KTOS 2012.09.30 10-Q
Table of Contents

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

FORM 10-Q
 
ý      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended September 30, 2012
 
¨        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
 
Commission file number 001-34460
 
 
KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
(Exact name of Registrant as specified in its charter)
Delaware
13-3818604
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer Identification No.)
4820 Eastgate Mall, Suite 200
San Diego, CA 92121
(858) 812-7300
(Address, including zip code, and telephone number, including
area code, of Registrant’s principal executive offices)
 
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes ý  No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes ý  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

Large accelerated filer o
Accelerated filer ý
 
 
Non-accelerated filer o
Smaller reporting company o
(Do not check if a smaller reporting company)
 
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o  No ý
 
As of November 2, 2012, 56,604,000 shares of the registrant’s common stock were outstanding.
 

Table of Contents

KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
 
FORM 10-Q
 
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2012
 
INDEX
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2
Table of Contents

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements.

KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
 (in millions, except par value and number of shares)
 (Unaudited)
 
December 25, 2011
 
September 30, 2012
Assets
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
69.6

 
$
37.6

Restricted cash
1.1

 
5.6

Accounts receivable, net
245.3

 
281.4

Inventoried costs
76.6

 
99.9

Prepaid expenses
12.7

 
17.6

Other current assets
15.7

 
14.5

Total current assets
421.0

 
456.6

Property, plant and equipment, net
72.5

 
84.6

Goodwill
571.6

 
678.5

Intangible assets, net
124.6

 
132.2

Other assets
26.3

 
21.0

Total assets
$
1,216.0

 
$
1,372.9

Liabilities and Stockholders’ Equity
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
48.8

 
$
81.0

Accrued expenses
50.7

 
51.7

Accrued compensation
39.8

 
41.9

Accrued interest
5.1

 
21.7

Billings in excess of costs and earnings on uncompleted contracts
36.2

 
44.0

Other current liabilities
33.2

 
33.8

Total current liabilities
213.8

 
274.1

Long-term debt principal, net of current portion
630.8

 
630.0

Long-term debt premium
22.8

 
19.7

Other long-term liabilities
36.0

 
36.5

Total liabilities
903.4

 
960.3

Commitments and contingencies


 


Stockholders’ equity:
 

 
 

Preferred stock, $0.001 par value, 5,000,000 shares authorized, 0 shares outstanding at December 25, 2011 and September 30, 2012
—

 
—

Common stock, $0.001 par value, 195,000,000 shares authorized; 32,421,135 and 56,554,000 shares issued and outstanding at December 25, 2011 and September 30, 2012, respectively
—

 
—

Additional paid-in capital
720.6

 
845.4

Accumulated other comprehensive loss
(0.2
)
 
(0.6
)
Accumulated deficit
(407.8
)
 
(432.2
)
Total stockholders' equity
312.6

 
412.6

Total liabilities and stockholders’ equity
$
1,216.0

 
$
1,372.9

 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(in millions, except per share amounts)
 (Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 25,
2011
 
September 30,
2012
 
September 25,
2011
 
September 30,
2012
Service revenues
$
93.2

 
$
125.6

 
$
248.3

 
$
339.8

Product sales
113.4

 
150.7

 
252.2

 
365.8

Total revenues
206.6

 
276.3

 
500.5

 
705.6

Cost of service revenues
68.6

 
98.3

 
186.9

 
264.8

Cost of product sales
79.0

 
103.9

 
181.8

 
251.6

Total costs
147.6

 
202.2

 
368.7

 
516.4

Gross profit
59.0

 
74.1

 
131.8

 
189.2

Selling, general and administrative expenses
42.4

 
54.5

 
95.7

 
140.9

Merger and acquisition expenses
3.7

 
0.3

 
11.3

 
2.7

Research and development expenses
3.2

 
4.5

 
5.0

 
12.9

Unused office space and other
—

 
0.7

 
—

 
2.1

Operating income from continuing operations
9.7

 
14.1

 
19.8

 
30.6

Other income (expense):
 

 
 

 
 

 
 

Interest expense, net
(15.0
)
 
(17.6
)
 
(34.8
)
 
(49.9
)
Other income, net
(0.3
)
 
0.4

 
—

 
1.3

Total other expense, net
(15.3
)
 
(17.2
)
 
(34.8
)
 
(48.6
)
Loss from continuing operations before income taxes
(5.6
)
 
(3.1
)
 
(15.0
)
 
(18.0
)
Provision for income taxes from continuing operations
1.6

 
1.3

 
1.3

 
3.8

Loss from continuing operations
(7.2
)
 
(4.4
)
 
(16.3
)
 
(21.8
)
Income (loss) from discontinued operations
0.3

 
0.2

 
0.7

 
(2.6
)
Net loss
$
(6.9
)
 
$
(4.2
)
 
$
(15.6
)
 
$
(24.4
)
 
 
 
 
 
 
 
 
Basic income (loss) per common share:
 

 
 

 
 

 
 

Net loss from continuing operations
$
(0.23
)
 
$
(0.08
)
 
$
(0.64
)
 
$
(0.50
)
Net income (loss) from discontinued operations
0.01

 
0.01

 
0.02

 
(0.06
)
Net loss per common share
$
(0.22
)
 
$
(0.07
)
 
$
(0.62
)
 
$
(0.56
)
Diluted income (loss) per common share:
 

 
 

 
 

 
 

Net loss from continuing operations
$
(0.23
)
 
$
(0.08
)
 
$
(0.64
)
 
$
(0.50
)
Net income (loss) from discontinued operations
0.01

 
0.01

 
0.02

 
(0.06
)
Net loss per common share
$
(0.22
)
 
$
(0.07
)
 
$
(0.62
)
 
$
(0.56
)
Weighted average common shares outstanding:
 

 
 

 
 

 
 

Basic
30.8

 
56.6

 
25.3

 
43.8

Diluted
30.8

 
56.6

 
25.3

 
43.8

Comprehensive Loss
 
 
 
 
 
 
 
Net loss from above
$
(6.9
)
 
$
(4.2
)
 
$
(15.6
)
 
$
(24.4
)
Other comprehensive income:
 
 
 
 
 
 
 
  Change in cumulative translation adjustment
0.1

 
0.2

 
0.1

 
0.4

Other comprehensive income, net of tax
0.1

 
0.2

 
0.1

 
0.4

Comprehensive loss
$
(6.8
)
 
$
(4.0
)
 
$
(15.5
)
 
$
(24.0
)
 
The accompanying notes are an integral part of these condensed consolidated financial statements.


