2). This guidance applies to financial statements for
periods ending after the date the Jobs Creation Act was enacted. The Jobs
Creation Act also provides for a change in the period of application of for
foreign tax credits, elimination of the 90-percent limitation of foreign tax
credits against Alternative Minimum Tax, expanded disallowance of interest
on convertible debt, and tax shelter disclosure penalties. ESSI adopted FSP
109-1 and FSP 109-2 in the first quarter of 2005. The one-time tax benefit
for the repatriation of foreign earnings does not apply to the Company. ESSI
anticipates that the Jobs Creation Act and related FASB pronouncements will
have a material impact its consolidated financial statements in future
periods. However, this impact was not material for the year ended October
31, 2005.
In November 2004, the FASB issued Statement of Financial Accounting
Standards (SFAS) No. 151, "Inventory Costs - an amendment of ARB No. 43,
Chapter 4." SFAS 151 seeks to clarify the accounting for abnormal amounts of
idle facility expense, freight, handling costs and wasted material
(spoilage) in the determination of inventory carrying costs. The statement
requires such costs to be treated as current period expense. This statement
is effective November 1, 2005 for ESSI. ESSI does not believe that the
adoption of SFAS 151 will have a significant impact on the consolidated
financial statements.
26
In December 2004, the FASB issued SFAS 123 (revised 2004),
"Share-Based Payment", (SFAS 123R). SFAS 123R requires companies to expense
the value of employee stock options and similar awards. SFAS 123R is
effective November 1, 2005 for ESSI. ESSI is currently evaluating its
compensation policies and practices, along with the impact of SFAS 123R on
its consolidated results of operations.
In May 2005, the FASB issued SFAS 154, "Accounting Changes and
Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement
No. 3" (SFAS 154). SFAS 154 requires retrospective application to prior
period financial statements of changes in accounting principle, unless it is
impracticable to determine either the period-specific effects or the
cumulative effect of the change. SFAS 154 also redefines "restatement" as
the revising of previously issued financial statements to reflect the
correction of an error. This statement is effective for accounting changes
and corrections of errors made in fiscal years beginning after December 15,
2005 (or fiscal 2007 for ESSI). ESSI does not believe that the adoption of
SFAS 154 will have a significant impact on the consolidated financial
statements.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
-------- ----------------------------------------------------------
Market risks relating to ESSI's operations result primarily from
changes in interest rates. Given ESSI's existing debt levels, significant
cash flows and anticipated expenditures, ESSI's management has not utilized
interest rate swaps or other derivative contracts to hedge this risk since
November 2002. ESSI's management does not believe its exposure to interest
rate fluctuations has had, or will have, a significant impact on ESSI's
operations. A 10% increase in ESSI's effective interest rate would have
resulted in additional interest expense of $0.2 million for the year ended
October 31, 2005.
27
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
------- -------------------------------------------
ENGINEERED SUPPORT SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
In thousands, except per share amounts
October 31 2005 2004
---------------------------------------------------------------------------------------------------------------------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents $ 13,064 $ 33,153
Accounts receivable, net 151,210 139,191
Contracts in process and inventories, net 77,193 61,009
Income taxes receivable 1,046
Deferred income taxes 6,284 6,921
Prepaid expenses and other assets 3,568 2,846
---------------------------------------------------------------------------------------------------------------------------
Total Current Assets 252,365 243,120
PROPERTY, PLANT AND EQUIPMENT
Land 4,390 4,387
Buildings and improvements 46,385 39,704
Machinery and equipment 32,753 26,567
Furniture and fixtures 7,303 5,465
---------------------------------------------------------------------------------------------------------------------------
90,831 76,123
Accumulated depreciation (36,281) (29,177)
---------------------------------------------------------------------------------------------------------------------------
54,550 46,946
Goodwill 332,109 167,358
Acquired customer-related intangibles 51,868 38,314
Deferred income taxes 1,876
Other assets 11,265 13,520
---------------------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $702,157 $511,134
---------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Notes payable $ 45,000 $
Current maturities of long-term debt 187 340
Accounts payable 79,705 71,796
Income taxes payable 10,067
Accrued employee compensation 33,534 27,806
Other liabilities 22,007 21,063
---------------------------------------------------------------------------------------------------------------------------
Total Current Liabilities 180,433 131,072
Long-term debt 1,952 781
Deferred income taxes 1,873
Minimum pension liability 31,141 28,237
Other liabilities 13,449 14,088
Commitments and contingencies (Note M)
SHAREHOLDERS' EQUITY
Common stock, par value $.01 per share; 85,000 shares
authorized; 41,912 and 26,642 shares issued 419 266
Additional paid-in capital 205,998 151,805
Retained earnings 286,559 202,730
Accumulated other comprehensive loss (19,667) (17,845)
---------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 473,309 336,956
---------------------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $702,157 $511,134
---------------------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements.
28
ENGINEERED SUPPORT SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF INCOME
In thousands, except per share amounts
Year Ended October 31 2005 2004 2003
---------------------------------------------------------------------------------------------------------------------------
Net revenues:
Products $ 560,929 $596,162 $461,490
Services 457,444 287,468 111,211
---------------------------------------------------------------------------------------------------------------------------
1,018,373 883,630 572,701
---------------------------------------------------------------------------------------------------------------------------
Cost of revenues:
Products 378,162 408,282 340,380
Services 395,175 252,658 94,262
---------------------------------------------------------------------------------------------------------------------------
773,337 660,940 434,642
---------------------------------------------------------------------------------------------------------------------------
Gross profit 245,036 222,690 138,059
Selling, general and administrative expense 103,590 98,042 63,832
Restructuring expense 62 1,758
Gain (loss) on sale of assets (24) (1,290) 147
---------------------------------------------------------------------------------------------------------------------------
Operating income from continuing operations 141,422 123,296 72,616
Interest expense (2,651) (1,215) (1,881)
Interest income 828 353 221
---------------------------------------------------------------------------------------------------------------------------
Income from continuing operations 139,599 122,434 70,956
Income tax provision 52,350 46,525 27,673
---------------------------------------------------------------------------------------------------------------------------
Net income from continuing operations 87,249 75,909 43,283
Discontinued operations:
Income from discontinued operations,
net of income tax 294
Loss on disposal, net of income tax (2,073) (169)
---------------------------------------------------------------------------------------------------------------------------
Net income $ 85,176 $ 75,909 $ 43,408
===========================================================================================================================
Basic earnings per share:
Continuing operations $ 2.11 $ 1.95 $ 1.19
Discontinued operations (0.05)
---------------------------------------------------------------------------------------------------------------------------
Total $ 2.06 $ 1.95 $ 1.19
===========================================================================================================================
Diluted earnings per share:
Continuing operations $ 2.02 $ 1.82 $ 1.12
Discontinued operations (0.05)
---------------------------------------------------------------------------------------------------------------------------
Total $ 1.97 $ 1.82 $ 1.12
===========================================================================================================================
See Notes to Consolidated Financial Statements.
29
ENGINEERED SUPPORT SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
Accumulated
In thousands Additional Other
Common Paid-in Retained Comprehensive Treasury
Stock Capital Earnings Loss Stock Total
---------------------------------------------------------------------------------------------------------------------------
Balance at October 31, 2002 $170 $ 95,569 $84,961 $(14,275) $(31,568) $134,857
Comprehensive income:
Net income 43,408 43,408
Other components of
comprehensive
income, net of tax:
Minimum pension
liability adjustment (2,044) (2,044)
Adjustment to fair
value of derivatives 177 177
--------
Total comprehensive income 41,541
--------
Cash dividends (616) (616)
Issuance of common stock 1 1,727 1,728
Exercise of stock options 8,682 9,705 18,387
Purchase of treasury stock (557) (557)
Issuance of treasury stock 983 844 1,827
Three-for-two stock split 82 (449) 367
---------------------------------------------------------------------------------------------------------------------------
Balance at October 31, 2003 253 106,512 127,753 (16,142) (21,209) 197,167
Comprehensive income:
Net income 75,909 75,909
Other components of
comprehensive
income, net of tax:
Minimum pension
liability adjustment (2,293) (2,293)
Currency translation
adjustment 590 590
--------
Total comprehensive income 74,206
--------
Cash dividends (932) (932)
Issuance of common stock 1 4,135 4,136
Exercise of stock options 12 36,594 19,920 56,526
Issuance of treasury stock 409 1,289 1,698
Stock option compensation 4,155 4,155
---------------------------------------------------------------------------------------------------------------------------
Balance at October 31, 2004 266 151,805 202,730 (17,845) 336,956
Comprehensive income:
Net income 85,176 85,176
Other components of
comprehensive
income, net of tax:
Minimum pension
liability adjustment (2,014) (2,014)
Currency translation
adjustment 192 192
--------
Total comprehensive income 83,354
--------
Cash dividends (1,347) (1,347)
Issuance of common stock
related to Spacelink acquisition 2 13,241 13,243
Issuance of common stock 2 9,342 9,344
Exercise of stock options 10 31,749 31,759
Three-for-two stock split 139 (139)
---------------------------------------------------------------------------------------------------------------------------
Balance at October 31, 2005 $419 $205,998 $286,559 $(19,667) $ $473,309
===========================================================================================================================
See Notes to Consolidated Financial Statements.
30
ENGINEERED SUPPORT SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
In thousands
Year Ended October 31 2005 2004 2003
----------------------------------------------------------------------------------------------------------------------
CASH FLOW FROM OPERATING ACTIVITIES:
Net income $ 85,176 $ 75,909 $ 43,408
Adjustments to reconcile net income from continuing
operations to net cash provided by continuing
operations:
Loss (gain) from discontinued operations 2,073 (125)
Depreciation and amortization 18,286 12,991 8,961
Deferred income taxes 5,918 2,423 5,768
Loss (gain) on sale of assets 24 1,290 (147)
Stock option compensation expense 4,155
----------------------------------------------------------------------------------------------------------------------
Cash provided by continuing operations
before changes in operating assets and
liabilities, excluding the effects
of acquisitions 111,477 96,768 57,865
Changes in operating assets and liabilities:
Accounts receivable 13,801 (47,657) (13,639)
Contracts in process and inventories (11,501) (7,520) 3,065
Accounts payable 6,895 22,455 5,539
Current income taxes (11,113) 7,826 4,996
Net changes in other assets and liabilities (7,708) (5,303) 7,017
----------------------------------------------------------------------------------------------------------------------
Net cash provided by continuing operations 101,851 66,569 64,843
Net cash provided by discontinued
operations 1,612
----------------------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 101,851 66,569 66,455
----------------------------------------------------------------------------------------------------------------------
CASH FLOW FROM INVESTING ACTIVITIES:
Purchase of PCA, net of cash acquired (37,648)
Purchase of Spacelink, net of cash acquired (136,149)
Purchase of Mobilized Systems, net of cash acquired (16,744)
Purchase of Pivotal Power, net of cash acquired (10,064)
Purchase of TAMSCO, net of cash acquired (7,440) (77,415)
Purchase of EEI, net of cash acquired (99) (16,630)
Purchase of UPSI, net of cash acquired (2,026) (5,008)
Additions to property, plant and equipment (12,066) (8,034) (9,681)
Proceeds from sale of property, plant and equipment 59 5,674 316
----------------------------------------------------------------------------------------------------------------------
Net cash used in continuing operations (202,548) (21,989) (108,418)
Net cash provided by discontinued operations 2,918
----------------------------------------------------------------------------------------------------------------------
Net cash used in investing activities (202,548) (21,989) (105,500)
----------------------------------------------------------------------------------------------------------------------
CASH FLOW FROM FINANCING ACTIVITIES:
Net borrowings (payments) under line-of-credit agreement 45,000 (73,100) 60,100
Payments of long-term debt (431) (285) (41,910)
Proceeds of long-term debt 1,409 382
Exercise of stock options, including related income tax benefit 31,759 56,526 18,387
Purchase of treasury stock (557)
Cash dividends (1,347) (932) (616)
Issuance of common stock to employee
stock purchase plan 4,268 3,079 1,728
----------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) continuing operations 80,658 (14,330) 37,132
Net cash provided by (used in) discontinued operations
----------------------------------------------------------------------------------------------------------------------
Net cash provided by (used in) financing activities 80,658 (14,330) 37,132
----------------------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash (50) 23
----------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents (20,089) 30,273 (1,913)
Cash and cash equivalents at beginning of year 33,153 2,880 4,793
----------------------------------------------------------------------------------------------------------------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 13,064 $ 33,153 $ 2,880
======================================================================================================================
See Notes to Consolidated Financial Statements.
31
ENGINEERED SUPPORT SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share amounts)
NOTE A -- SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Principles of Consolidation: The
Consolidated Financial Statements include the accounts of Engineered Support
Systems, Inc. (Company) and its wholly-owned subsidiaries. These
subsidiaries are organized within the Company's two business segments:
Support Systems and Support Services. The Support Systems segment includes
the operations of Systems & Electronics Inc. (SEI), Keco Industries, Inc.
(Keco), Engineered Air Systems, Inc. (Engineered Air), Engineered Coil
Company, d/b/a Marlo Coil (Marlo Coil), Engineered Electric Company, d/b/a
Fermont (Fermont), Universal Power Systems, Inc. (UPSI), Engineered
Environments, Inc. (EEI), Pivotal Power Inc. (Pivotal Power), Prospective
Computer Analysts, Inc. (PCA) and Mobilized Systems, Inc. (Mobilized
Systems). The Support Services segment includes the operations of Technical
and Management Services Corporation (TAMSCO), Radian, Inc. (Radian),
Spacelink International, LLC (Spacelink) and ESSIbuy.com, Inc. (ESSIbuy).
All material intercompany accounts and transactions have been eliminated in
consolidation.
Industry Information: The Company's Support Systems segment
designs, engineers and manufactures integrated military electronics and
other military support equipment primarily for the U.S. Department of
Defense (DoD), as well as related heat transfer and air handling equipment
for domestic commercial and industrial users. Segment products include
environmental control systems, load management and transport systems, power
generation, distribution and conditioning systems, airborne radar systems,
reconnaissance, surveillance and target acquisition systems, chemical and
biological protection systems, petroleum and water distribution systems and
other multipurpose military support equipment. The Company's Support
Services segment provides engineering services, logistics and training
services, advanced technology services, asset protection systems and
services, telecommunication systems integration and information technology
services primarily for the DoD. The Support Services segment also provides
certain power generation and distribution equipment and vehicle armor
installation to the DoD. Substantially all revenues are directly or
indirectly derived from contracts with the U.S. Government.
Use of Estimates: In preparing these financial statements,
management makes estimates and uses assumptions that affect some of the
reported amounts and disclosures. Actual results could differ from these
estimates and assumptions.
Cash and Cash Equivalents: Cash equivalents include temporary
investments with original maturities of three months or less.
Revenue Recognition: Revenues on long-term contracts,
substantially all of which are with the U.S. government, are recognized
under the percentage of completion method and include a proportion of the
earnings that are expected to be realized on the contract in the ratio that
production measures, primarily labor, incurred bear to the total estimated
production measures for the contract. Earnings expectations are based upon
estimates of contract values and costs at completion. Contracts in process
are reviewed on a periodic basis. Adjustments to revenues and earnings are
made in the current accounting period based upon revisions in contract
values and estimated costs at completion. Amounts representing contract
change orders, claims and other items are included in revenues, as
recognized under the percentage of completion method, only when these
amounts can be reliably estimated and realization is probable. Provisions
for estimated losses on contracts are recorded when identified.
Substantially all other revenues are recognized when title passes to the
customer.
Stock-Based Compensation: The Company applies Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees," and
related interpretations in accounting for all stock option plans. (See Note
J for a further description of these plans.) Accordingly, no compensation
expense has been recognized for stock option awards. The following table
illustrates the effect on net income and earnings per share had the Company
applied the fair value recognition provisions of Statement of Financial
Accounting Standards (SFAS) 123, "Accounting for Stock-Based Compensation,"
to stock option awards.
32
Year Ended October 31 2005 2004 2003
--------------------- ---- ---- ----
Reported net income $85,176 $75,909 $43,408
Total stock-based employee compensation
expense determined under the fair value method
for all stock option awards, net of income tax 7,265 2,924 3,521
------- ------- -------
Pro forma net income $77,911 $72,985 $39,887
======= ======= =======
Earnings per share:
Basic - as reported $ 2.06 $ 1.95 $ 1.19
======= ======= =======
Basic - pro forma $ 1.89 $ 1.87 $ 1.10
======= ======= =======
Diluted - as reported $ 1.97 $ 1.82 $ 1.12
======= ======= =======
Diluted - pro forma $ 1.80 $ 1.75 $ 1.03
======= ======= =======
The fair value of options at the grant date was estimated using
the Black-Scholes model with the following weighted average assumptions for
2005, 2004 and 2003, respectively: an expected life of 2.5, 1.5 and 1.5
years; volatility of 35%, 26%, and 36%; a dividend yield of 0.08%, 0.11% and
0.18%; and a risk-free interest rate of 3.59%, 3.52%, and 3.25%.