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KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
(Unaudited)
 
Nine Months Ended September 25, 2011
 
Nine Months Ended September 30, 2012
Operating activities:
 

 
 

Net loss
$
(15.6
)
 
$
(24.4
)
Less: Income (loss) from discontinued operations
0.7

 
(2.6
)
Loss from continuing operations
(16.3
)
 
(21.8
)
Adjustments to reconcile loss from continuing operations to net cash provided by operating activities from continuing operations:
 

 
 

Depreciation and amortization
31.4

 
42.5

Deferred income taxes
0.2

 
1.4

Stock-based compensation
2.3

 
4.6

Mark to market on swaps
(0.3
)
 
—

Amortization of deferred financing costs
2.5

 
3.8

Amortization of premium on Senior Secured Notes
—

 
(3.1
)
Provision for doubtful accounts
0.3

 
0.4

Changes in assets and liabilities, net of acquisitions:
 

 
 

Accounts receivable
(10.6
)
 
(6.3
)
Inventoried costs
3.3

 
(10.4
)
Prepaid expenses and other assets
10.3

 
(1.9
)
Accounts payable
(42.4
)
 
22.8

Accrued compensation
1.1

 
(1.5
)
Accrued expenses
17.3

 
(5.2
)
Accrued interest payable
20.6

 
16.6

Billings in excess of costs and earnings on uncompleted contracts
(5.9
)
 
(4.7
)
Income tax receivable and payable
1.0

 
(0.8
)
Other liabilities
(2.2
)
 
(1.3
)
Net cash provided by operating activities from continuing operations
12.6

 
35.1

Investing activities:
 

 
 

Cash paid for acquisitions, net of cash acquired
(373.8
)
 
(149.4
)
Decrease in restricted cash
3.3

 
0.5

Capital expenditures
(5.3
)
 
(12.0
)
Net cash used in investing activities from continuing operations
(375.8
)
 
(160.9
)
Financing activities:
 

 
 

Proceeds from the issuance of long-term debt
427.5

 
—

Proceeds from the issuance of common stock
61.1

 
97.0

Debt issuance costs
(20.6
)
 
(1.2
)
Borrowing under the line of credit
—

 
40.0

Repayment of debt
(2.5
)
 
(40.8
)
Cash paid for contingent acquisition consideration
—

 
(2.5
)
Other
1.5

 
(0.9
)
Net cash provided by financing activities from continuing operations
467.0

 
91.6

Net cash flows of continuing operations
103.8

 
(34.2
)
Net operating cash flows of discontinued operations
(5.3
)
 
2.1

Effect of exchange rate changes on cash and cash equivalents
(0.2
)
 
0.1

Net increase (decrease) in cash and cash equivalents
98.3

 
(32.0
)
Cash and cash equivalents at beginning of period
10.8

 
69.6

Cash and cash equivalents at end of period
$
109.1

 
$
37.6

The accompanying notes are an integral part of these condensed consolidated financial statements.

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KRATOS DEFENSE & SECURITY SOLUTIONS, INC.
 
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 
(Unaudited)
 
Note 1. Summary of Significant Accounting Policies
 
All references to the “Company” and “Kratos” refer to Kratos Defense & Security Solutions, Inc., a Delaware corporation, and its subsidiaries.
 
(a)
Basis of Presentation
 
The information as of September 30, 2012 and for the three and nine months ended September 25, 2011 and September 30, 2012 is unaudited. The condensed consolidated balance sheet as of December 25, 2011 was derived from the Company’s audited consolidated financial statements at that date. In the opinion of management, these unaudited condensed consolidated financial statements include all adjustments, consisting of normal recurring adjustments necessary for a fair presentation of the Company’s financial position, results of operations and cash flows for the interim periods presented. The results have been prepared in accordance with the instructions to Form 10-Q and do not necessarily include all information and footnotes necessary for presentation in accordance with accounting principles generally accepted in the U.S. (“GAAP”). These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and the related notes included in the Company’s audited annual consolidated financial statements for the fiscal year ended December 25, 2011, included in the Company’s Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission ("SEC") on March 7, 2012 (the “Form 10-K”). Interim operating results are not necessarily indicative of operating results expected in subsequent periods or for the year as a whole.
 
(b)
Principles of Consolidation
 
The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries for which all inter-company transactions have been eliminated in consolidation
 
(c)
Fiscal Year
 
The Company has a 52/53 week fiscal year ending on the last Sunday of the calendar year, with interim fiscal periods ending on the last Sunday of the last month of each calendar quarter. The nine months ended September 25, 2011 consisted of a 39-week period. The nine months ended September 30, 2012 consisted of a 40-week period. There were 52 calendar weeks in the fiscal year ended on December 25, 2011 and there are 53 calendar weeks in the fiscal year ending December 30, 2012.
 
(d)
Accounting Policies and Accounting Standards Updates
 
There have been no changes in the Company's significant accounting policies for the nine months ended September 30, 2012 as compared to the significant accounting policies described in the Form 10-K. In addition, none of the new accounting standards updates issued by the Financial Accounting Standards Board ("FASB") during the nine months ended September 30, 2012 have had or are expected to have a material effect on the Company's consolidated financial position, results of operations, or cash flows.

(e)
Concentrations and Uncertainties
 
The Company maintains cash balances at various financial institutions and such balances commonly exceed the $250,000 insured amount by the Federal Deposit Insurance Corporation. The Company has not experienced any losses in such accounts, and management believes that the Company is not exposed to any significant credit risk with respect to such cash and cash equivalents.
 
Financial instruments, which subject the Company to potential concentrations of credit risk, consist principally of the Company’s billed and unbilled accounts receivable. The Company’s accounts receivable result from sales to customers within the federal government, state and local agencies and commercial customers in various industries. The Company performs ongoing credit evaluations of its commercial customers. Credit is extended based on evaluation of the customer’s financial condition, and collateral is not required. Accounts receivable are recorded at the invoiced amount and do not bear interest. See Note 12 for a discussion of the Company’s significant customers.

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Table of Contents

 
The Company has outstanding 10% Senior Secured Notes due 2017 ("the Notes") with an aggregate principal amount of $625.0 million outstanding as of September 30, 2012. The Notes are due on June 1, 2017 and the Company pays interest at the rate of 10% per annum semi-annually, in arrears, on June 1 and December 1 of each year. In addition, the Company has $88.9 million available under its existing revolving credit agreement. See Note 9 for a complete description of the Company’s debt.
 
The Company intends to fund its cash requirements with cash on hand, cash flows from operating activities and borrowings under its existing revolving credit facility. Management believes these sources of liquidity should be sufficient to meet the Company’s cash needs for at least the next 12 months. The Company’s quarterly and annual operating results have fluctuated in the past and may vary in the future due to a variety of factors, many of which are external to the Company's control. If the conditions in its industry deteriorate, its customers cancel or postpone projects or if the Company is unable to sufficiently increase its revenues or reduce its expenses, the Company may experience, in the future, a significant long-term negative impact to its financial results and cash flows from operations. In such a situation, the Company could fall out of compliance with its financial and other covenants which, if not waived, could limit its liquidity and capital resources.

Note 2.  Acquisitions
 
(a)    Summary of Recent Acquisitions

Composite Engineering, Inc.

On July 2, 2012, the Company completed the acquisition of Composite Engineering, Inc. ("CEI") for approximately $163.5 million. The purchase price, which is subject to adjustments for working capital, consists of $135.0 million paid in cash, of which $10.7 million was placed into an escrow account as security for CEI's indemnification obligations as set forth in the CEI purchase agreement, and 4.0 million shares of the Company's common stock, valued at $5.94 per share on July 2, 2012, or $23.8 million. In addition, the Company paid $2.5 million to retire certain pre-existing CEI debt and settle pre-existing accounts receivable from CEI at its carrying and fair value of $3.0 million. The Company plans to make an election under Section 338(h)(10) of the Internal Revenue Code, which will result in tax deductible goodwill related to this transaction and will cover an estimated $0.8 million in additional tax liability incurred by the shareholders of CEI for this election. The Company estimates that the tax deductible goodwill, which is subject to change based upon the final fair value of assets acquired and liabilities assumed, will be approximately $101.0 million and can be deducted for federal and California state income taxes over a 15-year period.