The weighted average fair value of options granted in 2005, 2004
and 2003 was $9.03, $5.37 and $5.03, respectively.
Fair Value of Financial Instruments: For purposes of financial
reporting, the Company has determined that the fair value of the Company's
financial instruments, including cash and cash equivalents, accounts
receivable, accounts payable, accrued liabilities and long-term debt,
approximates book value at October 31, 2005 and 2004, based on either their
short-term nature or on terms currently available to the Company in
financial markets.
Credit Risk: Financial instruments which potentially subject the
Company to concentrations of credit risk consist principally of cash and
cash equivalents, and accounts receivable. At October 31, 2005 and 2004, the
Company's cash and cash equivalents were primarily invested in money market
accounts at a financial institution. Management believes the credit risk is
limited due to the short-term nature of these funds. Management believes the
credit risk related to accounts receivable is limited due to the fact that
76% and 79% of accounts receivable at October 31, 2005 and 2004,
respectively, are due from the U.S. government and its agencies. Allowances
for anticipated doubtful accounts are provided based on historical
experience and evaluation of specific accounts. The allowance for doubtful
accounts was $1,060 and $90 at October 31, 2005 and 2004, respectively.
Interest Rate Risk: Interest rate risk is managed through a
portfolio of variable- and fixed-rate debt that management deems
appropriate. Furthermore, the Company will periodically convert its
variable-rate debt to fixed rates via interest rate swaps. Given the
Company's outstanding debt position and anticipated cash flows, management
does not believe its exposure to interest rate fluctuations has had, or will
have, a significant impact on the Company's operations. The Company,
therefore, had no interest rate swaps as of October 31, 2005.
Contracts in Process and Inventories: Contracts in process and
inventories represent accumulated contract costs, estimated earnings thereon
based upon the percentage of completion method and contract inventories
reduced by the contract value of delivered items. Accumulated contract costs
and inventories are stated at actual costs incurred and consist of direct
engineering, production, tooling, applicable overhead and other costs
(excluding selling, general and administrative costs which are charged
against income as incurred). Title to or a security interest in certain
items included in contracts in process and inventories is vested in the U.S.
government by reason of the progress payment provisions of related
contracts. In accordance with industry standards, contracts in process and
inventories related to long-term contracts are classified as current assets
although a portion may not be realized within one year. Substantially all
inventories related to contracts not accounted for under the percentage of
completion method are valued at the lower of cost or market using the
first-in, first-out method.
Property, Plant and Equipment: Property, plant and equipment are
stated at cost and are depreciated using the straight-line method over their
estimated useful lives of 15 to 40 years for buildings and improvements, 5
to 15 years for machinery and equipment, and 3 to 10 years for furniture and
fixtures. Depreciation expense totaled $7,752 in 2005, $5,627 in 2004 and
$5,387 in 2003.
33
Income Taxes: The income tax provision is based on earnings
reported in the financial statements. Deferred income taxes are provided for
the tax effects of temporary differences between financial and income tax
reporting using current statutory tax rates.
Impairment of Long-lived Assets: Long-lived assets, including
goodwill, are reviewed for impairment annually or whenever events or changes
in circumstances indicate that the carrying amount may not be recoverable.
If the sum of the expected future undiscounted cash flows is less than the
carrying amount of the asset, a loss is recognized for the difference
between the fair value and the carrying value of the asset.
Earnings Per Share: Basic earnings per share is based on average
basic common shares outstanding, after the effect to the stock split
described in Note O, of 41,329 in 2005, 38,987 in 2004 and 36,305 in 2003.
Diluted earnings per share is based on average diluted common shares
outstanding, after giving effect to the stock split described in Note O, of
43,232 in 2005, 41,799 in 2004 and 38,757 in 2003. Average diluted common
shares outstanding include common stock equivalents, which represent common
stock options as computed using the treasury stock method.
Treasury Stock: Shares of treasury stock are valued at cost using
the first-in, first-out method.
Recently Issued Accounting Pronouncements: In October 2004, the
U.S. Congress passed the American Jobs Creation Act of 2004 (the Jobs
Creation Act). The Jobs Creation Act includes numerous provisions that may
materially affect business practices and accounting for income taxes. For
companies that pay U.S. income taxes on manufacturing activities in the
U.S., the Jobs Creation Act provides a phased-in deduction from taxable
income equal to a stipulated percentage of qualified income from domestic
production activities. In December 2004, the Financial Accounting Standards
Board (FASB) issued two FASB Staff Positions (FSP) regarding the accounting
implications of the Act related to (1) the deduction for qualified domestic
production activities (FSP 109-1) and (2) the one-time tax benefit for the
repatriation of foreign earnings (FSP 109-2). This guidance applies to
financial statements for periods ending after the date the Act was enacted.
The Jobs Creation Act also provides for a change in the period of
application for foreign tax credits, elimination of the 90-percent
limitation of foreign tax credits against Alternative Minimum Tax, expanded
disallowance of interest on convertible debt, and tax shelter disclosure
penalties. The Company adopted FSP 109-1 and FSP 109-2 in the first quarter
of 2005. The one-time tax benefit for the repatriation of foreign earnings
does not apply to the Company. The Company anticipates that the Jobs
Creation Act and related FASB pronouncements will have a material impact on
the Company's consolidated financial statements in future periods. However,
this impact was not material for the year ended October 31, 2005.
In November 2004, the FASB issued Statement of Financial Accounting
Standards (SFAS) 151, "Inventory Costs - an amendment of ARB No. 43, Chapter
4." SFAS 151 seeks to clarify the accounting for abnormal amounts of idle
facility expense, freight, handling costs and wasted material (spoilage) in
the determination of inventory carrying costs. The statement requires such
costs to be treated as a current period expense. This statement is effective
November 1, 2005 for the Company. The Company does not believe that the
adoption of SFAS 151 will have a significant impact on its consolidated
financial statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004),
"Share-Based Payment," (SFAS 123R). SFAS 123R requires companies to expense
the value of employee stock options and similar awards. SFAS 123R is
effective November 1, 2005 for the Company. The Company is currently
evaluating its compensation policies and practices, along with the impact of
SFAS 123R on its consolidated results of operations.
In May 2005, the FASB issued SFAS 154, "Accounting Changes and
Error Corrections - a Replacement of APB Opinion No. 20 and FASB Statement
No. 3." SFAS 154 requires retrospective application to prior period
financial statements of changes in accounting principle, unless it is
impracticable to determine either the period-specific effects or the
cumulative effect of the change. SFAS 154 also redefines "restatement" as
the revising of previously issued financial statements to reflect the
correction of an error. This statement is effective for accounting changes
and corrections of errors made in fiscal years beginning after December 15,
2005 (or fiscal 2007 for the Company). The Company does not believe that the
adoption of SFAS 154 will have a significant impact on its consolidated
financial statements.
34
NOTE B -- ACQUISITIONS
On January 7, 2005, the Company acquired all of the outstanding
stock of PCA, which develops and manufactures electronic test and
measurement equipment provided for electronic warfare and avionics systems
primarily to military customers. The purchase price was $37.6 million and is
subject to a working capital adjustment. The purchase price was financed
with the Company's existing cash balances. The fair value of assets
acquired, including goodwill of $24.1 million and acquired customer-related
intangibles of $6.4 million, was $38.1 million and liabilities assumed
totaled $0.5 million.
Effective February 1, 2005, the Company acquired all of the
outstanding stock of Spacelink, which designs, integrates, operates and
maintains deployed satellite and wireless networks for the DoD, the U.S.
intelligence community and other forward deployed federal agencies and
multinational organizations worldwide. The purchase price, including
transaction costs, was $154.6 million, which included common stock of the
Company with a value of $13.2 million. The cash consideration was financed
with short-term borrowings under the Company's revolving credit facility.
The purchase price was net of $2.2 million of cash acquired. The purchase
price is also subject to a working capital adjustment of approximately $2.9
million, tax adjustments pursuant to Section 338(h)(10) of the Internal
Revenue Code of approximately $2.3 million and to certain contingent cash
consideration based upon Spacelink's earnings before interest, taxes,
depreciation and amortization, as defined, for each of the twelve month
periods ending January 31, 2006 and 2007. The fair value of assets acquired,
including goodwill of $128.0 million and acquired customer-related
intangibles of $13.8 million, was $165.7 million and liabilities assumed
totaled $11.1 million.
The following unaudited pro forma summary presents the combined
results for the years ended October 31, 2005 and 2004, respectively, as
adjusted to reflect the Spacelink purchase transaction assuming the
acquisition had occurred at November 1, 2003. These pro forma results are
not necessarily indicative of the combined results that would have occurred
had the acquisition actually taken place on November 1, 2003, nor are they
necessarily indicative of the combined results that may occur in the future.
Year Ended October 31
---------------------
2005 2004
---- ----
Net revenues $1,040,087 $979,790
========== ========
Net income $85,181 $76,415
======= =======
Basic earnings per share $2.06 $1.94
===== =====
Diluted earnings per share $1.97 $1.81
===== =====
35
Pro forma net income from operations for the year ended October 31,
2005 includes $1,249, or $0.03 per basic and diluted earnings per share from
continuing operations, related to the combined after-tax impact of one-time
bonus expenses and transaction costs incurred by Spacelink.
Certain information with respect to the assets and liabilities of
Spacelink as of the acquisition date is summarized below:
February 1, 2005
----------------
Accounts receivable $ 19,930
Other current assets 910
Property, plant and equipment 3,021
Goodwill 127,955
Acquired customer-related intangibles 13,810
--------
Total assets $165,626
========
Accounts payable $ 398
Accrued liabilities 10,675
--------
Total liabilities $ 11,073
========
Effective May 1, 2005, the Company acquired all of the outstanding
stock of Mobilized Systems, which designs, manufacturers and tests highly
specialized trailers, shelters and environmental control systems, primarily
for the defense industry. The purchase price was $17.5 million, net of cash
acquired, of which $16.7 million has been paid as of October 31, 2005 as
reflected in the Consolidated Statement of Cash Flows. The remaining $0.8
million of consideration is in the form of long-term promissory notes
payable to the sellers. The cash portion of the purchase price was financed
with short-term borrowings under the Company's revolving credit facility.
The fair value of assets acquired, including goodwill of $12.7 million and
customer-related intangibles of $3.2 million, was $19.1 million and
liabilities assumed totaled $1.6 million.
On December 5, 2003, the Company acquired all of the outstanding
stock of Pivotal Power, a supplier of high-performance static power
conversion equipment primarily to military customers. The purchase price was
approximately $10.1 million, net of cash acquired. The fair value of assets
acquired, including goodwill of $4.8 million and acquired customer-related
intangibles of $1.2 million, was $11.6 million and liabilities assumed
totaled $1.5 million. The purchase price was financed with short-term
borrowings under the Company's revolving credit facility.
On September 24, 2003, the Company acquired all of the outstanding
common stock of EEI, a designer and manufacturer of specialized
environmental control units and heat transfer systems for defense and
industrial markets. The purchase price was approximately $15.6 million. The
purchase of EEI, net of cash acquired, totaled $16.7 million in the
Consolidated Statements of Cash Flows, which represents the $15.6 million
purchase price plus assumed indebtedness of $1.1 million. The initial
purchase price allocation for EEI was based on preliminary information,
which was subject to adjustment upon obtaining complete valuation
information. During the fourth quarter of 2004, the Company completed its
valuation and reclassified $2.9 million from goodwill, as recorded in the
preliminary allocation, to acquired customer-related intangibles and
recorded a $0.5 million non-cash charge in the quarter ended October 31,
2004 to reflect the related amortization expense from acquisition date. The
fair value of assets acquired, including goodwill of $11.6 million and
acquired customer-
36
related intangibles of $2.9 million, was $19.9 million and liabilities
assumed totaled $4.3 million. The purchase price was financed with
short-term borrowings under the Company's revolving credit facility.
On May 1, 2003, the Company acquired all of the outstanding common
stock of TAMSCO, a provider of information technology logistics and
digitization services and a designer and integrator of telecommunication
systems primarily for the DoD. The purchase price was approximately $71.1
million, which is net of $0.1 million of cash acquired. Approximately $1.1
million of the purchase price has not been paid subject to final collection
of accounts receivable. In connection with this transaction, the Company
also assumed and paid $14.9 million of TAMSCO indebtedness. The purchase of
TAMSCO, net of cash acquired, totals $84.9 million in the Consolidated
Statements of Cash Flows, which represents the $71.1 million purchase price
plus assumed indebtedness of $14.9 million less $1.1 million of purchase
price not yet paid. The initial purchase price allocation for TAMSCO was
based on preliminary information, which was subject to adjustment upon
obtaining complete valuation information. During the second quarter of 2004,
the Company completed its valuation of the assets acquired and liabilities
assumed. As a result, the Company reclassified $29.9 million from goodwill,
as recorded in the preliminary allocation, to acquired customer-related
intangibles and recorded a $2.2 million non-cash charge in the quarter ended
April 30, 2004 to reflect the related amortization expense from acquisition
date. The fair value of assets acquired, including goodwill of $35.9 million
and acquired customer-related intangibles of $29.9 million, was $103.9
million and liabilities assumed totaled $32.8 million. The purchase price
was financed with short-term borrowings under the Company's revolving credit
facility.
The following unaudited pro forma summary presents the combined
historical results of operations, after giving effect to the stock split
described in Note O, for the year ended October 31, 2003 as adjusted to
reflect the TAMSCO purchase transaction assuming the acquisition had
occurred at November 1, 2002. These pro forma results are not necessarily
indicative of the combined results that would have occurred had the
acquisition actually taken place on November 1, 2002, nor are they
necessarily indicative of the combined results that may occur in the future.
Year Ended
October 31
2003
----------
Net revenues $ 652,655
==========
Net income $ 46,269
==========
Basic earnings per share $ 1.27
==========
Diluted earnings per share $ 1.19
==========
37
Spacelink and TAMSCO are included in the Support Services segment.
PCA, Mobilized Systems, Pivotal Power and EEI are included in the Support
Systems segment. The operating results of each are included in consolidated
operations since their respective dates of acquisition.
NOTE C -- GOODWILL AND INTANGIBLE ASSETS
The following table presents changes in the Company's goodwill for
the Support Systems segment and for the Support Services segment for the three
years ended October 31, 2005:
Support Support
Systems Services Total
------- -------- -----
October 31, 2002 $ 76,833 $ 26,611 $103,444
Acquisitions 18,886 69,002 87,888
-------- -------- --------
October 31, 2003 95,719 95,613 191,332
Acquisitions 6,935 1,821 8,756
Reclassification to
acquired
customer-related
intangibles (2,880) (29,850) (32,730)
-------- -------- --------
October 31, 2004 99,774 67,584 167,358
Acquisitions 36,796 127,955 164,751
-------- -------- --------
October 31, 2005 $136,570 $195,539 $332,109
======== ======== ========
As of October 31, 2005, the Company had $271.3 million of remaining
tax deductible goodwill.
The following disclosure presents certain information on the
Company's acquired identifiable intangible assets as of October 31, 2005,
2004 and 2003. All acquired identifiable intangible assets are being
amortized over their estimated useful lives, as indicated below, with no
estimated residual values.
38
Weighted Average
Amortization Gross Accumulated Net
Period Amount Amortization Amount
---------------- ------- ------------ -------
Customer-related intangibles:
October 31, 2005 9.3 years $72,660 $20,792 $51,868
October 31, 2004 11.6 years 49,263 10,949 38,314
October 31, 2003 5.4 years 15,300 4,251 11,049
The amortization expense related to acquired intangible assets was
$9,843, $6,698 and $2,831, respectively, for the years ended October 31,
2005, 2004 and 2003. (Amoritization expense related to acquired intangible
assets for the year ended October 31, 2004 includes $2,151 related to
finalization of the TAMSCO intangible asset valuation. Total related TAMSCO
amoritization expense was $1,981 and $3,142, respectively, for the years
ended October 31, 2005 and 2004.) Related estimated amortization expense is
$10,953 for the year ending October 31, 2006, $10,204 for the year ending
October 31, 2007, $7,001 for the year ending October 31, 2008, $4,879 for
the year ending October 31, 2009 and $3,222 for the year ending October 31,
2010.
NOTE D -- OPERATIONAL RESTRUCTURING
During the quarter ended April 30, 2003, the Company announced a
restructuring plan under which electronics assembly work performed at the
Sanford, Florida facility of the Company's SEI subsidiary would be relocated
to alternate SEI facilities. Statement of Financial Accounting Standards No.
146 (SFAS 146), "Accounting for Costs Associated with Exit or Disposal
Activities," applies to all disposal activities initiated after December 31,
2002. SFAS 146 requires that a liability for employee termination costs
associated with an exit or disposal activity be recognized when the
liability is incurred. In accordance with SFAS 146, the Company recorded
restructuring expense of $2.1 million in the year ended October 31, 2003 and
$0.1 million in the year ended October 31, 2004, consisting of $1.3 million
for severance and related benefits and $0.9 million for non-cash costs
associated with the write-down of the Sanford, Florida facility to its fair
market value. The Company anticipates that it will record no additional
restructuring expense related to this plan. The plan involved the
termination of 107 employees, all of which had been terminated as of
October 31, 2004. All related severance costs had been paid as of October 31,
2004.