In connection with the completion of the CEI transaction, certain CEI personnel entered into long-term employment agreements with the Company and on July 2, 2012, the Company granted an aggregate 2.0 million restricted stock units ("RSUs") as long-term retention inducement grants to certain employees of CEI who have joined Kratos. The RSUs, which have an estimated value of $11.9 million, vest on the fourth anniversary of the closing of the CEI acquisition, or earlier upon the occurrence of certain events, and are being accounted for as compensation expense over such four-year period.

To fund the acquisition of CEI, on May 14, 2012, the Company sold approximately 20.0 million shares of its common stock at a purchase price of $5.00 per share in an underwritten public offering. The Company received gross proceeds of approximately $100.0 million and net proceeds of approximately $97.0 million after deducting underwriting fees and other offering expenses. The Company used the net proceeds from this offering to fund a portion of the purchase price for the acquisition of CEI. In addition, the Company used borrowings of $40.0 million from its revolving line of credit to fund the purchase price of CEI.

CEI is a vertically integrated manufacturer and developer of unmanned aerial target systems and composite structures used for national security programs. Its drones are designed to replicate some of the most lethal aerial threats facing warfighters and strategic assets. CEI's customers include U.S. agencies and foreign governments. CEI is a part of the Kratos Government Solutions ("KGS") segment.

The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by enabling it to strategically expand its strengths in the areas of design, engineering, development, manufacturing and production of unmanned aerial targets, and will also enable the Company to realize significant cross selling opportunities.


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The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The following table summarizes the preliminary estimated fair values of the major assets acquired and liabilities assumed (in millions):
Cash
$
8.9

Accounts receivable
9.3

Inventoried costs
12.5

Other current assets
8.8

Property and equipment
7.8

Intangible assets
38.0

Goodwill
103.2

  Total assets
188.5

Current liabilities
(25.0
)
  Net assets acquired
$
163.5



The goodwill recorded in this transaction is tax deductible.

As of July 2, 2012, the expected fair value of accounts receivable approximated historical cost. The gross accounts receivable was $9.3 million, none of which is not expected to be collectible. There was no contingent purchase consideration associated with the acquisition of CEI.

The amounts of revenue and operating income of CEI included in the Company's Condensed Consolidated Statement of Operations for the three months ended September 30, 2012 are $34.7 million and $1.7 million, respectively.

Asset Purchase

On December 30, 2011, the Company acquired selected assets of a critical infrastructure security and public safety system integration business (the “Critical Infrastructure Business”) for approximately $20.0 million. The asset purchase agreement provides that the purchase price will be (i) increased on a dollar-for-dollar basis if the working capital on the closing date (as defined in the asset purchase agreement) exceeds $17.0 million or (ii) decreased on a dollar-for-dollar basis if the working capital is less than $17.0 million. In accordance with the terms of the asset purchase agreement, the Company submitted its computation of the closing working capital to the Seller on April 27, 2012, which reflected a deficiency to the minimum required working capital. The Seller had 60 days to object to the Company's computation of the closing working capital. Recently, both parties have mutually agreed to extend the time to discuss the Company's closing working capital computations and the Seller's objections to November 30, 2012. As the Seller and the Company have not yet agreed on the working capital adjustment, the Company has not reflected an adjustment to the purchase price.

The Critical Infrastructure Business designs, engineers, deploys, manages and maintains specialty security systems at some of the most strategic asset and critical infrastructure locations in the U.S. Additionally, these security systems are typically integrated into command and control system infrastructure or command centers. Approximately 15% of the revenues of the Critical Infrastructure Business are recurring in nature due to the operation, maintenance or sustainment of the security systems once deployed. The Critical Infrastructure Business is part of the Company's Public Safety & Security (“PSS”) segment.

The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by enabling it to strategically expand its strengths in the areas of homeland security solutions and will also enable the Company to realize significant cross selling opportunities and increase its sales of higher margin, fixed price products.

The transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the acquisition date. The following table summarizes the preliminary estimated fair values of the major assets acquired and liabilities assumed (in millions):

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Accounts receivable
$
23.4

Other assets
0.5

Intangible assets
2.0

Goodwill
3.8

    Total assets
29.7

Current liabilities
(9.7
)
    Net assets acquired
$
20.0


The goodwill recorded in this transaction is tax deductible.

As of December 30, 2011, the expected fair value of accounts receivable approximated historical cost. The gross accounts receivable was $24.4 million, of which approximately $1.0 million is not expected to be collectible.

Due to the integration of the Critical Infrastructure Business with our existing PSS business it is impractical to estimate the amounts of revenue and operating income (loss) included in the Company's Condensed Consolidated Statement of Operations.

SecureInfo Corporation

On November 15, 2011, the Company acquired SecureInfo Corporation (“SecureInfo”) for $20.3 million in cash, which includes a $1.5 million earn-out that was paid in March 2012. Upon completion of the SecureInfo transaction, the Company deposited $1.8 million of the purchase price into an escrow account as security for SecureInfo's indemnification obligations as set forth in the SecureInfo purchase agreement. In addition, the SecureInfo purchase agreement provided that the purchase price would be (i) increased on a dollar for dollar basis if the working capital on the closing date (as defined in the SecureInfo purchase agreement) exceeded $2.2 million or (ii) decreased on a dollar for dollar basis if the working capital was less than $2.2 million. The SecureInfo working capital was $2.1 million, and the Company and SecureInfo agreed to a working capital adjustment of $0.1 million.

Based in northern Virginia, SecureInfo is a cybersecurity company specializing in assisting defense, intelligence, civilian government and commercial customers to identify, understand, document, manage, mitigate and protect against cybersecurity risks while reducing information security costs and achieving compliance with applicable regulations, standards and guidance. SecureInfo offers strategic advisory, operational cybersecurity and cybersecurity risk management services and is a recognized leader in the rapidly evolving fields of cloud security, continuous monitoring and cybersecurity training. Customers include the Department of Defense, the Department of Homeland Security and large commercial customers, including market leading cloud computing service providers. SecureInfo is part of the KGS segment.

The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by SecureInfo's nationally recognized expertise in operational cybersecurity, cybersecurity risk management and cybersecurity training programs.

The SecureInfo transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the merger date. The following table summarizes the preliminary estimated fair values of the major assets acquired and liabilities assumed (in millions):


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Cash
$
1.4

Other assets
3.0

Property and equipment
0.1

Intangible assets
4.5

Goodwill
12.2

    Total assets
21.2

Current liabilities
(0.9
)
    Net assets acquired
$
20.3


The goodwill recorded in this transaction is not tax deductible.

As of November 15, 2011, the expected fair value of accounts receivable approximated historical cost. The gross accounts receivable was $2.9 million, none of which is not expected to be collectible.

The amounts of revenue and operating loss of SecureInfo included in the Company's Condensed Consolidated Statement of Operations for the three months ended September 30, 2012 were $4.6 million and $0.2 million, respectively. The amounts of revenue and operating income for the nine months ended September 30, 2012 were $12.3 million and $0.2 million, respectively.

Integral Systems, Inc.
 
On July 27, 2011, the Company acquired Integral Systems, Inc. (“Integral”) in a cash and stock transaction valued at $241.1 million. Upon completion of the acquisition, the Company paid an aggregate of $131.4 million in cash, issued approximately 10.4 million shares of the Company's common stock valued at $108.7 million and issued replacement stock options with a fair value of $1.0 million.

To fund the cash portion of the acquisition, on July 27, 2011, the Company issued $115.0 million aggregate principal amount of 10% Senior Secured Notes due 2017 (the “Notes”). The Notes were issued at a premium of 105% for an effective interest rate of approximately 8.9%. The gross proceeds of approximately $120.8 million, which includes an approximate $5.8 million issuance premium and excludes accrued interest received of $1.8 million, were used to finance, in part, the cash portion of the purchase price for the acquisition of Integral, to refinance existing indebtedness of Integral and its subsidiaries, to pay certain severance payments in connection with the acquisition and to pay related fees and expenses. See Note 9 for a complete description of the Company's debt.

As consideration for the acquisition of Integral, each Integral stockholder received (i) $5.00 in cash, without interest, and (ii) 0.588 shares of the Company's common stock for each share of Integral common stock. In addition, upon completion of the acquisition (i) each outstanding Integral stock option with an exercise price less than $13.00 per share was, if the holder thereof had so elected in writing, canceled in exchange for an amount in cash equal to the product of the total number of shares of Integral common stock subject to such in-the-money option, multiplied by the aggregate value of the excess, if any, of $13.00 over the exercise price per share applicable to such option, less the amount of any tax withholding, (ii) each outstanding Integral stock option with an exercise price equal to or greater than $13.00 per share and each Integral in-the-money option the holder of which had not made the election described in (i) above was converted into an option to purchase Company common stock, with the number of shares subject to such option adjusted to equal the number of shares of Integral common stock subject to such out-of-the-money option multiplied by 0.9559, rounded up to the nearest whole share, and the per share exercise price under each such option adjusted by dividing the per share exercise price applicable to such option by 0.9559, rounded up to the nearest whole cent, and (iii) each outstanding share of restricted stock granted under an Integral equity plan or otherwise, whether vested or unvested, was canceled and converted into the right to receive $13.00, less the amount of any tax withholding.

Integral is a global provider of products, systems and services for satellite command and control, telemetry and digital signal processing, data communications, enterprise network management and communications information assurance.  Integral specializes in developing, managing and operating secure communications networks, both satellite and terrestrial, as well as systems and services to detect, characterize and geolocate sources of radio frequency or RF interference.  Integral’s customers include U.S. and foreign commercial, government, military and intelligence organizations.  For almost 30 years, customers have relied on Integral to design and deliver innovative commercial-based products, solutions and services that are cost-effective and reduce delivery schedules and risk. Integral is part of the Company’s KGS segment. 


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The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by Integral’s significant expertise with satellite operations, ground systems, signal processing and other areas of satellite command and control, as well as advanced technologies for Unmanned Aerial Vehicles, situational awareness, remote management and numerous established electronic attack and electronic warfare platforms, tactical missile systems, and strategic deterrence systems. The Integral transaction has been accounted for using the acquisition method of accounting which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the merger date. The following table summarizes the fair values of the major assets acquired and liabilities assumed (in millions):


 
Cash
$
6.8

Accounts receivable
68.4

Inventoried costs
15.8

Deferred tax assets
36.4

Other assets
3.5

Property and equipment
12.9

Intangible assets
32.0

Goodwill
187.8

Total assets
363.6

Current liabilities
(84.5
)
Deferred tax liabilities
(19.5
)
Long-term liabilities
(18.5
)
Net assets acquired
$
241.1

 
The goodwill recorded in this transaction is not tax deductible.
 
As of July 27, 2011, the expected fair value of accounts receivable approximated the historical cost. The gross accounts receivable was $68.5 million, of which $0.1 million is not expected to be collectible. There was no contingent purchase consideration associated with the acquisition of Integral.
 
The amounts of revenue and operating income of Integral included in the Company’s Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2012 were $58.1 million and $5.0 million, and $152.9 million and $7.2 million, respectively. The amounts of revenue and operating income of Integral included in the Company's Condensed Consolidated Statements of Operations for both the three and nine months ended September 25, 2011 was $44.9 million and $5.1 million, respectively.
 
Herley Industries, Inc.
 
On March 25, 2011, the Company acquired approximately 13.2 million shares of Herley Industries, Inc. ("Herley") common stock, representing approximately 94% of the total outstanding shares of Herley common stock, in a tender offer to purchase all of the outstanding shares of Herley common stock. The fair value of the non-controlling interest related to Herley as of March 25, 2011 was $16.9 million, which represents the market trading price of $19.00 per share multiplied by approximately 0.9 million shares that were not tendered as of March 25, 2011. On March 30, 2011, following the purchase of the non-controlling interest in a subsequent offering period, Herley became a wholly owned subsidiary of the Company. The shares of Herley common stock were purchased at a price of $19.00 per share. Accordingly, the Company paid approximately $245.5 million in cash consideration as of March 27, 2011, and as of April 15, 2011 the Company had paid aggregate cash consideration of $270.7 million for the shares of Herley common stock and certain in-the-money options, which were exercised upon the change in control. In addition, upon completion of the subsequent short-form merger, all unexercised options to purchase Herley common stock were assumed by the Company and converted into options to purchase Kratos common stock, entitling the holders thereof to receive 1.3495 shares of Kratos common stock for each share of Herley common stock underlying the options (“Herley Options”). The Company assumed each Herley Option in accordance with the terms (as in effect as of the date of the Herley Merger Agreement) of the applicable Herley equity plan and the option agreement pursuant to which such Herley Option was granted. The Herley Options are exercisable for an aggregate of approximately 0.8 million shares of the Company’s common stock. All Herley Options were fully vested upon the change in control, and the fair value of the Herley Options assumed was $1.9 million. The total aggregate consideration for the purchase of Herley was $272.5 million. 

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In addition, the Company assumed change in control obligations of $4.0 million related to the transaction and incurred combined transaction expenses of $11.1 million.
 
To fund the acquisition of Herley, on February 11, 2011, Kratos sold approximately 4.9 million shares of its common stock at a purchase price of $13.25 per share in an underwritten public offering. Kratos received gross proceeds of approximately $64.8 million and net proceeds of approximately $61.1 million after deducting underwriting fees and other offering expenses. Kratos used the net proceeds from this offering to fund a portion of the purchase price for the acquisition of Herley. To fund the remaining purchase price, Kratos issued $285.0 million in aggregate principal amount of Notes at a premium of 107% through its wholly owned subsidiary, Acquisition Co. Lanza Parent ("Lanza"), on March 25, 2011, in an unregistered offering pursuant to Rule 144A and Regulation S under the Securities Act of 1933, as amended. On April 4, 2011, after the acquisition of Herley was complete, Lanza was merged with and into Kratos and all assets and liabilities of Lanza became assets and liabilities of Kratos. See Note 9 for a complete description of the Company’s debt.