NOTE E -- DISCONTINUED OPERATIONS
The Company completed the sale of Engineered Specialty Plastics,
Inc. (ESP), a wholly-owned subsidiary, in the quarter ended April 30, 2003
to a private equity group (the Buyers). The Buyers subsequently alleged that
the Company breached certain representations made under the related Stock
Purchase Agreement (the Agreement) and sought a claim for associated damages
under the binding arbitration provisions of the Agreement. During the
quarter ended April 30, 2005, the Company and the Buyers reached a
settlement on this claim, which included modification of the Company's $3.2
million note receivable from the Buyers to provide for suspension of
interest charges and payments through July 31, 2006, extension of the note's
repayment term to a balloon payment due in April 2009, and the release of
the underlying real estate collateral securing the note. Because of this
settlement, the Company recorded a charge for the impairment of the note
during the quarter ended April 30, 2005 equal to $1.7 million, or $1.1
million net of income tax. During the quarter ended October 31, 2005, the
Company was informed that the Buyers had liquidated all ESP assets, and the
Company reserved an additional $1.6 million, or $1.0 million net of income
tax, for the impairment of the remainder of the note. These amounts are
reflected in discontinued operations on the Consolidated Statements of
Income for the year ended October 31, 2005. Certain information with respect
to the discontinued operations of ESP is as follows:
Year Ended October 31 2005 2003
--------------------------------------------------------------------------
Net revenues $ $9,136
--------------------------------------------------------------------------
Income from discontinued operations,
net of income tax of $188 in 2003 $ $ 294
Loss on disposal, net of income tax of
$(1,244) in 2005 and $(108) in 2003 (2,073) (169)
--------------------------------------------------------------------------
Income (loss) on discontinued operations $(2,073) $ 125
======= ======
39
NOTE F -- ACCOUNTS RECEIVABLE
Accounts receivable includes amounts due from the U.S. government
and its agencies of $115,561 and $109,991 at October 31, 2005 and 2004,
respectively.
NOTE G -- CONTRACTS IN PROCESS AND INVENTORIES
Contracts in process and inventories are comprised of the following:
October 31 2005 2004
----------------------------------------------------------------------------
Raw materials $ 1,638 $ 1,874
Work-in-process 5,345 5,246
Finished goods 454 493
Inventories substantially applicable
to government contracts in process,
reduced by progress payments of
$54,039 and $54,629 69,756 53,396
----------------------------------------------------------------------------
$77,193 $61,009
============================================================================
Contracts in process and inventories at October 31, 2005 and 2004
include estimated revenue of $95,610 and $82,763, respectively, representing
accumulated contract costs and related estimated earnings on uncompleted
government contracts.
NOTE H -- NOTES PAYABLE
On January 27, 2005, the Company entered into an Amended and
Restated Credit Agreement (Amended Credit Agreement) with its banks. The
Amended Credit Agreement replaced the Company's previous credit agreement
dated April 23, 2003. The Amended Credit Agreement, which expires January
27, 2010, provides for a $200 million unsecured revolving credit facility.
The Company may request, subject to certain conditions, an increase of up to
$100 million in the amount of the aggregate commitment under the Amended
Credit Agreement.
Borrowings under the Amended Credit Agreement bear interest, at the
Company's option, at either the Eurodollar rate plus an applicable margin,
or at the higher of the prime rate or the federal funds rate plus one-half
of one percent. The margin applicable to the Eurodollar rate varies from
0.625% to 1.375% depending upon the Company's ratio of total indebtedness to
earnings before interest, taxes, depreciation and amortization (leverage
ratio). The Amended Credit Agreement contains certain covenants, including
maintaining net worth of at least $265 million, plus 50% of the sum, to the
extent positive, of the Company's consolidated net income and other
comprehensive income (loss) reported after October 31, 2004, plus the net
proceeds of all subsequent equity offerings. The Company must also comply
with certain financial covenants, including maintenance of a leverage ratio
of no greater than 2.75 to 1. The Company is also subject to various other
financial and operating covenants and maintenance criteria, including
restrictions on the Company's ability to incur additional indebtedness, make
investments, create liens, dispose of material assets and enter into merger
transactions and acquisitions. As of October 31, 2005, the Company was in
compliance with all applicable covenants of the Amended Credit Agreement. No
compensating balance is required or maintained related to the Amended Credit
Agreement.
As of October 31, 2005, the Company had $45.0 million in borrowings
under the Amended Credit Agreement. Borrowings under the Amended Credit
Facility and the Company's previous revolving credit facility averaged $26.5
million for the year ended October 31, 2005. Borrowings under the Amended
Credit Agreement are unsecured and are guaranteed by the Company.
Interest paid was $2,460 in 2005, $1,370 in 2004 and $2,215 in 2003.
40
NOTE I -- INCOME TAXES
The income tax provision is comprised of the following:
Year Ended October 31 2005 2004 2003
--------------------- -------------------------- ----------- -------------------------------
Continuing Continuing
Operations Combined Operations Combined
---------- -------- ---------- --------
Current:
Federal $42,840 $42,840 $40,338 $20,091 $20,187
State 3,896 3,896 4,153 1,798 1,798
Foreign (304) (304) (389)
------- ------- ------- ------- -------
46,432 46,432 44,102 21,889 21,985
------- ------- ------- ------- -------
Deferred:
Federal 5,250 4,089 2,184 5,191 5,176
State 375 292 187 593 592
Foreign 293 293 52
------- ------- ------- ------- -------
5,918 4,674 2,423 5,784 5,768
------- ------- ------- ------- -------
$52,350 $51,106 $46,525 $27,673 $27,753
======= ======= ======= ======= =======
The deferred income tax provision (benefit) results from the
following temporary differences:
Year Ended October 31 2005 2004 2003
--------------------- -------------------------- ----------- -------------------------------
Continuing Continuing
Operations Combined Operations Combined
---------- -------- ---------- --------
Uncompleted contracts $ 771 $ 771 $ (146) $ 541 $ 541
Depreciation 75 75 90 289 343
Goodwill and intangible
amortization 3,224 3,224 2,035 3,589 3,589
Employee benefit plans 882 882 685 (57) (57)
Loss on disposal of
discontinued
operations (1,244) (60)
Other, net 966 966 (241) 1,422 1,412
------ ------ ------- ------- -------
$5,918 $4,674 $ 2,423 $ 5,784 $ 5,768
====== ====== ======= ======= =======
Deferred income tax liabilities (assets) are comprised of the
following:
Year Ended October 31 2005 2004
----------------------------------------------------------------------------
Depreciation $ 2,441 $ 2,398
Uncompleted contracts (571) (1,360)
Employee benefits (5,527) (6,291)
Goodwill and intangibles 16,139 13,087
Asset reserves (1,211) (1,160)
Capital loss carryforward (3,994) (2,814)
Other comprehensive loss (12,270) (11,299)
Other, net (3,742) (4,475)
----------------------------------------------------------------------------
(8,735) (11,914)
Valuation allowance 4,324 3,117
----------------------------------------------------------------------------
$ (4,411) $ (8,797)
============================================================================
41
Deferred income tax liabilities (assets) are presented on the
Consolidated Balance Sheets as follows:
Year Ended October 31 2005 2004
--------------------------------------------------------------------------
Current assets $(6,284) $(6,921)
Non-current assets (1,876)
Non-current liabilities 1,873
--------------------------------------------------------------------------
$(4,411) $(8,797)
==========================================================================
A reconciliation between the income tax provision and the annual
amount computed by applying the statutory federal income tax rate to income
before income taxes is as follows:
Year Ended October 31 2005 2004 2003
------------------------------------------------------------------------------------------
Income tax provision at
statutory federal rate $48,860 $42,852 $24,835
State income taxes and
other, net 3,490 3,673 2,838
------------------------------------------------------------------------------------------
$52,350 $46,525 $27,673
==========================================================================================
As of October 31, 2005, the Company had U.S. capital loss carryovers
of $10,652, which expire in 2009. As of October 31, 2005, the Company had
foreign investment tax credit carryovers of $1,405 which will begin to
expire in 2006. The Company provided a valuation allowance of $4,324 in 2005
and $3,117 in 2004 on the capital loss and foreign investment tax credit
carryovers, the recovery of which is uncertain.
Income taxes paid were $40,059 in 2005, $12,479 in 2004 and $13,923
in 2003.
NOTE J -- STOCK OPTIONS
The Company has established plans whereby options may be granted to
employees and directors of the Company to purchase shares of the Company's
common stock. Options granted are at an option price equal to the market
value on the date the option is granted and vest immediately. Subject to
continuation of employment, all options must be exercised within five years
from the date of grant and are exercisable at any time during this period.
As of October 31, 2005, 4,711 shares of unissued common stock were
authorized and reserved for outstanding options, which had a weighted
average remaining contractual life of 2.9 years at that date. Transactions
involving the stock option plans are as follows:
Shares Price per share
------------------------------------------------------------------------------
Outstanding at October 31, 2002 6,753 $ 2.48 to $13.42
Options granted 1,148 $15.91 to $29.46
Options exercised (1,251) $ 2.48 to $16.61
------------------------------------------------------------------------------
Options forfeited (2) $13.42
------------------------------------------------------------------------------
Outstanding at October 31, 2003 6,648 $ 2.56 to $29.46
Options granted 879 $29.63 to $37.07
Options exercised (2,697) $ 2.56 to $29.46
Options forfeited (2) $13.42 to $36.83
------------------------------------------------------------------------------
Outstanding at October 31, 2004 4,828 $ 2.56 to $37.07
Options granted 1,288 $34.93 to $41.11
Options exercised (1,345) $ 2.56 to $36.83
Options forfeited (60) $29.46 to $36.83
------------------------------------------------------------------------------
Outstanding at October 31, 2005 4,711 $ 5.19 to $41.11
==============================================================================
42
The following table summarizes information for stock options
outstanding at October 31, 2005:
Weighted Weighted
Average Average
Options Remaining Exercise
Range of Exercise Prices Outstanding Life Price
-----------------------------------------------------------------------------
$ 5.19 to $ 8.86 377 0.4 years $ 5.38
$12.63 to $16.61 1,885 1.9 years $12.91
$29.46 to $37.07 1,212 3.4 years $33.20
$34.93 to $41.11 1,237 4.6 years $35.75
During the quarter ended October 31, 2004, the Company recorded a
charge of $5.0 million ($3.1 million on an after-tax basis) for severance
and related benefit costs incurred in connection with the resignation of the
Company's former Chief Executive Officer. Of this amount, $4.2 million ($2.6
million on an after-tax basis) represents a non-cash charge associated with
the extension of the exercise period of vested non-qualified stock options
in accordance with FASB Interpretation No. 44 (FIN44), "Accounting for
Certain Transactions Involving Stock Compensation."
NOTE K -- PENSION AND OTHER POSTRETIREMENT BENEFITS
Effective September 30, 1999, the Company acquired SEI and assumed
the pension and other postretirement benefit plans related to SEI's
employees and non-employee participants. Substantially all employees of SEI
are covered by defined benefit or defined contribution pension plans. In
addition, certain retirees of SEI are eligible for postretirement health and
life insurance benefits. To qualify for postretirement health and life
insurance benefits, an SEI employee must retire at age 55 or later and the
employee's age plus service must equal or exceed 75. Retiree contributions
are defined as a percentage of medical premiums. Consequently, retiree
contributions increase with increases in the medical premiums. The life
insurance plans are noncontributory and provide coverage of a flat dollar
amount for qualifying retired SEI employees.
All former full-time employees of Engineered Air who were covered
by a collective bargaining agreement are also covered by a defined benefit
pension plan. These SEI and Engineered Air benefits are provided under
defined benefit pay-related and flat-dollar plans, which are primarily
non-contributory. Annual Company
43
contributions to retirement plans equal or exceed the minimum funding
requirements of the Employee Retirement Income Security Act or other
applicable regulations.
The components of pension and other postretirement benefit costs
are presented below for 2005, 2004 and 2003:
2005 2004 2003
------------------------------------------------------------------------
PENSION BENEFITS
Service cost $ 3,191 $ 2,896 $ 2,859
Interest cost 7,383 7,035 7,018
Expected return on plan
assets (7,505) (7,201) (6,994)
Amortization of prior service
cost 536 536 556
Recognized actuarial
loss 3,764 3,344 1,526
Other 36
------------------------------------------------------------------------
Net pension costs $ 7,369 $ 6,610 $ 5,001
========================================================================
OTHER POSTRETIREMENT BENEFITS
Service cost $216 $ 236 $ 273
Interest cost 620 593 713
Actuarial loss 455 339 343
------------------------------------------------------------------------
Net other benefit costs $ 1,291 $ 1,168 $ 1,329
========================================================================
A reconciliation of the changes in the plans' benefit obligations
and fair values of assets over the two-year period ending October 31, 2005
and a statement of the funded status at October 31, 2005 and 2004 follows.
2005 2004
-------------------------------------------------------------------------------
PENSION BENEFITS
RECONCILIATION OF BENEFIT OBLIGATION:
Benefit obligation at beginning of year $126,804 $115,842
Service cost 3,191 2,896
Interest cost 7,383 7,035
Actuarial loss 5,758 5,255
Benefit payments (4,291) (4,124)
Other (100) (100)
-------------------------------------------------------------------------------
Benefit obligation at October 31 $138,745 $126,804
===============================================================================
RECONCILIATION OF FAIR VALUE OF PLAN ASSETS:
Fair value of plan assets at beginning of year $ 77,829 $ 69,272
Actual return on plan assets 6,521 6,276
Employer contributions 6,326 6,405
Benefit payments (4,291) (4,124)
Other (129)
-------------------------------------------------------------------------------
Fair value of plan assets at October 31 $ 86,256 $ 77,829
===============================================================================
44
FUNDED STATUS:
Funded status at October 31 $(52,489) $(48,975)
Unrecognized prior service cost 2,214 2,750
Unrecognized actuarial loss 47,661 44,652
-------------------------------------------------------------------------------
Accrued benefit cost $ (2,614) $ (1,573)
===============================================================================
OTHER POSTRETIREMENT BENEFITS
RECONCILIATION OF BENEFIT OBLIGATION:
Benefit obligation at beginning of year $ 9,746 $ 11,384
Service cost 216 236
Interest cost 620 593
Plan amendments (4,670)
Actuarial loss (gain) 1,724 (1,069)
Benefit payments (1,596) (1,398)
-------------------------------------------------------------------------------
Benefit obligation at October 31 $ 6,040 $ 9,746
===============================================================================
RECONCILIATION OF FAIR VALUE OF PLAN ASSETS:
Fair value of plan assets at beginning of year $ $
Employer contributions 1,596 1,398
Benefit payments (1,596) (1,398)
-------------------------------------------------------------------------------
Fair value of plan assets at October 31 $ $
===============================================================================
FUNDED STATUS:
Funded status at October 31 $ (6,040) $ (9,746)
Unrecognized prior service cost (4,670)
Unrecognized actuarial loss 4,531 3,270
-------------------------------------------------------------------------------
Accrued benefit cost $ (6,179) $ (6,476)
===============================================================================
The amounts recognized in the Company's Consolidated Balance Sheets as of
October 31 are as follows:
2005 2004
-------------------------------------------------------------------------------
PENSION BENEFITS
Accrued benefit cost $ (6,407) $ (5,627)
Intangible asset 2,214 2,557
Additional minimum liability (31,141) (28,237)
Other comprehensive loss 32,720 29,734
-------------------------------------------------------------------------------
Net amount recognized $ (2,614) $ (1,573)
===============================================================================
OTHER POSTRETIREMENT BENEFITS
Accrued benefit cost $ (6,179) $ (6,476)
-------------------------------------------------------------------------------
Net amount recognized $ (6,179) $ (6,476)
===============================================================================
The postretirement plan amendment is that prescription drug
coverage will no longer be offered to participants after the age of 65. This
change is being made concurrently with the new Medicare Part D coverage for
prescription drugs effective in 2006. Under the new arrangement, retiree
contributions provide for 100% of the cost for post-65 coverage.
45
Assumptions used in accounting for the defined benefit plans in
2005, 2004 and 2003 were a discount rate of 5.50%, 5.75% and 6.00%,
respectively, a rate of compensation increase of 3.75% in each year, and an
expected long-term rate of return on assets of 8.75% in each year. A 1%
increase in the discount rate would decrease net pension costs for 2005 and
the accrued benefit cost at October 31, 2005 by $1.8 million and a 1%
decrease in the discount rate would increase net pension benefit costs for
2005 and the accrued benefit cost at October 31, 2005 by $1.9 million. A 1%
increase in the expected long-term rate of return on assets would decrease
net pension costs for 2005 and the accrued benefit cost at October 31, 2005
by $0.8 million and a 1% decrease in the expected long-term rate of return
on assets would increase net pension benefit costs for 2005 and the accrued
benefit cost at October 31, 2005 by $0.8 million.
Assumptions used in accounting for other postretirement benefits in
2005, 2004 and 2003 were a discount rate 5.50% 5.75% and 6.00%,
respectively, and a health care cost trend of 9.5%, 9.5% and 10.0%,
respectively, decreasing 0.5% annually to an ultimate rate of 5.5%. A 1%
increase in the discount rate would decrease net other benefit costs for
2005 by $0.1 million and a 1% decrease in the discount rate would increase
net other benefit costs for 2005 by $0.1 million. A 1% increase in the
health care cost trend rate for each year would increase the October 31,
2005 net benefit obligation by approximately $12, while a 1% decrease in the
health care cost trend rate for each year would decrease the October 31,
2005 net benefit obligation by approximately $14.
The accumulated benefit obligation for defined benefit pension
plans was $123.8 million and $111.7 million at October 31, 2005 and 2004,
respectively.
The weighted average asset allocation and the target allocation for
the Company's pension benefit plans, by asset category, is as follows:
Asset Target
Allocation Allocation
at October 31 at October 31
-------------------- -------------
2005 2004 2005
------ ------ ------
Equity securities 63.7% 66.2% 62.5%
Debt securities 32.0% 30.1% 33.0%
Real estate 2.9% 2.7% 2.5%
Cash 1.4% 1.0% 2.0%
----- ----- -----
Total 100.0% 100.0% 100.0%
===== ===== =====
The Company expects to contribute $6,771 to its pension benefit
plans and contribute $700 in expected benefit payments attributable to its
other postretirement benefit plans during the year ending October 31, 2006.
The following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid:
Year Other Post
Ending Pension Retirement
October 31 Benefits Benefits
---------- -------- ----------
2006 $ 5,379 $ 558
2007 5,892 552
2008 6,258 548
2009 6,709 530
2010 7,115 504
2011 - 2015 43,391 2,721
46
The Company's pension plan assets are managed by outside investment
managers and assets are rebalanced when the target ranges are exceeded.
Pension plan assets consist of marketable securities including common
stocks, bonds, real estate and interest-bearing deposits. The Company's
investment strategy with respect to pension assets is to achieve a total
rate of return (income and capital appreciation) that is sufficient to
provide retirement benefits to all eligible and future retirees of the
pension plans. The Company regularly monitors performance and compliance
with investment guidelines.
The Company sponsors the Engineered Support Systems, Inc. 401(k)
and Employee Stock Ownership Plan (ESOP), which covers all employees of
Engineered Air, Marlo Coil, Keco, Fermont, ESSIbuy, UPSI, Radian, TAMSCO,
EEI, PCA, Spacelink and Mobilized Systems and all employees of SEI with an
employment starting date after December 31, 2004. The ESOP provides for a
matching contribution by the Company of no less than 25% of each employee's
contributions up to a maximum of 6% of the employee's earnings. The Company
also makes discretionary annual contributions. All employee and employer
contributions to the ESOP are 100% vested. In addition, the Company
previously sponsored the TAMSCO Tax Deferred Retirement Plan, the Engineered
Environments, Inc. 401(k) Plan, the Prospective Computer Analysts, Inc.
Employee Savings and Retirement Plan, the Spacelink International, LLC
401(k) Plan, and Mobilized Systems, Inc. 401(k) Incentive Savings Plan. The
Company has recorded expense based on contributions to the ESOP, the TAMSCO
plan, the EEI plan, the PCA plan, the Spacelink plan, and the MSI plan for
the years ended October 31, 2005, 2004 and 2003 of $7,173, $4,600 and
$1,989, respectively.
The Company also has a qualified Employee Stock Purchase Plan
(ESPP), the terms of which allow for qualified employees, as defined, to
purchase the Company's common stock at a price equal to 95% of the closing
price at the beginning of each semi-annual stock purchase period. Prior to
July 1, 2005, the plan allowed plan participants to purchase shares of the
Company's common stock at a price equal to 85% of the lower of the closing
price at the beginning or end of each semi-annual stock purchase period, but
was amended to comply with recently enacted income tax law changes
concerning employer-sponsored stock purchase plans. The Company issued 128,
129 and 81 shares of common stock during the years ended October 31, 2005,
2004 and 2003 pursuant to the ESPP at an average price per share of $31.69,
$22.79 and $20.27, respectively.
NOTE L -- BUSINESS SEGMENT INFORMATION
Based on its organizational structure, the Company operates in two
business segments: Support Systems and Support Services. The Support Systems
segment designs, engineers and manufactures integrated military electronics
and other military support equipment primarily for the DoD, as well as
related heat transfer and air handling equipment for domestic commercial and
industrial users. Segment products include environmental control systems,
load management and transport systems, power generation, distribution and
conditioning systems, airborne radar systems, reconnaissance, surveillance
and target acquisition systems, chemical and biological protection systems,
petroleum and water distribution systems and other multipurpose military
support equipment. The Support Services segment provides engineering
services, logistics and training services, advanced technology services,
asset protection systems and services, telecommunication systems integration
and information technology services primarily for the DoD. The Support
Services segment also provides certain power generation and distribution
equipment and vehicle armor installation to the DoD.
Management utilizes more than one measurement and multiple views of
data to measure business segment performance and to allocate resources to
the segments. However, the dominant measurements are consistent with the
Company's Consolidated Financial Statements and, accordingly, are reported
on the same basis herein. Management evaluates the performance of its
business segments and allocates resources to them primarily based on income
from operations, along with cash flows and overall economic returns. The
Company's export net revenues are not significant. All corporate expenses
and assets have been allocated to the segments. In 2005, 2004 and 2003,
approximately, 96%, 94% and 95% of consolidated net revenues were derived
directly or indirectly from the U.S. government.
47
The following table summarizes the Company's net revenues
attributed to the United States and to foreign countries:
United Foreign Total
October 31 States Countries Revenues
---------- -------- --------- --------
2005 $993,288 $25,085 $1,018,373
2004 853,286 30,344 883,630
2003 556,809 15,892 572,701
The Company attributes foreign net revenues based on the domicile
of the purchaser of the product or service.
Of the $702.2 million in total Company assets as of October 31,
2005, $13.9 million were located in countries other than the U.S.
Information by segment is summarized as follows:
------------------------------------------------------------------------------------------
Year Ended October 31 2005 2004 2003
------------------------------------------------------------------------------------------
NET REVENUES:
Support Systems:
Products $ 501,013 $514,702 $389,301
Services
------------------------------------------------------------------------------------------
501,013 514,702 389,301
------------------------------------------------------------------------------------------
Support Services:
Products 135,247 155,353 99,534
Services 457,444 287,468 111,211
------------------------------------------------------------------------------------------
592,691 442,821 210,745
------------------------------------------------------------------------------------------
Intersegment Revenues (75,331) (73,893) (27,345)
------------------------------------------------------------------------------------------
$1,018,373 $883,630 $572,701
==========================================================================================
48
OPERATING INCOME FROM CONTINUING OPERATIONS:
Support Systems $ 87,490 $ 92,966 $ 54,200
Support Services 53,932 30,330 18,416
------------------------------------------------------------------------------------------
141,422 123,296 72,616
Interest expense (2,651) (1,215) (1,881)
Interest income 828 353 221
------------------------------------------------------------------------------------------
Income from continuing
operations before income tax $139,599 $122,434 $ 70,956
==========================================================================================
IDENTIFIABLE ASSETS:
Support Systems $319,180 $272,605 $224,599
Support Services 382,977 238,529 194,702
------------------------------------------------------------------------------------------
$702,157 $511,134 $419,301
==========================================================================================
DEPRECIATION AND AMORTIZATION:
------------------------------------------------------------------------------------------
Support Systems $ 7,221 $ 6,113 $ 5,529
Support Services 11,065 6,878 3,432
------------------------------------------------------------------------------------------
$18,286 $ 12,991 $ 8,961
==========================================================================================
CAPITAL EXPENDITURES:
Support Systems $ 2,420 $ 5,763 $ 8,782
Support Services 9,646 2,271 899
------------------------------------------------------------------------------------------
$ 12,066 $ 8,034 $ 9,681
==========================================================================================
NOTE M -- COMMITMENTS AND CONTINGENCIES
As a government contractor, the Company is continually subject to
audit by various agencies of the U.S. government to determine compliance
with various procurement laws and regulations. As a result of such audits
and as part of normal business operations of the Company, various claims and
charges are asserted against the Company. It is not possible at this time to
predict the outcome of all such actions. However, management is of the
opinion that it has good defenses against such actions and believes that
none of these matters will have a material effect on the consolidated
financial position or the results of operations of the Company.
Total contractual and contingent obligations as of October 31, 2005
are as follows:
Payments / Expiration
--------------------------------------------------------------
2006 2007 2008 2009 2010 Total
-------- ------- ------- ------ ------ --------
Contractual Obligations:
Long-term debt $ 187 $ 198 $ 391 $ 533 $ $ 1,309
Operating leases 5,347 4,087 2,384 1,495 573 13,886
Unconditional purchase
obligations 202,834 8,912 211,746
Contributions to pension
and other postretirement
benefit plans 7,471 7,471 7,371 7,371 3,871 33,555
-------- ------- ------- ------ ------ --------
215,839 20,668 10,146 9,399 4,444 260,496
Contingent Obligations:
Letters of credit 1,840 1,840
-------- ------- ------- ------ ------ --------
Total Obligations $217,679 $20,668 $10,146 $9,399 $4,444 $262,336
======== ======= ======= ====== ====== ========
While contingent obligations are included in the table above, the
Company does not expect to fund the full amounts indicated for letters of
credit. Lease expense totaled $5.9 million, $5.0 million and $4.2 million
for the years ended October 31, 2005, 2004 and 2003, respectively.
NOTE N -- SEC INVESTIGATION
In December 2004, the Company was notified by the Enforcement
Division of the SEC of the issuance of a formal order directing a private
investigation captioned In the Matter of Engineered
49
Support Systems, Inc. and that the SEC had issued subpoenas to various
individuals associated with the Company to produce certain documents. The
SEC staff also requested that the Company voluntarily produce certain
documents in connection with the investigation. The subpoenas related to
trading in the Company's stock around the Company's earnings releases in
2003 and the adequacy of certain disclosures made by the Company regarding
related-party transactions in 2002 and 2003 involving insurance policies
placed by the Company through an insurance brokerage firm in which a
director of the Company was a principal at the time of the transactions. On
or about September 23, 2005, the SEC staff contacted the Company's counsel
and advised that it had issued a subpoena directed to the Company and
expanded its investigation to include the Company's disclosure of a November
2004 stop-work order relating to the Company's Deployable Power Generation
and Distribution System program for the U.S. Air Force, and trading in the
Company's stock by certain individuals associated with the Company.
In connection with the foregoing SEC investigation, the Company and
certain of its directors and officers have provided information and
testimony to the SEC. The Company continues to furnish information requested
by the SEC. The Company is unable to determine at this time either the
timing of the investigation or the impact, if any, which the investigation
could have on the Company or the combined company following the Company's
proposed merger with DRS as explained in Note P.
NOTE O -- STOCK SPLIT
On April 15, 2005, the Company effected a three-for-two stock split
in the form of a 50% stock dividend. All per share amounts, as well as all
share amounts related to the Company's stock option and stock purchase
plans, have been restated to reflect this stock split.
NOTE P -- MERGER AGREEMENT WITH DRS TECHNOLOGIES, INC.
On September 21, 2005, the Company and DRS Technologies, Inc. (DRS)
entered into a definitive agreement which provides for the acquisition by
DRS of all of the outstanding common stock of the Company for approximately
$1.9 billion, or $43.00 per share (subject to possible adjustment), through
a combination of cash and DRS common stock. Pending customary regulatory
approvals and other closing conditions, including approval by DRS and
Company shareholders, the transaction is anticipated to close before
March 31, 2006.
50
SUPPLEMENTAL INFORMATION
The table below presents unaudited quarterly financial information for the
years ended October 31, 2005 and 2004 (in thousands, except for per share
amounts):
Quarter Ended January 31 April 30 July 31 October 31 Fiscal Year
-----------------------------------------------------------------------------------------------------------------------------------
2005 2004 2005 2004 2005 2004 2005 2004 2005 2004
---- ---- ---- ---- ---- ---- ---- ---- ---- ----
Net revenues $233,533 $195,130 $263,768 $210,136 $258,735 $221,991 $262,337 $256,373 $1,018,373 $883,630
Gross profit 57,544 46,271 60,324 53,425 63,450 56,816 63,718 66,178 245,036 222,690
Net income from
continuing
operations 20,611 15,743 20,093 18,323 22,564 20,506 23,981 21,337 87,249 75,909
Net income 20,611 15,743 19,045 18,323 22,564 20,506 22,956 21,337 85,176 75,909
Diluted earnings
per share;
Continuing
operations $0.48 $0.38 $0.46 $0.44 $0.52 $0.49 $0.55 $0.51 $2.02 $1.82
Total $0.48 $0.38 $0.44 $0.44 $0.52 $0.49 $0.53 $0.51 $1.97 $1.82
Earnings per share calculations are based on the average basic and diluted
common shares outstanding for each quarter and, therefore, the sum of the
quarters may not necessarily be equal to the full year basic and diluted
earnings per share amounts.
The results for the quarter ended October 31, 2004 include $1.7 million of
net income resulting from revisions, adjustments and changes in estimates
for certain long-term contracts, primarily at the Company's Keco subsidiary.
51
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Engineered Support Systems, Inc.:
We have completed an integrated audit of Engineered Support Systems, Inc.'s
2005 consolidated financial statements and of its internal control over
financial reporting as of October 31, 2005 and audits of its 2004 and 2003
consolidated financial statements in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Our opinions,
based on our audits, are presented below.
Consolidated financial statements and financial statement schedule
------------------------------------------------------------------
In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Engineered Support Systems, Inc. and its subsidiaries at October
31, 2005 and 2004, and the results of their operations and their cash flows
for each of the three years in the period ended October 31, 2005 in
conformity with accounting principles generally accepted in the United
States of America. In addition, in our opinion, the financial statement
schedule listed in the accompanying index presents fairly, in all material
respects, the information set forth therein when read in conjunction with
the related consolidated financial statements. These financial statements
and financial statement schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with the standards of
the Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit of financial statements includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
Internal control over financial reporting
-----------------------------------------
Also, in our opinion, management's assessment, included in the Report of
Management on Internal Control over Financial Reporting appearing under Item
9A, that the Company maintained effective internal control over financial
reporting as of October 31, 2005 based on criteria established in Internal
Control - Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), is fairly stated, in all
material respects, based on those criteria. Furthermore, in our opinion, the
Company maintained, in all material respects, effective internal control
over financial reporting as of October 31, 2005, based on criteria
established in Internal Control - Integrated Framework issued by the COSO.
The Company's management is responsible for maintaining effective internal
control over financial reporting and for its assessment of the effectiveness
of internal control over financial reporting. Our responsibility is to
express opinions on management's assessment and on the effectiveness of the
Company's internal control over financial reporting based on our audit. We
conducted our audit of internal control over financial reporting in
accordance with the standards of the Public Company Accounting Oversight
Board (United States). Those standards require that we plan and perform the
audit to obtain reasonable assurance about whether effective internal
control over financial reporting was maintained in all material respects. An
audit of internal control over financial reporting includes obtaining an
understanding
52
of internal control over financial reporting, evaluating management's
assessment, testing and evaluating the design and operating effectiveness of
internal control, and performing such other procedures as we consider
necessary in the circumstances. We believe that our audit provides a
reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed
to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes
in accordance with generally accepted accounting principles. A company's
internal control over financial reporting includes those policies and
procedures that (i) pertain to the maintenance of records that, in
reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (ii) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the company are being made
only in accordance with authorizations of management and directors of the
company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate.
As described in the Report of Management on Internal Control over Financial
Reporting appearing under Item 9A, management has excluded certain elements
of the internal control over financial reporting of Spacelink, LLC,
Prospective Computer Analysts Incorporated, and Mobilized Systems, Inc. from
its assessment of the Company's internal control over financial reporting as
of October 31, 2005 because each was acquired by the Company in a purchase
business combination during 2005. Subsequent to the acquisition, certain
elements of the acquired businesses' internal control over financial
reporting and related processes were integrated into the Company's existing
systems and internal control over financial reporting. Those controls that
were not integrated have been excluded from management's assessment of the
effectiveness of internal control of financial reporting as of October 31,
2005. We have also excluded those elements from our audit of internal
control over financial reporting. The combined excluded elements of
Spacelink, LLC, Prospective Computer Analysts Incorporated, and Mobilized
Systems, Inc. represent controls over accounts of approximately 4% of total
assets and 8% of total revenues of the related consolidated financial
statement amounts as of and for the year ended October 31, 2005.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
St. Louis, Missouri
January 9, 2006
53
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
------- ---------------------------------------------------------------
FINANCIAL DISCLOSURES
---------------------
None.