Herley is a leading provider of microwave technologies for use in command and control systems, flight instrumentation, weapons sensors, radar, communication systems, electronic warfare and electronic attack systems. Herley has served the defense industry for approximately 45 years by designing and manufacturing microwave devices for use in high-technology defense electronics applications. It has established relationships, experience and expertise in the military electronics, electronic warfare and electronic attack industry. Herley’s products represent key components in the national security efforts of the U.S., as they are employed in mission-critical electronic warfare, electronic attack, electronic warfare threat and radar simulation, command and control network, and cyber warfare/cyber security applications. Herley is part of the KGS segment.
 
The excess of the purchase price over the fair value of the tangible and identifiable intangible assets acquired and liabilities assumed in the acquisition was allocated to goodwill. The value of the goodwill represents the value the Company expects to be created by Herley’s significant expertise in numerous established electronic attack and electronic warfare platforms, tactical missile systems, and strategic deterrence systems, which complement the Company’s existing business in manned and unmanned aircraft, missile systems and certain other programs.
 
The Herley transaction has been accounted for using the acquisition method of accounting, which requires, among other things, that the assets acquired and liabilities assumed be recognized at their fair values as of the merger date. The following table summarizes the fair values of the major assets acquired and liabilities assumed (in millions):
 
Cash
$
21.8

Accounts receivable
39.1

Inventoried costs
42.8

Deferred tax assets
17.3

Other assets
7.2

Property and equipment
34.2

Intangible assets
37.0

Goodwill
146.4

Total assets
345.8

Current liabilities
(40.8
)
Deferred tax liabilities
(16.8
)
Debt
(9.5
)
Long-term liabilities
(6.2
)
Net assets acquired
$
272.5

 
The goodwill recorded in this transaction is not tax deductible.
 
As of March 25, 2011, the expected fair value of accounts receivable approximated the historical cost. The gross accounts receivable was $39.3 million, of which $0.2 million is not expected to be collectible. There were no contingent liabilities associated with the acquisition of Herley. The Company initially recorded $47.9 million of inventory and $30.4 million in property and equipment. The Company decreased the value of acquired inventory to $42.8 million and increased the value of acquired property and equipment to $34.2 million based on the final valuations.
 

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The amounts of revenue and operating income of Herley included in the Company’s Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2012 were $50.0 million and $8.4 million, and $145.9 million and $22.5 million, respectively. The amounts of revenue and operating income of Herley included in the Company's condensed consolidated statements of operations for the three and nine months ended September 25, 2011 were $48.7 million and $3.4 million, and $100.6 million and $9.9 million, respectively.
 
In accordance with FASB Accounting Standards Codification ("ASC") Topic 805, Business Combinations (“Topic 805”), the allocation of the purchase price for the Company’s acquisitions of SecureInfo, the Critical Infrastructure Business, and CEI are subject to adjustment during the measurement period after the respective closing dates when additional information on asset and liability valuations become available. The above estimated fair values of assets acquired and liabilities assumed are provisional and are based on the information that was available as of the respective acquisition dates to estimate the fair value of assets acquired and liabilities assumed. Measurement period adjustments reflect new information obtained about facts and circumstances that existed as of the respective acquisition dates. The Company believes that such information provides a reasonable basis for estimating the fair values of assets acquired and liabilities assumed, but the Company is waiting for additional information necessary to finalize those fair values. The Company has not finalized its valuation of certain assets and liabilities recorded in connection with these transactions, including intangible assets, inventory, property and equipment, contingent liabilities, and deferred taxes. Thus, the provisional measurements recorded are subject to change. Any changes will be recorded as adjustments to the fair value of those assets and liabilities, and residual amounts will be allocated to goodwill. The final valuation adjustments may also require adjustment to the Condensed Consolidated Statements of Operations.
 
Pro Forma Financial Information
 
The following tables summarize the supplemental Condensed Consolidated Statements of Operations information on an unaudited pro forma basis as if the acquisitions of CEI, the Critical Infrastructure Business, SecureInfo, Integral, and Herley occurred on December 27, 2010 and include adjustments that were directly attributable to the foregoing transactions or were not expected to have a continuing impact on the Company. All acquisitions were included in the results of operations for the three months ended September 30, 2012 and all acquisitions, except CEI, were included in the Company's results of operations for the nine months ended September 30, 2012. There are no material, nonrecurring pro forma adjustments directly attributable to the business combinations included in the reported pro forma revenue and earnings for 2011 and 2012. The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results that would have occurred had the transactions been completed as of the beginning of the period, nor are they indicative of results of operations that may occur in the future (all amounts, except per share amounts are in millions):
 
For the Three Months Ended September 25, 2011
 
For the Nine Months Ended September 25, 2011
 
For the Nine Months Ended September 30, 2012
 
Pro forma revenues
$
244.7

 
$
771.4

 
$
752.8

 
Pro forma net loss before tax
(32.4
)
 
(60.3
)
 
(27
)
 
Pro forma net loss
(34.0
)
 
(61.7
)
 
(29.6
)
 
Net loss attributable to the registrant
(7.2
)
 
(16.3
)
 
(16.2
)
 
Basic and diluted pro forma loss per share
$
(0.58
)
 
$
(1.06
)
 
$
(0.52
)
 
 
The pro forma financial information reflects acquisition related expenses incurred, pro forma adjustments for the additional amortization associated with finite-lived intangible assets acquired, additional incremental interest expense, deferred financing costs related to the financing undertaken for the Integral and Herley transactions, the change in stock compensation expense as a result of the exercise of stock options and restricted stock immediately prior to closing of the Integral and Herley transactions, stock compensation related to the RSUs granted in the CEI transaction, and the related tax expense. The weighted average common shares also reflect the issuance of 4.9 million shares in February 2011 for the Herley acquisitions and 10.4 million shares in July 2011 for the Integral acquisition.

These adjustments are as follows (in millions except per share data):
 

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For the Three Months Ended September 25, 2011
 
For the Nine Months Ended September 25, 2011
 
For the Nine Months Ended September 30, 2012
 
Acquisition related expenses
$
3.7

 
$
11.3

 
$
2.7

 
Intangible amortization
6.0

 
28.0

 
12.1

 
Net change in stock compensation expense
2.2

 
(1.4
)
 
2.2

 
Net change in interest expense
1.3

 
11.3

 
—

 
Net change in income tax benefit (expense)
(0.2
)
 
(0.1
)
 
—

 
Increase in weighted average common shares outstanding for shares issued and not already included in the weighted average common shares outstanding
27.5

 
32.9

 
12.7

 

Contingent Acquisition Consideration

In connection with certain acquisitions, the Company has agreed to make additional future payments to the seller contingent upon achievement of specific performance-based milestones by the acquired entities. Pursuant to the provisions of Topic 805, the Company will re-measure these liabilities each reporting period and record changes in the fair value in its Condensed Consolidated Statement of Operations. Increases or decreases in the fair value of the contingent consideration liability which is measured as the present value of expected future cash flows, a Level 3 (Level 3 hierarchy as defined by ASC Topic 820, Fair Value Measurements and Disclosures (“Topic 820”)) measurement in the fair value hierarchy, can result from changes in discount periods and rates, as well as changes in the estimates on the achievement of the performance-based milestones.