ITEM 9A. CONTROLS AND PROCEDURES
-------- -----------------------
ESSI carried out an evaluation, under the supervision and with the
participation of its management, including ESSI's Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design and
operation of ESSI's disclosure controls and procedures, as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended (the "Exchange Act") as of October 31, 2005. Based upon that
evaluation, ESSI's Chief Executive Officer and Chief Financial Officer
concluded that ESSI's disclosure controls and procedures are effective.
Disclosure controls and procedures are controls and procedures that are
designed to ensure that information required to be disclosed in ESSI's
reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities
and Exchange Commission's rules and forms.
There have been no changes in ESSI's internal control over
financial reporting (as defined in Rule 13a-15(f) under the Exchange Act)
during the fiscal quarter ended October 31, 2005 that have materially
affected, or are reasonably likely to materially affect, ESSI's internal
control over financial reporting.
REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The management of ESSI is responsible for establishing and
maintaining adequate internal control over financial reporting. Internal
control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of ESSI's financial reporting for
external purposes in accordance with accounting principles generally
accepted in the United States of America. Internal control over financial
reporting includes maintaining records that in reasonable detail accurately
and fairly reflect ESSI's transactions and dispositions of assets of the
Company; providing reasonable assurance that transactions are recorded as
necessary for preparation of our financial statements in accordance with
generally accepted accounting principles; providing reasonable assurance
that receipts and expenditures of company assets are made in accordance with
management authorization; and providing reasonable assurance that
unauthorized acquisition, use or disposition of company assets that could
have a material effect on our financial statements would be prevented or
detected on a timely basis.
Management conducted an evaluation of the effectiveness of ESSI's
internal control over financial reporting based on the framework and
criteria established in Internal Control -- Integrated Framework, issued by
the Committee of Sponsoring Organizations of the Treadway Commission. This
evaluation included review of the documentation of controls, evaluation of
the design effectiveness of controls, testing of the operating effectiveness
of controls and a conclusion on this evaluation.
Based on this evaluation, management concluded that ESSI's internal
control over financial reporting was effective as of October 31, 2005.
Management's assessment of the effectiveness of ESSI's internal control over
financial reporting as of October 31, 2005 has been audited by
PricewaterhouseCoopers LLP, an independent registered public accounting
firm, as stated in their report which is included in Item 8 of this Annual
Report on Form 10-K.
Management has excluded certain elements of the internal control
over financial reporting of Spacelink, LLC, Prospective Computer Analysts
Incorporated, and Mobilized Systems, Inc. from its assessment of the
Company's internal control over financial reporting as of October 31, 2005
because each was acquired by the Company in a purchase business combination
during 2005. Subsequent to the acquisition, certain elements of the acquired
businesses' internal control over financial reporting and related processes
were integrated into the Company's existing systems and internal control
over financial reporting. Those controls that were not integrated have been
excluded from management's assessment of the effectiveness of internal
control of financial reporting as of October 31, 2005. The combined excluded
elements of Spacelink, LLC, Prospective Computer Analysts Incorporated, and
Mobilized Systems, Inc. represent controls over accounts of approximately 4%
of total assets and 8% of total revenues of the related consolidated
financial statement amounts as of and for the year ended October 31, 2005.
54
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
-------- --------------------------------------------------
DIRECTORS
The following table sets forth, for each director of ESSI, his
principal occupation, the year in which his current term ends, the year in
which he was first elected as a director and his age.
Current First
Name and Principal Term Elected/
Occupation or Employment (1) Ends Appointed Age
---------------------------- ---- --------- ---
Michael F. Shanahan, Sr. March December 66
Non-Executive Chairman 2006 1983
Gerald A. Potthoff March October 65
Vice Chairman and Chief Executive Officer 2008 1999
Gary C. Gerhardt March March 60
Vice Chairman and Chief Financial 2008 1998
Officer
Gregory P. Boyer March April 67
Principal, Retired 2007 2005
Century Administrative Services
William H.T. Bush March March 67
Chairman 2007 2000
Bush-O'Donnell & Co., Inc.
General Michael P.C. Carns March March 68
U.S. Air Force, Retired 2006 2000
Major General (MG) George E. Friel March September 63
U.S. Army, Retired 2008 1998
Thomas J. Guilfoil March March 86
Attorney at Law 2008 1993
Guilfoil, Petzall & Shoemake
S. Lee Kling March March 77
Chairman 2007 2000
The Kling Company
Lieutenant General (LTG) March March
Kenneth E. Lewi 2006 1992 75
U.S. Army, Retired
General Charles T. Robertson, Jr. March December 59
U.S. Air Force, Retired 2008 2001
Vice President, Business Development
Aerospace Support
The Boeing Company
General Crosbie E. Saint March August 69
U.S. Army, Retired 2007 2000
James A. Schaefer March March 66
Audit Partner, Retired 2008 2005
Baird, Kurtz & Dobson LLP
Michael F. Shanahan, Jr. March December 39
President and Chief Executive Officer 2006 1994
Huntleigh McGehee
Earl W. Wims, Ph.D. March March 66
Chairman, Retired 2007 1992
Marketing Horizons, Inc.
--------
(1) Michael F. Shanahan, Jr. is the son of Michael F. Shanahan, Sr. and the
son-in-law of Earl W. Wims.
55
Michael F. Shanahan, Sr. became ESSI's Non-executive Chairman of
the Board in 2005. Prior thereto, he served as Chairman of the Board since
1987. He also served as Chief Executive Officer of ESSI from 1985 to 2003.
Gerald A. Potthoff has been Vice Chairman and Chief Executive Officer
of ESSI since 2004 and was President and Chief Operating Officer of ESSI
from 1999 to 2004. Prior thereto, Mr. Potthoff served as President of
Systems & Electronics Inc. from 1991 to 2000.
Gary C. Gerhardt has been Vice Chairman of ESSI since 1999 and
prior thereto served as Executive Vice President since 1994. He has been
Chief Financial Officer of ESSI since 1993.
Gregory P. Boyer served as principal of Century Administrative
Services for 15 years prior to his retirement in 2004. Century
Administrative Services is a St. Louis-based firm specializing in human
resources, labor relations, workers' compensation and safety/loss prevention
services. From 1984 to 1989, Mr. Boyer served in various managerial
capacities with ESSI and has provided professional consulting services to
ESSI periodically since his employment.
William H.T. Bush has been Chairman of the investment firm
Bush-O'Donnell & Co., Inc. since 1986. Previously, he was President and
Chief Executive Officer of Boatmen's National Bank of St. Louis. Mr. Bush is
also on the Board of Directors of DT Industries, Inc., WellPoint Healthcare
Networks, Inc. and the Lord Abbett Family of Mutual Funds.
General Michael P.C. Carns (U.S. Air Force, Retired) served in the
United States Air Force for 35 years until his retirement in 1994. From May
1991 until his retirement, General Carns served as Vice Chief of Staff,
Headquarters U.S. Air Force. From September 1989 to May 1999, he served as
director of the Joint Staff. He also serves on the Board of Directors of
Rockwell Collins, Inc. and Entegris, Inc.
MG George E. Friel (U.S. Army, Retired) served in the United States
Army for 38 years until his retirement in 1998. In the six years preceding
his retirement, Major General Friel headed the U.S. Army Chemical and
Biological Defense Command. He also serves on the Board of Directors of
Quick-Med Technologies, Inc.
Thomas J. Guilfoil is the Senior and Founding Partner of the St. Louis
law firm, Guilfoil, Petzall & Shoemake. Mr. Guilfoil's distinguished legal
career of over 50 years began in St. Louis in 1941.
S. Lee Kling has been Chairman of the Kling Company, a merchant
banking company, since 2002 and from 1991 to 2002 was Chairman of Kling
Rechter & Company, a merchant banking company. Previously, he was Chairman
of Landmark Bancshares Corp., a bank holding company. Mr. Kling also serves
on the Board of Directors of Bernard Chaus, Inc., Electro Rent Corporation,
Kupper Parker Communications, Inc. and National Beverage Corporation.
LTG Kenneth E. Lewi (U.S. Army, Retired) served in the United
States Army for 34 years until his retirement in 1989. His career in the
U.S. Army centered primarily on providing logistical support to U.S. armed
forces.
General Charles T. Robertson, Jr. (U.S. Air Force, Retired) has
served as Vice President, Air Force Support Programs, Aerospace Support, The
Boeing Company since December 2004. From April 2002 until December 2004, he
served as Vice President of Business Development and then as Vice President,
Mods and Upgrades. For 33 years until his retirement in 2001, he served in
the United States Air Force. General Robertson served as Commander in Chief,
U.S. Transportation Command, and Commander, Air Mobility Command, Scott Air
Force Base, from 1998.
General Crosbie E. Saint (U.S. Army, Retired) served in the United
States Army for 34 years until his retirement in 1992. In the four years
preceding his retirement, General Saint served as Commander in Chief, United
States Army, Europe and Seventh Army; Commander, Central Army Group (NATO).
56
James A. Schaefer has been a Certified Public Accountant since 1965
and was an Audit Partner for 30 years. Most recently, he served as Audit
Partner for the accounting firm of Baird, Kurtz & Dobson LLP from 1988 until
his retirement in 2004.
Michael F. Shanahan, Jr. has served as President and Chief
Executive Officer of Huntleigh McGehee, an insurance concern, since July
2004. Mr. Shanahan served as Executive Vice President of Lockton Companies,
an insurance concern, from November 2000 to September 2003. From October
1994 to September 2003, he was a Producer for Lockton Companies.
Earl W. Wims, Ph.D. co-founded and served as Chairman of Marketing
Horizons, Inc., a marketing research and consulting firm, from 1986 until he
retired in December 2005.
EXECUTIVE OFFICERS
Executive officers and key employees of ESSI are as follows:
Name Age Position
---- --- --------
Gerald A. Potthoff 65 Vice Chairman and Chief Executive Officer
Gary C. Gerhardt 60 Vice Chairman and Chief Financial Officer
Daniel A. Rodrigues 50 President and Chief Operating Officer
James T. Myrick 60 Group President - Support Systems
Mitchell B. Rambler 55 Group President - Support Services
Larry K. Brewer 62 President - Washington D.C. Operations
Dan D. Jura 53 President - Business Development
Karen A. Bedell 46 Senior Vice President - Marketing and Strategic Planning
Ronald W. Hauser 59 Interim President (Spacelink); Vice President - Strategy,
Plans and Market Research
Allan K. Kaste 59 Senior Vice President - Human Resources
Robert L. Klautzer 61 Chief Information Officer
Daniel E. Kreher 41 Senior Vice President - Acquisitions and Investor Relations
Steven J. Landmann 46 Senior Vice President - Controller and Chief Accounting Officer
David D. Mattern 47 Secretary and General Counsel
John R. Wootton 58 Senior Vice President - Advanced Development and Technology
David D. Burton 63 President (TAMSCO)
Thomas G. Cornwell 50 President (SEI)
Joseph H. Creaghead 62 President (Keco)
Frederic D. Knight 49 President (UPSI)
Lisa A. Lairson 45 President (Mobilized Systems)
Gerald A. Nicholson 59 President (Marlo Coil)
Thomas C. Santoro 52 President (Fermont)
Timothy J. Schneider 56 President (EEi)
Carlo M. Shimoon 44 President (Pivotal Power)
E. Allen Springer, Jr. 60 President (Engineered Air)
Frank A. Tricomi 60 President (ESSIbuy)
Lloyd T. Waterman 57 President (Radian)
57
The officers serve at the discretion of the Board of Directors,
subject to the terms and conditions of their employment or consulting
agreements. Background information regarding Gerald A. Potthoff and Gary C.
Gerhardt is included above in this section under "Directors."
Daniel A. Rodrigues was named President and Chief Operating Officer
of ESSI in 2005 and was ESSI's Group President - Support Systems from 2002
to 2005. Prior thereto, he served as President of SEI since 2000, as Senior
Vice President and General Manager of SEI since 1999 and as its Vice
President of Program Administration since 1995.
James T. Myrick was named ESSI's Group President - Support Services
in 2005. Prior thereto he served as President of SEI since 2002, as SEI's
Executive Vice President since 2001 and as its Vice President - Finance
since 1997.
Mitchell B. Rambler joined ESSI as its Group President - Support
Services in 2006. Prior thereto, he served as Senior Vice President and
General Manger, Military Operations for BAE Systems since 2003 and as
International Sales and Marketing Director for Perot Systems from 2001 to
2003. Mr. Rambler served as President and Chief Executive Officer of
Cyntergy Corporation, a professional services firm, from 1998 to 2001.
Larry K. Brewer has been ESSI's President - Washington D.C.
Operations since 2003. Previously, he was Senior Vice President-Business
Development of ESSI since 2000. Prior thereto, he served SEI as Vice
President-Business Development since 1998, Vice President-Corporate
Marketing & Washington DC Operations since 1997 and Vice
President-Government Relations since 1995.
Dan D. Jura was named ESSI's President, Business Development in
2005. Prior thereto, he served as Senior Vice President-Sales of ESSI since
2002, Vice President-Sales for ESSI since 1999 and for Engineered Air since
1993.
Karen A. Bedell has been Senior Vice President - Marketing and
Strategic Planning of ESSI since 2003. Prior thereto, she served as Vice
President of Community and Education Relations and President of the
Boeing-McDonnell Foundation for the Integrated Defense Group of the Boeing
Company since 2001 and before that as its Director - Naval Missile Systems
International Programs since 2000. She was F/A-18 Program Manager for
Australia from 1996 to 1999.
58
Ronald W. Hauser has been Interim President of Spacelink since July
2005. He continues to hold the position of Vice President - Strategy, Plans
and Market Research of ESSI since 2003. Prior thereto, he served as Director
- Market Research of ESSI since 2001, as Director - Business Development of
ESSI since 2000 and as Program Director of the Battlefield & Integration
Group for SEI from 1999. He served as Director - Domestic Marketing for SEI
from 1995 to 1999.
Allan K. Kaste was named Senior Vice President-Human Resources of
ESSI in 2005. Prior thereto, he served as Vice President - Human Resources
of ESSI since 2000 and as Vice President-Human Resources for SEI from 1994
to 2003.
Robert L. Klautzer was named Chief Information Officer of ESSI in
2005. Prior thereto, he served as Vice President-Management Information
Systems of ESSI since 2000 and as Vice President-Management Information
Systems and Quality Assurance for SEI from 1997 to 2003.
Daniel E. Kreher was named Senior Vice President - Acquisitions and
Investor Relations of ESSI in 2005. Prior thereto, he served as ESSI's Vice
President - Acquisitions and Investor Relations since 2003 and as Director -
Acquisitions and Investor Relations since 1999. Prior thereto, he was Vice
President - Finance and Administration of D&K Healthcare Resources, Inc.
since 1996.
Steven J. Landmann was named Vice President--Controller and Chief
Accounting Officer of ESSI in 2005. Prior thereto, he served as Vice
President -- Finance & Controller of ESSI since 1999, as Controller for ESSI
since 1998 and for Engineered Air since 1994.
David D. Mattern has been Secretary and General Counsel of ESSI
since 1999. Prior thereto, he served as ESSI's Secretary since 1992 and as
outside legal counsel to ESSI. Mr. Mattern is the son-in-law of Michael F.
Shanahan, Sr.
John R. Wootton was named Senior Vice President - Advanced
Development and Technology of ESSI in 2005. Prior thereto, he served as Vice
President-Advanced Development and Technology of ESSI since 2000, as Vice
President-Technology for SEI since 1997 and as SEI's Director-Technology
since 1994.
David D. Burton was named President of TAMSCO in 2005. Prior
thereto, he served TAMSCO as Vice President of Operations since 2003 and as
Vice President of Strategic Planning from 2001. Prior to TAMSCO, he served
as Director of Contracting for Warner Robins Air Force Base as a member of
the Senior Executive Service.
Thomas G. Cornwell was named President of SEI in 2005. Prior
thereto, he served as President of Engineered Air since 2000 and as
Director-Program Management for SEI since 1992.
Joseph H. Creaghead has been President of Keco since 2002. Prior
thereto, he was General Manager - Managing Director of Husco International
Ltd since 1997.
Frederic D. Knight has been President of UPSI since 2002.
Previously, he served as its Chief Technology Officer since 2000, and, prior
thereto, as its President and Chief Executive Officer since 1989.
Lisa A. Lairson has been President of Mobilized Systems since 2001.
Prior thereto, she served as its Operations Manager since 1993.
Gerald A. Nicholson has been President of Marlo Coil since 2001.
Prior thereto, he was Executive Vice President for the Tweco/Arcair and
Coyne Cylinder divisions of Thermadyne Industries from 1995 to 1998.
Thomas C. Santoro has been President of Fermont since 1995.
59
Timothy J. Schneider has been President of EEi since 2004. Prior
thereto, he served as Executive Vice President of EEi from 1997.
Carlo M. Shimoon has been President of Pivotal Power since 2000.
Prior thereto, he was President and Chief Executive Officer of Senstar
Stellar since 1999 and President and Chief Executive Officer of Newhaven
Media from 1995 to 1998.
E. Allen Springer, Jr. was named President of Engineered Air in
2005. Prior thereto, he served as its Vice President of Engineering since
1992.