Contingent acquisition consideration as of December 25, 2011 and September 30, 2012 is summarized in the following table (in millions):

Balance as of December 25, 2011
 
$
7.6

 
Cash payments
 
(4.0
)
 
Adjustments
 
(0.5
)
 
Balance as of September 30, 2012
 
$
3.1

 

As of September 30, 2012, $2.0 million is reflected in other current liabilities and $1.1 million is reflected in other long-term liabilities in the condensed consolidated balance sheet. Other than the cash payments noted above, there were no changes in the fair value of contingent consideration for the three and nine month periods ended September 30, 2012.

Pursuant to the terms of the agreement and plan of merger with DEI Services Corporation entered into on August 9, 2010 (“the DEI Agreement”), upon achievement of certain cash receipts, revenue, EBITDA and backlog amounts in 2010, 2011 and 2012, the Company will be obligated to pay certain additional contingent consideration (the “DEI Contingent Consideration”). The Company has paid $2.9 million related to the DEI Contingent Consideration, of which $2.5 million was paid in April 2012. As of September 30, 2012, the potential undiscounted amount of future DEI Contingent Consideration that may be payable by the Company under the DEI Agreement is between $1.0 million and $4.0 million, subject to potential reductions if certain cash receipts are not collected, which was reduced by $0.5 million in the third quarter of 2012 related to certain amounts that were not collected. The DEI Contingent Consideration, which includes contingent consideration already paid and potential future contingent consideration, has a right of offset in the event certain anticipated cash receipts are not collected within agreed upon time period and could reduce the prior and future contingent consideration by approximately $5.5 million.

Note 3. Goodwill and Intangible Assets
 
(a)
Goodwill
 
The Company performs its annual impairment test for goodwill in accordance with ASC Topic 350, Intangibles-Goodwill and Other (“Topic 350”) as of the last day of each fiscal year or when evidence of potential impairment exists.

The Company assesses goodwill for impairment at the reporting unit level, which is defined as an operating segment

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or one level below an operating segment, referred to as a component. The Company determines its reporting units by first identifying its operating segments, and then assessing whether any components of these segments constitute a business for which discrete financial information is available and where segment management regularly reviews the operating results of that component. The Company aggregates components within an operating segment that have similar economic characteristics. For the annual and, if necessary, interim impairment assessment, the Company identified its reporting units to be its KGS and PSS operating segments.

In order to test for potential impairment, the Company estimates the fair value of each of its reporting units based on a comparison and weighting of the income approach, specifically the discounted cash flow method and the market approach, which estimates the fair value of the Company's reporting units based upon comparable market prices and recent transactions and also validates the reasonableness of the implied multiples from the income approach. The Company reconciles the fair value of its reporting units to its market capitalization by calculating its market capitalization based upon an average of its stock price prior to and subsequent to the date the Company performs its analysis and assuming a control premium. The Company uses these methodologies to determine the fair value of its reporting units for comparison to their corresponding book values because there are no observable inputs available, a Level 3 measurement. If the book value exceeds the estimated fair value for a reporting unit a potential impairment is indicated, and Topic 350 prescribes the approach for determining the impairment amount, if any.

In accordance with Topic 350, as a result of the Company's decision in June 2012 to dispose of certain non-core businesses acquired in the Integral acquisition, the Company allocated $1.5 million of goodwill to discontinued operations, which resulted in an impairment charge (see Note 8). The Company then tested the goodwill remaining in the KGS reporting unit. The fair value of the KGS reporting unit exceeded its carrying value by 7.4% Considering the relatively small excess of fair value over carrying value for the KGS reporting unit and given the current market conditions and continued economic uncertainty in the U.S. defense industry as a result of the Budget Control Act of 2011 (the "Budget Control Act"), the fair value of the KGS reporting unit may deteriorate, resulting in an impairment of the goodwill in that unit. Due to continual changes in market and general business conditions, the Company cannot predict whether, and to what extent, its goodwill and long-lived intangible assets may be impaired in future periods. Any resulting impairment loss could harm the Company's profitability and financial condition.

 The changes in the carrying amount of goodwill for the nine months ended September 30, 2012 are as follows (in millions):
 
 
Public
Safety &
Security
 
Kratos Government
Solutions
 
Total
Balance as of December 25, 2011
$
33.0

 
$
539.0

 
$
572.0

Retrospective adjustments
—

 
(0.4
)
 
(0.4
)
Balance as of December 25, 2011 after retrospective adjustments
33.0

 
538.6

 
571.6

Additions due to business combinations
3.8

 
103.1

 
106.9

Balance as of September 30, 2012
$
36.8

 
$
641.7

 
$
678.5

 
The accumulated impairment losses as of December 25, 2011 and September 30, 2012 were $165.4 million, of which $147.1 million was associated with the KGS segment and $18.3 million was associated with the PSS segment.
 
(b)
Purchased Intangible Assets
 
The following table sets forth information for finite-lived intangible assets subject to amortization (in millions):
 

15
Table of Contents

 
As of December 25, 2011
 
As of September 30, 2012
 
Gross
Value
 
Accumulated
Amortization
 
Net
Value
 
Gross
Value
 
Accumulated
Amortization
 
Net
Value
Acquired finite-lived intangible assets:
 

 
 

 
 

 
 

 
 

 
 

Customer relationships
$
78.1

 
$
(19.8
)
 
$
58.3

 
$
97.7

 
$
(31.7
)
 
$
66.0

Contracts and backlog
60.1

 
(39.6
)
 
20.5

 
80.0

 
(58.0
)
 
22.0

Developed technology and technical know-how
22.1

 
(4.1
)
 
18.0

 
22.1

 
(5.8
)
 
16.3

Trade names
2.6

 
(0.8
)
 
1.8

 
3.1

 
(1.1
)
 
2.0

Favorable operating lease
1.8

 
(0.3
)
 
1.5

 
1.8

 
(0.4
)
 
1.4

Total
$
164.7

 
$
(64.6
)
 
$
100.1

 
$
204.7

 
$
(97.0
)
 
$
107.7


In addition to the finite-lived intangible assets listed in the table above, the Company has $24.5 million of indefinite-lived intangible assets consisting of trade names at both December 25, 2011 and September 30, 2012.
 
Consolidated amortization expense related to intangible assets subject to amortization was $11.9 million and $13.0 million for the three months ended September 25, 2011 and September 30, 2012, respectively, and $24.5 million and $32.4 million for the nine months ended September 25, 2011 and September 30, 2012, respectively.
 
The estimated future amortization expense of purchased intangible assets with finite lives as of September 30, 2012 is as follows (in millions):
 
Fiscal Year
Amount
2012 (remaining three months)
$
11.6

2013
34.7

2014
20.2

2015
14.4

2016
9.7

Thereafter
17.1

Total
$
107.7

 
Note 4. Inventoried Costs
 
Inventoried costs are stated at the lower of cost or market. Cost is determined using the average cost or first-in, first-out method and is applied consistently within an operating entity. Inventoried costs primarily relate to work in process under fixed-price contracts using costs as the basis of the percentage-of-completion calculation under the units produced method of revenue recognition. These costs represent accumulated contract costs less the portion of such costs allocated to delivered items. Accumulated contract costs include direct production costs, factory and engineering overhead and production tooling costs. Pursuant to contract provisions of U.S. Government contracts, such customers may have title to, or a security interest in, inventories related to such contracts as a result of advances, performance-based payments or progress payments. The Company reflects those advances and payments as an offset against the related inventory balances.
 
The Company regularly reviews inventory quantities on hand, future purchase commitments with its suppliers, and the estimated utility of its inventory. If the Company’s review indicates a reduction in utility below carrying value, it reduces its inventory to a new cost basis.
 
Inventoried costs consisted of the following components (in millions):
 

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Table of Contents

 
December 25,
2011
 
September 30,
2012
Raw materials
$
43.3

 
$
48.4

Work in process
25.7

 
41.9

Finished goods
6.9

 
7.8

Supplies and other
4.0

 
1.9

Subtotal inventoried costs
79.9

 
100.0

Less customer advances and progress payments
(3.3
)
 
(0.1
)
Total inventoried costs
$
76.6

 
$
99.9

 
Note 5. Stockholders’ Equity
 
On May 14, 2012, the Company sold 20.0 million shares of its common stock at a purchase price of $5.00 per share in an underwritten public offering. The Company received gross proceeds of $100.0 million. After deducting underwriting and other offering expenses, the Company received approximately $97.0 million in net proceeds. The Company used the net proceeds from this offering to fund a portion of the cash consideration paid to the stockholders of CEI in connection with the Company's acquisition thereof on July 2, 2012.

On February 11, 2011, the Company sold approximately 4.9 million shares of its common stock at a purchase price of $13.25 per share in an underwritten public offering. The Company received gross proceeds of approximately $64.8 million. After deducting underwriting and other offering expenses, the Company received approximately $61.1 million in net proceeds.
 
A summary of the changes in stockholders’ equity is provided below (in millions):
 
 
Nine Months Ended
 
Nine Months Ended
 
September 25,
2011
 
September 30,
2012
Stockholders’ equity at beginning of period
$
169.9

 
$
312.6

Comprehensive income:
 

 
 

Net loss
(15.6
)
 
(24.4
)
Foreign currency translation
0.1

 
(0.4
)
Total comprehensive loss
(15.5
)
 
(24.8
)
Additional paid-in-capital from the issuance of common stock for cash
61.1

 
97.0

Additional paid-in-capital from the issuance of common stock in connection with acquisitions
—

 
23.8

Stock-based compensation
2.3

 
4.6

Restricted stock units traded for taxes
(0.1
)
 
(0.2
)
Employee stock purchase plan and restricted stock units settled in cash
0.9

 
(0.4
)
Exercise of stock options and warrants
1.2

 
—

Fair value of stock options assumed in acquisitions
111.6

 
—

Stockholders’ equity at end of period
$
331.4

 
$
412.6


In prior reporting periods, the Company had two classes of outstanding stock, Series B Convertible Preferred Stock and common stock. On March 8, 2011, all of the 10,000 shares of the previously issued and outstanding shares of Series B Convertible Preferred Stock were redeemed for 100,000 shares of common stock. Common stock issued by the Company for the nine months ended September 25, 2011 and September 30, 2012 was as follows (in millions):
 

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Table of Contents

 
Nine Months Ended
 
Nine Months Ended
 
September 25,
2011
 
September 30,
2012
Shares outstanding at beginning of the period
18.6

 
32.4

Stock issued for employee stock purchase plan, stock options and restricted stock units exercised
0.4

 
0.1

Common stock issued for acquisitions
10.4

 
4.0

Redemption of Series B Convertible Preferred Stock
0.1

 
—

Common stock issued for cash
4.9

 
20.0

Shares outstanding at end of the period
34.4

 
56.5

 
Note 6. Net Income (Loss) Per Common Share
 
The Company calculates net income (loss) per share in accordance with ASC Topic 260, Earnings Per Share (“Topic 260”). Under Topic 260, basic net income (loss) per common share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the reporting period. Diluted net income (loss) per common share reflects the effects of potentially dilutive securities.

 
 
For the Three Months Ended
 
For the Nine Months Ended
(In millions, except earnings per share)
 
September 25,
2011
 
September 30,
2012
 
September 25,
2011
 
September 30,
2012
Loss from continuing operations (A)
 
$
(7.2
)
 
$
(4.4
)
 
$
(16.3
)
 
$
(21.8
)
Weighted average outstanding shares of common stock (B)
 
30.8

 
56.6

 
25.3

 
43.8

Dilutive effect of employee stock options and awards
 
—

 
—

 
—

 
—

Common stock and common stock equivalents (C)
 
30.8

 
56.6

 
25.3

 
43.8

Loss per share:
 
 
 
 
 
 
 
 
Basic (A/B)
 
$
(0.23
)
 
$
(0.08
)
 
$
(0.64
)
 
$
(0.50
)
Diluted (A/C)
 
$
(0.23
)
 
$
(0.08
)
 
$
(0.64
)
 
$
(0.50
)

The following shares were excluded from the calculation of diluted loss per share because their inclusion would have been anti-dilutive:
 
 
 
For the Three Months Ended
 
For the Nine Months Ended
(In millions)
 
September 25,
2011
 
September 30,
2012
 
September 25,
2011
 
September 30,
2012
Shares from stock options and awards
 
2.8

 
4.3

 
2.0

 
3.3


Note 7. Income Taxes
 
As of December 25, 2011, the Company had $10.2 million of unrecognized tax benefits that, if recognized, would affect the effective tax rate, subject to possible offset by an increase in the valuation allowance. During the nine months ended September 30, 2012, this amount was reduced by $0.1 million relating to the expiration of statutes of limitations. This reduction in unrecognized tax benefits was recorded as a tax benefit from discontinued operations. Additionally, the unrecognized tax benefit amount was reduced by $0.3 million as a result of the completion of an Internal Revenue Service (“IRS”) audit. This reduction in unrecognized tax benefits was recorded as a benefit from continuing operations.

During the nine months ended September 30, 2012, the Company decreased the unrecognized tax benefits of Integral by $0.1 million, which was recorded as an adjustment to goodwill. Integral's unrecognized tax benefits are related to various federal tax issues.
 
The Company recognizes interest and penalties related to unrecognized tax benefits in its provision for income taxes. There was no material expense recorded during the nine months ended September 25, 2011. During the nine months ended September 30, 2012, a $0.3 million expense was recorded related to interest and penalties. The Company recorded a benefit for

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interest and penalties related to the reversal of prior positions of $0.7 million and $0.1 million for the nine months ended September 25, 2011 and September 30, 2012, respectively. The Company believes that it is reasonably possible that as much as $1.5 million of the liabilities for uncertain tax positions will expire within 12 months of September 30, 2012 due to the expiration of various applicable statutes of limitations.

The Company is subject to taxation in the U.S., various state tax jurisdictions and various foreign tax jurisdictions. The Company's tax years for 2000 and later are subject to examination by the U.S. and state tax authorities due to the existence of net operating loss (“NOL”) carryforwards. Generally, the Company's tax years for 2002 and later are subject to examination by various foreign tax authorities.
 