Frank A. Tricomi has been President of ESSIbuy since 2004. Prior
thereto, he served as Director of ESSIbuy since 2000, and was Director of
Program Management for EASI from 1996 to 2000.
Lloyd T. Waterman was named President of Radian in 2005. Prior
thereto, he served as its Executive Vice President since 2004 after a
distinguished career with the U.S. Army retiring with the rank of Brigadier
General.
CODE OF ETHICS
ESSI has a code of ethics which applies to the directors, officers,
all other employees and contract workers of ESSI and each of its
subsidiaries. The Engineered Support Systems, Inc. Code of Business Ethics
and Conduct is available free of charge upon written request to Engineered
Support Systems, Inc., Attention: Investor Relations, 201 Evans Lane, St.
Louis, Missouri 63121, and is available on ESSI's website at
www.engineeredsupport.com.
AUDIT COMMITTEE
The Audit Committee for fiscal 2005 consisted of William H.T. Bush,
General Michael P.C. Carns, MG George E. Friel, S. Lee Kling and James A.
Schaefer, all of whom are considered independent under the listing standards
of Nasdaq. Mr. Kling serves as the Audit Committee's financial expert. The
function of the Audit Committee is to: review, from time to time, the
financial statements of ESSI; meet, together and separately, with management
of ESSI and its independent accountants to discuss the financial statements
and general accounting policies of ESSI; and review the management letter
issued by the independent registered public accounting firm and ESSI's
responses thereto.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as
amended, requires that ESSI executive officers and directors, and persons
who own more than ten percent of ESSI's outstanding stock, file reports of
ownership and changes in ownership with the Securities and Exchange
Commission. To the knowledge of ESSI, all Section 16(a) filing requirements
applicable to its executive officers, directors and greater than ten percent
beneficial owners were complied with during the fiscal year ended October
31, 2005, except that each of Mssrs. Boyer and Jura filed a late Form 3,
"Initial Statement of Beneficial Ownership of Securities."
ITEM 11. EXECUTIVE COMPENSATION
-------- ----------------------
EMPLOYMENT AGREEMENTS
ESSI has employment agreements with certain executive officers. The
terms and conditions of those agreements with, the Vice Chairman and Chief
Executive Officer, the Vice Chairman and Chief Financial Officer, the
President and Chief Operating Officer, the President, Business Development
and the Senior Vice President, Controller and Chief Accounting Officer are
summarized below.
VICE CHAIRMAN AND CHIEF EXECUTIVE OFFICER. Under Mr. Potthoff's
employment agreement, he serves as
60
Vice Chairman and Chief Executive Officer until October 31, 2007.
Thereafter, the agreement automatically renews for successive one-year
periods unless he or ESSI gives notice to terminate the agreement at least
30 days prior to the expiration of the term. The agreement may be terminated
at any time by Mr. Potthoff upon not less than 90 days' written notice, or
by ESSI at any time with or without cause.
Under the terms of Mr. Potthoff's employment agreement, Mr.
Potthoff is paid a base annual salary of $720,000 and receives an annual
incentive bonus payment. In addition, Mr. Potthoff is entitled to: (a)
reimbursement of reasonable and necessary expenses incurred in the interest
of the business of ESSI; (b) a car allowance as determined by ESSI's board;
(c) payment of Mr. Potthoff's country club membership and other membership
privileges as approved by ESSI's board; and (d) participate in ESSI's
medical, life insurance, accidental death, disability income, profit sharing
trust and other employee benefits along with his spouse for the duration of
his life and the life of his spouse. The employment agreement also provides
that, for ESSI's 2005 fiscal year, Mr. Potthoff shall receive a stock option
award based on 22,500 shares of ESSI common stock. Mr. Potthoff elected to
forgo this stock option award for fiscal 2005. If the agreement is
terminated by ESSI other than for cause, Mr. Potthoff is entitled to
termination pay equal to his base salary upon the date of termination
payable over 12 months. Additionally, during the 12-month period, Mr.
Potthoff (and his eligible family members) are entitled to continue to
participate in and receive certain standard employee benefits. The agreement
prohibits Mr. Potthoff from competing with ESSI for a period of two years
after termination of employment. In the event of a change in control of
ESSI, Mr. Potthoff is entitled to receive a lump sum cash payment in an
amount equal to 2.99 times his average compensation for the prior five
fiscal years of employment with ESSI. Upon consummation of the merger with
DRS, Mr. Potthoff will receive a payment totaling $2,145,325.
VICE CHAIRMAN AND CHIEF FINANCIAL OFFICER. Under Mr. Gerhardt's
employment agreement, he serves as Vice Chairman and Chief Financial Officer
until October 31, 2007. Thereafter, the agreement automatically renews for
successive one-year periods unless he or ESSI gives notice to terminate the
agreement at least 30 days prior to the expiration of the term. The
agreement may be terminated at any time by Mr. Gerhardt upon not less than
90 days' written notice, or by ESSI at any time with or without cause.
Under the terms of Mr. Gerhardt's employment agreement, Mr.
Gerhardt is paid a base annual salary of $600,000 and receives an annual
incentive bonus payment. In addition, Mr. Gerhardt is entitled to: (a)
reimbursement of reasonable and necessary expenses incurred in the interest
of the business of ESSI; (b) a car allowance as determined by ESSI's board;
(c) payment of Mr. Gerhardt's country club membership and other membership
privileges as approved by ESSI's board; and (d) participate in ESSI's
medical, life insurance, accidental death, disability income, profit sharing
trust and other employee benefits along with his spouse for the duration of
his life and the life of his spouse. The employment agreement also provides
that, for ESSI's 2005 fiscal year, Mr. Gerhardt shall receive a stock option
award based on 22,500 shares of ESSI common stock. Mr. Gerhardt elected to
forgo this stock option award for fiscal 2005. If the agreement is
terminated by ESSI other than for cause, Mr. Gerhardt is entitled to
termination pay equal to his base salary upon the date of termination
payable over 12 months. Additionally, during the 12-month period, Mr.
Gerhardt (and his eligible family members) are entitled to continue to
participate in and receive certain standard employee benefits. The agreement
prohibits Mr. Gerhardt from competing with ESSI for a period of two years
after termination of employment. In the event of a change in control of
ESSI, Mr. Gerhardt is entitled to receive a lump sum cash payment in an
amount equal to 2.99 times his average compensation for the prior five
fiscal years of employment with ESSI. Upon consummation of the merger with
DRS, Mr. Gerhardt will receive a payment totaling approximately $1,970,410.
PRESIDENT AND CHIEF OPERATING OFFICER. Under Mr. Rodrigues'
employment agreement, he serves as President and Chief Operating Officer
until April 10, 2008. Thereafter, the agreement automatically renews for
successive one-year periods unless he or ESSI gives notice to terminate the
agreement at least 30 days prior to the expiration of the term. The
agreement may be terminated at any time by Mr. Rodrigues upon not less than
90 days' written notice, or by ESSI at any time with or without cause.
Under the terms of the employment agreement, Mr. Rodrigues is paid a
base annual salary of $400,000 and
61
receives an annual incentive bonus payment. In addition, Mr. Rodrigues is
entitled to: (a) reimbursement of reasonable and necessary expenses incurred
in the interest of the business of ESSI; (b) a car allowance as determined
by ESSI's board; (c) payment of Mr. Rodrigues' country club membership and
other membership privileges as approved by ESSI's board; and (d) participate
in ESSI's medical, life insurance, accidental death, disability income,
profit sharing trust and other employee benefits on the same basis as other
employees as ESSI. The employment agreement also provides that, for ESSI's
2005 fiscal year, Mr. Rodrigues shall receive a stock option award based on
142,500 shares of ESSI common stock. If the agreement is terminated by ESSI
other than for cause, Mr. Rodrigues is entitled to termination pay equal to
his base salary upon the date of termination payable over 12 months.
Additionally, during the 12-month period, Mr. Rodrigues (and his eligible
family members) are entitled to continue to participate in and receive
certain standard employee benefits. The agreement prohibits Mr. Rodrigues
from competing with ESSI for a period of two years after termination of
employment. In the event of a change in control of ESSI, Mr. Rodrigues is
entitled to receive a lump sum cash payment in an amount equal to 2.99 times
his average compensation for the prior five fiscal years of employment with
ESSI. Upon consummation of the merger with DRS, Mr. Rodrigues will receive a
payment totaling $933,977.
PRESIDENT, BUSINESS DEVELOPMENT. Under Mr. Jura's employment
agreement, he serves as President, Business Development until October 31,
2007. The initial term of the agreement can be extended upon mutual written
agreement between Mr. Jura and ESSI. The agreement may be terminated at any
time by ESSI if it gives notice to terminate the agreement at least 30 days
prior to the expiration of the term. The agreement may be terminated at any
time by Mr. Jura upon not less than 90 days' written notice, or by ESSI at
any time with or without cause.
Under the terms of the employment agreement, Mr. Jura is paid a
base annual salary of $229,500 and receives an annual incentive bonus
payment. In addition, Mr. Jura is entitled to: (a) reimbursement of
reasonable and necessary expenses incurred in the interest of the business
of ESSI; (b) a car allowance as determined by ESSI's board; (c) payment of
Mr. Jura's country club membership; and (d) participate in ESSI's medical,
life insurance, accidental death, disability income, profit sharing trust
and other employee benefits on the same basis as other employees as ESSI.
The employment agreement also provides that, for ESSI's 2005 fiscal year,
Mr. Jura shall receive a stock option award based on 60,000 shares of ESSI
common stock. If the agreement is terminated by ESSI other than for cause,
Mr. Jura is entitled to termination pay equal to his base salary upon the
date of termination payable over 12 months. Additionally, during the
12-month period, Mr. Jura (and his eligible family members) are entitled to
continue to participate in and receive certain standard employee benefits.
The agreement prohibits Mr. Jura from competing with ESSI for a period of
two years after termination of employment. The agreement provides that if
Mr. Jura's employment is terminated under certain circumstances following a
change in control of ESSI, Mr. Jura is entitled to receive cash severance
payments equal to his base salary payable over 12 months.
SENIOR VICE PRESIDENT, CONTROLLER AND CHIEF ACCOUNTING OFFICER.
Under Mr. Landmann's employment agreement, he serves as Senior Vice
President, Controller and Chief Accounting Officer until October 31, 2007.
The agreement may be terminated at any time by ESSI if it gives notice to
terminate the agreement at least 30 days prior to the expiration of the
term. The agreement may be terminated at any time by Mr. Landmann upon not
less than 90 days' written notice, or by ESSI at any time with or without
cause.
Under the terms of the employment agreement, Mr. Landmann is paid a
base annual salary of $220,000 and receives an annual incentive bonus
payment. In addition, Mr. Landmann is entitled to: (a) reimbursement of
reasonable and necessary expenses incurred in the interest of the business
of ESSI; (b) a car allowance as determined by ESSI's board; (c) payment of
Mr. Landmann's country club membership; and (d) participate in ESSI's
medical, life insurance, accidental death, disability income, profit sharing
trust and other employee benefits on the same basis as other employees as
ESSI. The employment agreement also provides that, for ESSI's 2005 fiscal
year, Mr. Landmann shall receive a stock option award based on 60,000 shares
of ESSI common stock. If the agreement is terminated by ESSI other than for
cause, Mr. Landmann is entitled to termination pay equal to his base salary
upon the date of termination payable over 12 months. Additionally, during
the 12-month period, Mr. Landmann (and his eligible family members) are
entitled to continue to participate in and receive certain standard employee
benefits.
62
The agreement prohibits Mr. Landmann from competing with ESSI for a period
of two years after termination of employment. The agreement provides that if
Mr. Landmann's employment is terminated under certain circumstances
following a change in control of ESSI, Mr. Landmann is entitled to receive
cash severance payments equal to his base salary payable over 12 months.
CONSULTING AGREEMENTS
ESSI has consulting agreements with certain former executive
officers. The terms and conditions of those agreements with the
Non-Executive Chairman of the Board and its former President, Business
Development are summarized below.
NON-EXECUTIVE CHAIRMAN OF THE BOARD. Mr. Shanahan retired as ESSI's
executive Chairman on April 30, 2005 at which time the employment agreement
executed on November 1, 2004 was terminated. Mr. Shanahan entered a
consulting agreement, dated May 1, 2005, under which he provides consulting
and advisory services pertaining to the business and operations of ESSI and
serves as the Non-Executive Chairman of the Board. The initial term of the
agreement continues through April 30, 2006 and the agreement automatically
renews for an additional one-year period through April 30, 2007, unless
terminated by Mr. Shanahan upon written notice at least 30 days prior to the
expiration of the initial term. Thereafter, the agreement automatically
renews for successive one-year periods unless terminated by either party
upon written notice of at least 30 days prior to the expiration of the
then-current term. The agreement may be terminated at any time by Mr.
Shanahan upon not less than 30 days' written notice, or by ESSI at any time
with or without cause.
If the consulting agreement is terminated by ESSI without cause,
Mr. Shanahan is entitled to receive all compensation and benefits through
the latter of the expiration of the second term extending until April 30,
2007, or the renewal term in effect at the time of termination, and other
such considerations as is expressly provided for in the agreement. Mr.
Shanahan's consulting fee under the agreement is $62,500 per month. The
agreement also provides for payments in the amount of $52,500 per month for
24 consecutive months to Mr. Shanahan's designated beneficiary if Mr.
Shanahan's death occurs during the period that the agreement is in effect,
as well as payments in the amount of $52,500 per month for a period not to
exceed 60 consecutive months if Mr. Shanahan becomes disabled during the
period that the agreement is in effect. Additionally, the agreement provides
that, upon a termination of the agreement by Mr. Shanahan by written notice,
or upon a termination by ESSI without cause, or in the event that either
party determines not to renew the agreement for any reason, ESSI will pay
Mr. Shanahan $52,500 per month for 24 months following termination of the
agreement.
In addition to the consulting fee, Mr. Shanahan is entitled to: (a)
reimbursement of reasonable and necessary expenses incurred in the interest
of the business of ESSI,; (b) a car allowance of not less than $1,800 per
month: (c) participate in ESSI's medical and dental insurance programs along
with his spouse for the duration of his life and the life of his spouse; and
(d) participate in ESSI's life insurance, accidental death and disability
income benefit programs on the same basis as other executives of ESSI. The
agreement also contains non-compete and non-diversion covenants that extend
for so long as the agreement is in effect and during such period after any
termination that Mr. Shanahan is receiving compensation from ESSI under the
agreement.
In the event that ESSI was sold or merged with another firm, Mr.
Shanahan's previously existing employment agreement provided for a change in
control benefit consisting of a lump sum cash payment in the amount of 2.99
times Mr. Shanahan's average annual compensation for his prior five fiscal
years of employment with ESSI. In connection with the approval of the merger
agreement with DRS, ESSI's board of directors approved the recommendation of
the board's compensation committee for ESSI to pay a success fee of $5.0
million to Mr. Shanahan upon consummation of the merger. The payment will be
made pursuant to a memorandum of understanding, dated April 30, 2005,
between ESSI and Mr. Shanahan. The memorandum of understanding required ESSI
to negotiate in good faith with Mr. Shanahan the amount of a reasonable
success fee as compensation for Mr. Shanahan's consulting services, pursuant
to his consulting agreement, in connection with a possible sale of ESSI.
63
BUSINESS DEVELOPMENT CONSULTANT. ESSI's former President, Business
Development, Ronald W. Davis, retired from this position in June 2005. Mr.
Davis entered into a consulting agreement dated June 1, 2005 under which Mr.
Davis provides consulting and advisory services pertaining to transitioning
his prior position to a successor and other duties reasonably requested from
ESSI's board from time to time. The initial term of the agreement continues
through May 31, 2006. The agreement automatically renews for successive
one-year periods unless terminated by either party upon written notice at
least 30 days prior to the expiration of the current term. The agreement may
be terminated at any time by Mr. Davis upon not less than 30 days' written
notice, or by ESSI at any time with or without cause.
Mr. Davis's consulting fee under the agreement is $210 per hour, or
$1,680 per day if he performs services for eight or more hours on a given
day. If the consulting agreement with Mr. Davis is terminated by ESSI
without cause, Mr. Davis would be entitled to receive all compensation and
benefits through the effective date of termination, along with $14,333 per
month for 12 months following termination of the agreement.
In addition to the consulting fee, Mr. Davis is entitled to: (a)
reimbursement of reasonable and necessary expenses incurred in the interest
of the business of ESSI; (b) a car allowance of not less than $1,000 per
month; and (c) participate in ESSI's medical and dental insurance programs
for the duration of his life and the life of his spouse. The agreement also
contains non-compete and non-diversion covenants that extend for so long as
the agreement is in effect and for two years after termination of the
agreement.
EXECUTIVE COMPENSATION
The following table sets forth the compensation for the past three
fiscal years for the five most highly compensated executive officers for the
fiscal year ended October 31, 2005:
SUMMARY COMPENSATION TABLE
Securities
Name and Annual Underlying All Other
Principal Position Year Salary Bonus Options (1) Compensation
------------------ ---- ------ ----- ----------- ------------
Michael F. Shanahan, Sr. 2005 $625,000 $750,000 0 $422,500(3)
Non-Executive Chairman (2) 2004 $1,250,000 $1,500,000 0 $341,700
2003 $1,000,000 $1,500,000 0 $301,300
Gerald A. Potthoff 2005 $720,000 $0 0 $893,500(4)
Vice Chairman and Chief 2004 $550,000 $412,500 22,500 $1,426,600
Executive Officer 2003 $500,000 $375,000 22,500 $268,600
Gary C. Gerhardt 2005 $550,000 $267,300 0 $50,500(5)
Vice Chairman 2004 $480,000 $360,000 22,500 $30,700
and Chief Financial 2003 $400,000 $300,000 22,500 $29,600
Officer
Ronald W. Davis (6) 2005 $280,000 $136,000 0 $124,400(7)
President, Business 2004 $430,000 $322,500 22,500 $44,100
Development 2003 $350,000 $262,500 22,500 $30,200
Daniel A. Rodrigues 2005 $297,300 $121,500 142,500 $23,600(8)
President and Chief Operating Officer 2004 $220,000 $120,000 37,500 $18,600
2003 $190,000 $122,500 45,000 $15,000
Dan D. Jura 2005 $207,600 $69,300 60,000 $31,200(9)
President, Business Development 2004 $175,000 $82,500 22,500 $21,500
2003 $162,000 $76,500 33,750 $17,300
Steven J. Landmann 2005 $198,500 $73,300 60,000 $28,600(10)
Senior Vice President, Controller and 2004 $170,000 $84,000 22,500 $16,100
Chief Accounting Officer 2003 $162,000 $79,500 22,500 $15,300
64
--------
(1) All option amounts have been restated to reflect 3-for-2 stock splits
effected in the form of 50% stock dividends on April 15, 2005 and
October 31, 2003.
(2) Mr. Shanahan retired from his employment position as ESSI's Chairman of
the Board of Directors on April 30, 2005 and his underlying employment
agreement was terminated at that time. Compensation earned under the
consulting agreement with Mr. Shanahan dated May 1, 2005 is included
within "All Other Compensation."
(3) This amount includes $18,900 pursuant to the benefit of life insurance
premiums paid by ESSI on Mr. Shanahan's behalf; $13,900 of common stock
contributed through the Engineered Support Systems, Inc. 401(k) and
Employee Stock Ownership Plan; $375,000 in fees paid pursuant to Mr.
Shanahan's consulting agreement; and $14,700 for reimbursement of
personal expenses.
(4) This amount includes $861,000 accrued pursuant to Mr. Potthoff's
employment agreement in connection with a Supplemental Executive
Retirement Plan; $13,200 of life insurance premiums paid by ESSI on Mr.
Potthoff's behalf; and, $19,300 for reimbursement of personal expenses.
(5) This amount includes $4,000 pursuant to the benefit of life insurance
premiums paid by ESSI on Mr. Gerhardt's behalf; $13,900 of common stock
contributed through the Engineered Support Systems, Inc. 401(k) and
Employee Stock Ownership Plan; and $32,600 for reimbursement of
personal expenses.
(6) Mr. Davis retired from his employment position as President, Business
Development on June 1, 2005. Compensation earned under the consulting
agreement dated June 1, 2005 is included within "All Other
Compensation."
(7) This amount includes $9,500 pursuant to the benefit of life insurance
premiums paid by ESSI on Mr. Davis' behalf; $13,900 of common stock
contributed through the Engineered Support Systems, Inc. 401(k) and
Employee Stock Ownership Plan; $17,900 for reimbursement of personal
expenses; and $83,100 in fees paid pursuant to Mr. Davis' consulting
agreement.
(8) This amount includes $1,200 pursuant to the benefit of life insurance
premiums paid by ESSI on Mr. Rodrigues' behalf and $22,400 for
reimbursement of personal expenses.
(9) This amount includes $600 pursuant to the benefit of life insurance
premiums paid by ESSI on Mr. Jura's behalf; $13,900 of common stock
contributed through the Engineered Support Systems, Inc. 401(k) and
Employee Stock Ownership Plan; and $16,700 for reimbursement of
personal expenses.
(10) This amount includes $400 pursuant to the benefit of life insurance
premiums paid by ESSI on Mr. Landmann's behalf; $13,900 of common stock
contributed through the Engineered Support Systems, Inc. 401(k) and
Employee Stock Ownership Plan; and $14,300 for reimbursement of
personal expenses.
65
OPTION GRANTS IN LAST FISCAL YEAR
The following table sets forth information concerning stock option
grants made during the fiscal year ended October 31, 2005 to the individuals
named in the Summary Compensation Table.
Potential Realizable
Value at Assumed
Annual Rates of Stock
Number of Percent of Price Appreciation
Securities Total for Option Term (1)
Underlying Options Exercise --------------------------
Options Granted in Price Expiration 5% Assumed 10% Assumed
Name Granted Fiscal Year per Share Date Rate Rate
---- ------- ----------- --------- ---------- ---------- -----------
Michael F. Shanahan, Sr. -- --% -- -- -- --
Gerald A. Potthoff -- --% -- -- --
Gary C. Gerhardt -- --% -- -- -- --
Ronald W. Davis -- --% -- -- -- --
Daniel A. Rodrigues 142,500 11.07% $35.57 7/5/10 $1,400,395 $3,094,507
Dan D. Jura 60,000 4.67% $35.57 7/5/10 $589,640 $1,302,950
Steven J. Landmann 60,000 4.67% $35.57 7/5/10 $589,640 $1,302,950
--------
(1) The indicated 5% and 10% rates of appreciation are provided to
comply with Securities and Exchange Commission regulations and do not
necessarily reflect the views of ESSI's management as to the likely trend in
the common stock price. Actual gains, if any, on stock option exercises and
common stock holdings will be dependent on, among other things, the future
performance of the common stock and overall market conditions. There can be
no assurance that the amounts reflected above will be achieved.
Additionally, these values do not take into consideration the option
provision providing for non-transferability.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND
FISCAL YEAR END OPTION VALUES
The following table sets forth information concerning the number of
exercisable and unexercisable stock options at October 31, 2005 held by the
individuals named in the Summary Compensation Table.
Number of Value of
Securities Unexercised
Underlying In-the-Money
Number Options Options
of Shares at 10/31/05 at 10/31/05
Acquired on Value Exercisable/ Exercisable/
Name Exercise Realized Unexercisable Unexercisable
---- -------- -------- ------------- -------------
Michael F. Shanahan, Sr. -- $ -- 0/0 $0 / $0
Gerald A. Potthoff -- $ -- 833,907 / 0 $22,309,960 / $0
Gary C. Gerhardt 210,938 $7,459,107 867,657 / 0 $24,769,491 / $0
Ronald W. Davis 365,157 $8,416,342 0 / 0 $0 / $0
Daniel A. Rodrigues -- $ -- 225,000 / 0 $771,132 / $0
Dan D. Jura -- $ -- 116,250 / 0 $511,242 / $0
Steven J. Landmann -- $ -- 165,000 / 0 $2,050,947 / $0
66
RETIREMENT PLANS
ESSI maintains a defined benefit pension plan providing retirement
benefits for certain employees, including officers. Contributions are made
on an actuarial group basis, and no specific amount of contributions is set
aside for any individual participant. The following table sets forth the
approximate annual pension benefit based on years of service and
compensation and reflects dollar limitations under the Internal Revenue
Code, as amended, which limits the annual benefits which may be paid from a
tax-qualified retirement plan.
Average Annual Defined Benefit Pension Plan Table
Compensation for Approximate Annual Straight-Life Annuity
the Five Consecutive Pension Upon Retirement at 65
Calendar Years of -----------------------------
the Last Ten for
Which Compensa- 10 years 15 years 20 years 25 years 30 years
tion is Highest of Service of Service of Service of Service of Service
--------------- ---------- ---------- ---------- ---------- ----------
100,000............. $12,565 $18,848 $25,130 $31,413 $37,696
200,000............. $27,565 $41,348 $55,130 $68,913 $82,696
210,000 and above... $29,065 $43,598 $58,130 $72,663 $87,196
Of the named executive officers, only Messrs Potthoff and Rodrigues
participate in this plan. Estimated credited years of service are as
follows: Mr. Potthoff, 31; Mr. Rodrigues, 29.
The maximum benefit under the plan is $210,000. For purposes of the
retirement plan, an employee's compensation is his Annual Compensation as
set forth in the Summary Compensation Table.
ESSI also maintains a Supplemental Executive Retirement Plan under
which amounts in excess of the qualified plan limitations will be paid from
the general funds of ESSI, pursuant to the terms of this plan.
Average Annual Supplemental Executive Retirement Plan Table
Compensation for Approximate Annual Straight-Life Annuity
the Five Consecutive Pension Upon Retirement at 65
Calendar Years of -----------------------------
the Last Ten for
Which Compensa- 10 years 15 years 20 years 25 years 30 years
tion is Highest of Service of Service of Service of Service of Service
--------------- ---------- ---------- ---------- ---------- ----------
300,000............. $ 13,500 $ 20,250 $ 27,000 $ 33,750 $ 40,500
400,000............. 28,500 42,750 57,000 71,250 85,500
500,000............. 43,500 65,250 87,000 108,750 130,500
600,000............. 58,500 87,750 117,000 146,250 175,500
700,000............. 73,500 110,250 147,000 183,750 220,500
800,000............. 88,500 132,750 177,000 221,250 265,500
900,000............. 103,500 155,250 207,000 258,750 310,500
Of the named executive officers, only Mr. Potthoff is eligible to
receive amounts pursuant to the Supplemental Executive Retirement Plan.
Mr. Potthoff has 31 estimated credited years of service under the plan.
67
DIRECTORS FEES
Directors who are not full-time employees of ESSI are paid $1,000
for each meeting of the Board and $500 for each meeting of the committee(s)
on which they serve. Committee chairmen receive an additional $500 per
meeting. Directors are also paid $2,800 per month during their term.
Non-employee directors are reimbursed for expenses incurred in attending
meetings.
Non-employee directors also receive annual stock option awards in
accordance with the Engineered Support Systems, Inc. 2002 Stock Option Plan
for Non-Employee Directors. On March 1, 2005, Mssrs. Bush, Carns, Friel,
Guilfoil, Kling, Lewi, Robertson, Saint, Shanahan, Jr. and Wims each
received an option to acquire 8,438 shares of the Company's common stock at
an exercise price of $37.17 per share. Mr. Schaefer received an option on
that date to acquire 12,657 shares of the Company's common stock at the same
price.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
-------- --------------------------------------------------------------
BENEFICIAL OWNERSHIP OF COMMON STOCK OF THE COMPANY
The table below sets forth the number of shares of common stock
(the only class of outstanding securities of ESSI) held by each person known
to beneficially own 5% or more of ESSI's outstanding common stock as of
January 3, 2006.
Name and Address of Shares of Common Stock Percentage of Shares
Beneficial Owner Beneficially Owned Outstanding(1)
---------------- ------------------ --------------
Neuberger Berman, Inc.
605 Third Avenue
New York, NY 10158 5,557,686 (2) 13.24%
Deephaven Capital Management, LLC 2,841,070 (3) 6.77%
130 Cheshire Lane, Suite 102
Minnetonka, MN 55305
--------
(1) For purposes of this table, the calculation of the Percentage of Shares
Outstanding is based on the number of shares of common stock
outstanding as of January 3, 2006.
(2) The information provided herein is based on a Schedule 13G field by
Neuberger Berman, Inc. with the SEC on February 16, 2005, reporting
ownership of ESSI common stock as of December 31, 2004, adjusted for
the three-for-two stock split effected by ESSI on April 15, 2005.
(3) The information provided herein is based on a Schedule 13G filed by
Deephaven Capital Management, LLC with the SEC on January 3, 2006,
reporting ownership of ESSI common stock as of December 5, 2005.
68
The following table sets forth the number of shares of common stock
beneficially owned by (a) each director, (b) each executive officer named in
the Summary Compensation Table, and (c) all directors and executive officers
as a group as of January 3, 2006:
Shares of Common
Stock
Beneficially Percentage of Shares
Name of Beneficial Owner Owned (1) (2) Outstanding (3)
------------------------ ------------- ---------------
Michael F. Shanahan, Sr. 693,895 1.65%
Gerald A. Potthoff 926,977 2.17%
Gary C. Gerhardt 1,040,119 2.43%
Daniel A. Rodrigues 227,909 *
Dan D. Jura 117,076 *
Steven J. Landmann 186,978 *
Gregory P. Boyer 0 *
William H. T. Bush 88,595 *
General Michael P.C. Carns 81,329 *
U.S. Air Force, Retired
MG George E. Friel 22,514 *
U.S. Army, Retired
Thomas J. Guilfoil 139,262 *
S. Lee Kling 97,885 *
LTG Kenneth E. Lewi 81,905 *
U.S. Army, Retired
General Charles T. Robertson, Jr. 25,313 *
U.S. Air Force, Retired
General Crosbie E. Saint 20,533
U.S. Army, Retired
James A. Schaefer 12,657 *
Michael F. Shanahan, Jr. 123,712 *
Earl W. Wims, Ph.D. 38,621 *
Ronald W. Davis 5,085 *
All directors and executive officers 5,294,538 11.56%
as a group (42 persons)
69
--------
* The Percentage of Shares Outstanding is less than one percent.
(1) Except as otherwise noted, each individual has sole voting and
investment power with respect to shares listed above.
(2) Totals include the following shares issuable upon exercise of stock
options that either are presently exercisable or exercisable within 60
days after December 20, 2005: Mr. Potthoff (833,907), Mr. Gerhardt
(867,657), Mr. Rodrigues (225,000), Mr. Jura (116,250), Mr. Landmann
(165,000), Mr. Bush (75,938), General Carns (75,938), MG Friel
(16,875), Mr. Guilfoil (25,313), Mr. Kling (42,188), LTG Lewi (16,875),
General Robertson, Jr. (25,313), General Saint (20,533), Mr. Schaefer
(12,657), Mr. Shanahan, Jr. (16,875), Mr. Wims (16,875) and all
directors and executive officers as a group (3,840,132).
(3) For purposes of this table, the calculation of the Percentage of Shares
Outstanding is based on the number of shares of common stock
outstanding as of January 3, 2006, increased by the assumed exercise of
all options owned by the beneficial owners indicated.
EQUITY COMPENSATION PLAN INFORMATION
Information regarding ESSI's equity compensation plans is included
under Part II, Item 5 of this Annual Report on Form 10-K.
CHANGE IN CONTROL
On September 21, 2005, ESSI and DRS entered into a definitive
agreement which provides for the acquisition by DRS of all the outstanding
common stock of ESSI for approximately $1.9 billion, or $43.00 per share
(subject to possible adjustment), through a combination of cash and DRS
common stock. Pending customary regulatory approvals and other closing
conditions, including approval by ESSI and DRS shareholders, the transaction
is expected to close before March 31, 2006.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
-------- ----------------------------------------------
Huntleigh McGehee served as broker on substantially all of ESSI's
insurance policies in fiscal 2005. Total commissions earned by Huntleigh
McGehee on insurance premiums paid by ESSI in fiscal 2005 were $1,519,000.
Michael F. Shanahan, Jr. owns a majority of Huntleigh McGehee's outstanding
stock and has served as the President and Chief Executive Officer of
Huntleigh McGehee since July 2004. As a result of contractual arrangements
between Mr. Shanahan and the other stockholders of Huntleigh McGehee, Mr.
Shanahan has not received any compensation, either as shareholder or officer
of Huntleigh McGehee, as a result of insurance brokerage services paid by
ESSI to Huntleigh McGehee in fiscal 2005. Mr. Shanahan is a director of
ESSI, the son of Michael F. Shanahan, Sr., non-executive Chairman of the
Board of ESSI, and the son-in-law of director Earl W. Wims.
ESSI paid David D. Mattern $462,300 in fees during fiscal 2005 for
his services as Secretary and General Counsel of ESSI. Mr. Mattern is the
son-in-law of Michael F. Shanahan, Sr., non-executive Chairman of the Board
of ESSI.
The Audit Committee of the Board of Directors has formally approved
all related party transactions.
70
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
-------- --------------------------------------
PricewaterhouseCoopers LLP, an independent registered public
accounting firm, has been the auditors of the accounts of ESSI since 1991,
including the fiscal year ended October 31, 2005.
PricewaterhouseCoopers LLP has informed ESSI that it does not have
any direct financial interest in ESSI and that it has not had any direct
connection with ESSI as either a promoter, an underwriter, a director, an
officer or an employee.
The following table sets forth the aggregate fees for professional
audit services for the audit of the financial statements for the fiscal
years ended October 31, 2005 and 2004 and fees billed for other services
during those fiscal years by PricewaterhouseCoopers LLP. All fees include in
the table below have been pre-approved by the Audit Committee.
2005 2004
---- ----
Audit fees (1) ................ $1,190,000 $488,200
Audit-related fees (2)......... 291,500 153,225
Tax fees (3)................... 221,870 234,550
All other fees ................ - -
---------- --------
Total ......................... $1,703,370 $875,975
========== ========
--------
(1) Audit fees consisted of audit work performed in the preparation of
financial statements, including $580,000 and $0, respectively, for
Sarbanes-Oxley Section 404 internal control procedures in fiscal 2005 and
2004, as well as work generally only the independent auditors can reasonably
be expected to provide, such as statutory audits.
(2) Audit related fees consisted of the following: $68,000 and $82,400 in
fiscal 2005 and 2004, respectively, for employee benefit plan audits; $2,500
and $2,500 in fiscal 2005 and 2004, respectively, for Form S-8 consents; $0
and $62,125, respectively, in fiscal 2005 and 2004 for readiness efforts
related to Sarbanes-Oxley Section 404 internal control procedures; $11,000
and $0 in fiscal 2005 and 2004, respectively, related to Spacelink Form 8-K
procedures; $200,000 in fiscal 2005 for services performed in connection
with ESSI's pending merger transaction with DRS; and, $10,000 and $10,450 in
fiscal 2005 and 2004, respectively, for out-of-pocket expenses.
(3) Tax fees consisted of assistance with matters related to tax compliance
and consulting.
POLICY REGARDING THE APPROVAL OF INDEPENDENT AUDITOR PROVISION
OF AUDIT AND NON-AUDIT SERVICES
Consistent with Securities and Exchange Commission requirements
regarding auditor independence, the Audit Committee has adopted a policy to
pre-approve all audit and permissible non-audit services provided by the
independent auditor. Under the policy, the Committee must pre-approve
services prior to commencement of the specified service. The requests for
pre-approval are submitted to the Audit Committee by the Vice Chairman and
Chief Financial Officer or his designee with a statement as to whether in
their view the request is consistent with the Securities and Exchange
Commission's rules on auditor independence.
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENTS AND SCHEDULES
-------- --------------------------------------------
(a)(1) Financial Statements. See Item 8 above.
(2) The following financial statement schedule is included as
Exhibit 99.1.
71
Schedule II -Valuation and Qualifying Accounts - years ended October 31,
2005, 2004 and 2003
All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are
not required under the related instructions or are inapplicable, and
therefore have been omitted.
(3) Exhibits.
Lists of Exhibits (listed by numbers corresponding to exhibit table
of Item 601 in regulation S-K)
2.1 Agreement and Plan of Merger dated as of September 21,
2005, among Engineered Support Systems, Inc., DRS
Technologies, Inc. and Maxco, Inc. (21)
3.1 Articles of Incorporation of Engineered Support Systems,
Inc. (1)
3.2 Amendment of Articles of Incorporation (5)
3.3 Amendment of Articles of Incorporation
3.4 Amended and Restated By-Laws of Engineered Support
Systems, Inc. (5)
4.1 Amended and Restated Credit Agreement dated as of January
27, 2005 among Engineered Support Systems, Inc., as the
Borrower, Bank of America, N.A. and the Other Lenders
Party Hereto (3)
4.2 Engineered Air Systems, Inc. Employee Stock Ownership
Plan, subsequently renamed the Engineered Support Systems,
Inc. Employee Stock Ownership Plan (4)
4.3 Engineered Support Systems, Inc. 2000 Stock Option Plan (6)
4.4 Engineered Support Systems, Inc. 2000 Stock Option Plan
for Nonemployee Directors (7)
4.5 Engineered Support Systems, Inc. Employee Stock Purchase
Plan (8)
4.6 Engineered Support Systems, Inc. Stock Purchase Plan for
Nonemployee Directors (9)
4.7 Engineered Support Systems, Inc. 2002 Stock Option Plan (10)
4.8 Engineered Support Systems, Inc. 2002 Stock Option Plan
for Non-Employee Directors (11)
4.9 Engineered Support Systems, Inc. 2002 Non-Executive Stock
Option Plan (12)
4.10 Engineered Support Systems, Inc. 2003 Stock Option Plan (13)
4.11 Engineered Support Systems, Inc. 2003 Non-Executive Stock
Option Plan (14)
4.12 Engineered Support Systems, Inc. 2004 Stock Option Plan (16)
4.13 Engineered Support Systems, Inc. 2004 Non-Executive Stock
Option Plan (17)
4.14 Engineered Support Systems, Inc. 2005 Non-Executive Stock
Option Plan (18)
10.1 Employment Agreement with Gerald A. Potthoff (15)
10.2 Employment Agreement with Gary C. Gerhardt (15)
10.3 Employment Agreement with Daniel A. Rodrigues (19)
10.4 Consulting Agreement with Michael F. Shanahan, Sr. (19)
72
10.5 Consulting Agreement with Ronald W. Davis (20)
10.6 Employment Agreement with Dan D. Jura
10.7 Employment Agreement with Steven J. Landmann
10.8 Form of Indemnification Agreement with Directors (2)
10.9 Engineered Support Systems, Inc. Executive Incentive
Performance Plan (15)
10.10 Memorandum of Understanding, dated as of April 30, 2005,
issued by Engineered Support Systems, Inc. to Michael F.
Shanahan, Sr. (21)
10.11 Form of Purchase Agreement by and between Engineered
Support Systems, Inc. and Spacelink International LLC,
Spacelink International LTD and SatComSolutions LLC dated
December 9, 2004 (15)
10.12 Form of Stock Purchase Agreement by and between
Prospective Computer Analysts Incorporated, Edward Wenger,
The Lauren Wenger 2004 GRAT, The Eric Wenger 2004 GRAT,
the Mitchell Wenger 2004 GRAT and Engineered Support
Systems, Inc. (15)
11 Statement Re: Computation of Earnings Per Share
21 Subsidiaries of Registrant
23 Consent of PricewaterhouseCoopers LLP, Independent
Registered Public Accounting Firm
31.1 Certification of Chief Executive Officer
31.2 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
99.1 Valuation and Qualifying Accounts (Schedule II)
(1) This information is incorporated by reference
from Form S-1 Registration Statement filed on
July 10, 1985, registration number 2-98909 as
amended on August 13, 1985 and August 21, 1985.
(2) This information is incorporated by reference
from Form 10-K Annual Report filed on January 30,
1989.
(3) This information is incorporated by reference
from Form 8-K filed on February 2, 2005.
(4) This information is incorporated by reference
from Form S-8 registration statement, effective
June 11, 1987, registration number 33-14504.
(5) This information is incorporated by reference
from Form 10-K Annual Report filed on January 30,
2004.
(6) This information is incorporated by reference
from Form S-8 registration statement, effective
September 1, 2000, registration number 333-45022.
(7) This information is incorporated by reference
from Form S-8 registration statement, effective
September 1, 2000, registration number 333-45020.
(8) This information is incorporated by reference
from Form S-8 registration statement, effective
June 29, 2001, registration number 333-64126.
(9) This information is incorporated by reference
from Form S-8 registration statement, effective
July 20, 2001, registration number 333-65490.
73
(10) This information is incorporated by reference
from Form S-8 registration statement, effective
August 9, 2002, registration number 333-97859.
(11) This information is incorporated by reference
from Form S-8 registration statement, effective
August 9, 2002, registration number 333-97861.
(12) This information is incorporated by reference
from Form S-8 registration statement, effective
November 12, 2002, registration number
333-101161.
(13) This information is incorporated by reference
from Form S-8 registration statement, effective
October 31, 2003, registration number 333-110166.
(14) This information is incorporated by reference
from Form S-8 registration statement, effective
October 31, 2003, registration number 333-110165.
(15) This information is incorporated by reference
from Form 10-K Annual Report filed on January 14,
2005.
(16) This information is incorporated by reference
from Form S-8 registration statement, effective
June 22, 2004, registration number 333-116743.
(17) This information is incorporated by reference
from Form S-8 registration statement, effective
June 22, 2004, registration number 333-116744.
(18) This information is incorporated by reference
from Form S-8 registration statement, effective
July 7, 2005, registration number 333-126442.
(19) This information is incorporated by reference
from Form 8-K/A filed on May 6, 2005.
(20) This information is incorporated by reference
from Form 8-K filed on June 22, 2005.
(21) This information incorporated by reference from
Form 8-K filed on September 27, 2005.
(b) Exhibits
See list of Exhibits in this Part IV, Item 15(a)(3) above.
(c) Financial Statement Schedules
See Part IV, Item 15(a)(2) above.
74
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this annual report to
be signed on its behalf by the undersigned thereunto duly authorized.
ENGINEERED SUPPORT SYSTEMS, INC.
Dated: January 9, 2006 By: /s/ Gary C. Gerhardt
----------------- --------------------------------------
GARY C. GERHARDT
Vice Chairman and Chief Financial
Officer
Pursuant to the requirements of the Securities and Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Gerald A. Potthoff Vice Chairman and, January 9, 2006
-------------------------- Chief Executive Officer
GERALD A. POTTHOFF (Principal Executive Officer)
/s/ Gary C. Gerhardt Vice Chairman and January 9, 2006
-------------------------- Chief Financial Officer
GARY C. GERHARDT (Principal Financial
Officer)
/s/ Steven J. Landmann Vice President - Controller January 9, 2006
--------------------------- and Chief Accounting
STEVEN J. LANDMANN Officer (Principal
Accounting Officer)
75
SIGNATURES
----------
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Michael F. Shanahan, Sr. Non-Executive Chairman January 9, 2006
------------------------------ and Director
MICHAEL F. SHANAHAN, SR.
/s/ Gerald A. Potthoff Director January 9, 2006
------------------------------
GERALD A. POTTHOFF
/s/ Gary C. Gerhardt Director January 9, 2006
------------------------------
GARY C. GERHARDT
/s/ Gregory P. Boyer Director January 9, 2006
------------------------------
GREGORY P. BOYER
/s/ William H.T. Bush Director January 9, 2006
------------------------------
WILLIAM H.T. BUSH
/s/ Michael P.C. Carns Director January 9, 2006
------------------------------
MICHAEL P.C. CARNS
/s/ George E. Friel Director January 9, 2006
------------------------------
GEORGE E. FRIEL
/s/ Thomas J. Guilfoil Director January 9, 2006
------------------------------
THOMAS J. GUILFOIL
/s/ S. Lee Kling Director January 9, 2006
------------------------------
S. LEE KLING
/s/ Kenneth E. Lewi Director January 9, 2006
------------------------------
KENNETH E. LEWI
/s/ Charles T. Robertson, Jr. Director January 9, 2006
------------------------------
CHARLES T. ROBERTSON, JR.
/s/ Crosbie E. Saint Director January 9, 2006
------------------------------
CROSBIE E. SAINT
76
SIGNATURE TITLE DATE
--------- ----- ----
/s/ James A. Schaefer Director January 9, 2006
------------------------------
JAMES A. SCHAEFER
/s/ Michael F. Shanahan, Jr. Director January 9, 2006
------------------------------
MICHAEL F. SHANAHAN, JR.
/s/ Earl W. Wims Director January 9, 2006
------------------------------
EARL W. WIMS
77
ENGINEERED SUPPORT SYSTEMS, INC.
EXHIBIT INDEX
Lists of Exhibits (listed by numbers corresponding to exhibit table of
Item 601 in regulation S-K)
2.1 Agreement and Plan of Merger dated as of September 21,
2005, among Engineered Support Systems, Inc., DRS
Technologies, Inc. and Maxco, Inc. (21)
3.1 Articles of Incorporation of Engineered Support Systems,
Inc. (1)
3.2 Amendment of Articles of Incorporation (5)
3.3 Amendment of Articles of Incorporation
3.4 Amended and Restated By-Laws of Engineered Support
Systems, Inc. (5)
4.1 Amended and Restated Credit Agreement dated as of January 27,
2005 among Engineered Support Systems, Inc., as the
Borrower, Bank of America, N.A. and the Other Lenders
Party Hereto (3)
4.2 Engineered Air Systems, Inc. Employee Stock Ownership
Plan, subsequently renamed the Engineered Support Systems,
Inc. Employee Stock Ownership Plan (4)
4.3 Engineered Support Systems, Inc. 2000 Stock Option Plan (6)
4.4 Engineered Support Systems, Inc. 2000 Stock Option Plan
for Non-Employee Directors (7)
4.5 Engineered Support Systems, Inc. Employee Stock Purchase
Plan (8)
4.6 Engineered Support Systems, Inc. Stock Purchase Plan for
Non-Employee Directors (9)
4.7 Engineered Support Systems, Inc. 2002 Stock Option Plan (10)
4.8 Engineered Support Systems, Inc. 2002 Stock Option Plan
for Non-Employee Directors (11)
4.9 Engineered Support Systems, Inc. 2002 Non-Executive Stock
Option Plan (12)
4.10 Engineered Support Systems, Inc. 2003 Stock Option Plan (13)
4.11 Engineered Support Systems, Inc. 2003 Non-Executive Stock
Option Plan (14)
4.12 Engineered Support Systems, Inc. 2004 Stock Option Plan (16)
4.13 Engineered Support Systems, Inc. 2004 Non-Executive Stock
Option Plan (17)
4.14 Engineered Support Systems, Inc. 2005 Non-Executive Stock
Option Plan (18)
10.1 Employment Agreement with Gerald A. Potthoff (15)
10.2 Employment Agreement with Gary C. Gerhardt (15)
10.3 Employment Agreement with Daniel A. Rodrigues (19)
10.4 Consulting Agreement with Michael F. Shanahan, Sr. (19)
10.5 Consulting Agreement with Ronald W. Davis (20)
10.6 Employment Agreement with Dan D. Jura
78
10.7 Employment Agreement with Steven J. Landmann
10.8 Form of Indemnification Agreement with Directors (2)
10.9 Engineered Support Systems, Inc. Executive Incentive
Performance Plan (15)
10.10 Memorandum of Understanding, dated as of April 30, 2005,
issued by Engineered Support Systems, Inc. to Michael F.
Shanahan, Sr. (21)
10.11 Form of Purchase Agreement by and between Engineered
Support Systems, Inc. and Spacelink International LLC,
Spacelink International LTD and SatComSolutions LLC dated
December 9, 2004 (15)
10.12 Form of Stock Purchase Agreement by and between
Prospective Computer Analysts Incorporated, Edward Wenger,
The Lauren Wenger 2004 GRAT, The Eric Wenger 2004 GRAT,
the Mitchell Wenger 2004 GRAT and Engineered Support
Systems, Inc. (15)
11 Statement Re: Computation of Earnings Per Share
21 Subsidiaries of Registrant
23 Consent of PricewaterhouseCoopers LLP, Independent
Registered Public Accounting Firm
31.3 Certification of Chief Executive Officer
31.4 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
99.1 Valuation and Qualifying Accounts (Schedule II)
(1) This information is incorporated by reference
from Form S-1 Registration Statement filed on
July 10, 1985, registration number 2-98909 as
amended on August 13, 1985 and August 21, 1985.
(2) This information is incorporated by reference
from Form 10-K Annual Report filed on January 30,
1989.
(3) This information is incorporated by reference
from Form 8-K filed February 2, 2005.
(4) This information is incorporated by reference
from Form S-8 registration statement, effective
June 11, 1987, registration number 33-14504.
(5) This information is incorporated by reference
from Form 10-K Annual Report filed on January 30,
2004.
(6) This information is incorporated by reference
from Form S-8 registration statement, effective
September 1, 2000, registration number 333-45022.
(7) This information is incorporated by reference
from Form S-8 registration statement, effective
September 1, 2000, registration number 333-45020.
(8) This information is incorporated by reference
from Form S-8 registration statement, effective
June 29, 2001, registration number 333-64126.
(9) This information is incorporated by reference
from Form S-8 registration statement, effective
July 20, 2001, registration number 333-65490.
(10) This information is incorporated by reference
from Form S-8 registration statement, effective
August 9, 2002, registration number 333-97859.
(11) This information is incorporated by reference
from Form S-8 registration statement, effective
August 9, 2002, registration number 333-97861.
79
(12) This information is incorporated by reference
from Form S-8 registration statement, effective
November 12, 2002, registration number
333-101161.
(13) This information is incorporated by reference
from Form S-8 registration statement, effective
October 31, 2003, registration number 333-110166.
(14) This information is incorporated by reference
from Form S-8 registration statement, effective
October 31, 2003, registration number 333-110165.
(15) This information is incorporated by reference
from Form 10-K Annual Report filed on January 14,
2005.
(16) This information is incorporated by reference
from Form S-8 registration statement, effective
June 22, 2004, registration number 333-116743.
(17) This information is incorporated by reference
from Form S-8 registration statement, effective
June 22, 2004, registration number 333-116744.
(18) This information is incorporated by reference
from Form S-8 registration statement, effective
July 7, 2005, registration number 333-126442.
(19) This information is incorporated by reference
from Form 8-K/A filed on May 6, 2005.
(20) This information is incorporated by reference
from Form 8-K filed on June 22, 2005.
(21) This information incorporated by reference from
Form 8-K filed on September 27, 2005.
80