In assessing the Company's ability to realize deferred tax assets, management considers, on a periodic basis, whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. As such, management has determined that it is appropriate to maintain a full valuation allowance against the Company's deferred tax assets, with the exception of an amount equal to its deferred tax liabilities, which can be expected to reverse over a definite life. Management will continue to evaluate the necessity to maintain a valuation allowance against the Company's net deferred tax assets. A reconciliation of the total income tax provision to the amount computed by applying the statutory federal income tax rate of 35% to loss from continuing operations before income tax provision for the three and nine months ended September 25, 2011 and September 30, 2012 is as follows (in millions):
 
 
For the Three Months Ended
 
For the Nine Months Ended
 
September 25,
2011
 
September 30,
2012
 
September 25,
2011
 
September 30,
2012
Income tax benefit at federal statutory rate
$
(1.9
)
 
$
(0.9
)
 
$
(5.2
)
 
$
(6.3
)
State and foreign taxes, net of federal tax benefit and valuation allowance
1.5

 
1.0

 
3.1

 
3.5

Nondeductible expenses and other
0.6

 
1.3

 
2.2

 
2.0

Release of valuation allowance due to acquisitions
—

 
—

 
(0.1
)
 
—

Impact of indefinite lived deferred tax liabilities and state law changes
—

 
0.1

 
0.3

 
0.2

Settlement with IRS
—

 
—

 
(2.1
)
 
—

Increase/(decrease) in reserves for uncertain tax positions
0.1

 
0.1

 
0.1

 
0.1

Increase/(decrease) in federal valuation allowance
1.3

 
(0.3
)
 
3.0

 
4.3

Total
$
1.6

 
$
1.3

 
$
1.3

 
$
3.8


Federal and state income tax laws impose restrictions on the utilization of NOL and tax credit carryforwards in the event that an “ownership change” occurs for tax purposes, as defined by Section 382 (“Section 382”) of the Internal Revenue Code of 1986, as amended (the “Code”). In general, an ownership change occurs when shareholders owning 5% or more of a “loss corporation” (a corporation entitled to use NOL or other loss carryovers) have increased their ownership of stock in such corporation by more than 50 percentage points during any 3-year period. The annual base Section 382 limitation is calculated by multiplying the loss corporation's value (which may be modified for certain recent increases to capital) at the time of the ownership change times the greater of the long-term tax-exempt rate determined by the Internal Revenue Service (“IRS”) in the month of the ownership change or the two preceding months. In March 2010, an “ownership change” occurred that will limit the utilization of the loss carryforwards. Additionally, in May 2012, another “ownership change” was triggered. As a result of this change in May, the Company's federal annual utilization of NOL carryforwards will be limited to $28.1 million a year for the five years succeeding the initial ownership change and $11.6 million per year thereafter. If the entire limitation amount is not utilized in a year, the excess can be carried forward and utilized in future years. For the nine months ended September 30, 2012, there was no impact of such limitations on the income tax provision since the amount of taxable income did not exceed the annual limitation amount. In addition, future equity offerings or acquisitions that have equity as a component of the purchase price could also result in an “ownership change." If and when any other “ownership change” occurs, utilization of the NOL or other tax attributes may be further limited. As discussed elsewhere, deferred tax assets relating to the NOL and credit carryforwards are offset by a full valuation allowance. In addition, utilization of state tax loss carryforwards is dependent upon sufficient taxable income apportioned to the states.

Note 8. Discontinued Operations
 
In June of 2012, consistent with the Company's plans to complete its assessment and evaluation of the non-core businesses acquired in the Integral acquisition, the Company committed to a plan to sell certain lines of business associated

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with antennas, satellite-cased products and fly-away terminals. These operations were previously reported in the KGS segment, and in accordance with Topic 205, Presentation of Financial Statements ("Topic 205"), these businesses have been classified as held for sale and reported in discontinued operations in the accompanying condensed consolidated financial statements. In the second quarter of 2012, the Company recorded a $1.5 million impairment charge associated with the portion of goodwill that was allocated to the discontinued businesses based on management's estimate of the fair value of the business.
 
The following table presents the results of discontinued operations (in millions):
 
 
For the Three Months Ended
 
For the Nine Months Ended
 
September 25,
2011
 
September 30,
2012
 
September 25,
2011
 
September 30,
2012
Revenue
$
4.4

 
$
6.0

 
$
4.4

 
$
13.3

Net income (loss) before taxes
0.3

 
0.2

 
0.4

 
(2.7
)
Benefit for income taxes
—

 
—

 
(0.3
)
 
(0.1
)
Net income (loss) after taxes
$
0.3

 
$
0.2

 
$
0.7

 
$
(2.6
)
 
The benefit for income taxes for the nine months ended September 25, 2011 and September 30, 2012 was primarily due to the expiration of the statute of limitations for certain foreign tax contingencies related to the Company’s discontinued wireless services business.
 
The following is a summary of the assets and liabilities of discontinued operations, which are in other current assets, other non-current assets, other current liabilities and other long-term liabilities in the accompanying Condensed Consolidated Balance Sheets as of December 25, 2011 and September 30, 2012 (in millions):
 
 
December 25,
2011
 
September 30,
2012
Cash
$
0.2

 
$
0.2

Accounts receivable, net
5.3

 
1.8

Other current assets
4.2

 
3.9

Current assets of discontinued operations
$
9.7

 
$
5.9

Other non-current assets
$
2.4

 
$
0.8

Non-current assets of discontinued operations
$
2.4

 
$
0.8

Accounts payable
$
0.9

 
$
1.4

Accrued expenses
5.1

 
4.1

Other current liabilities
0.3

 
0.3

Current liabilities of discontinued operations
$
6.3

 
$
5.8

Other long-term liabilities
0.5

 
0.3

Long-term liabilities of discontinued operations
$
0.5

 
$
0.3


Note 9. Debt
 
(a)
Issuance of 10% Senior Secured Notes due 2017
 
On May 19, 2010, the Company entered into an indenture with the guarantors set forth therein and Wilmington Trust FSB, as trustee and collateral agent (as amended or supplemented the “Indenture”), to issue the Notes. As of September 30, 2012, the Company has issued Notes in the aggregate principal amount of $625.0 million under the Indenture, of which $225.0 million were issued on May 19, 2010, $285.0 million were issued on March 25, 2011 at a $20.0 million premium and an effective interest rate of 8.5%, and $115.0 million were issued on July 27, 2011 at a $5.8 million premium and an effective interest rate of 8.9%. These Notes have been used to fund acquisitions and for general corporate purposes. The holders of the Notes have a first priority lien on substantially all of the Company's assets and the assets of the guarantors, except with respect to accounts receivable, inventory, deposit accounts, securities accounts, cash, securities and general intangibles (other than intellectual property), on which the holders of the Notes have a second priority lien to the $110.0 million credit facility described below.

The Company pays interest on the Notes semi-annually, in arrears, on June 1 and December 1 of each year. The Notes

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include customary covenants and events of default as well as a consolidated fixed charge ratio of 2:1 for the incurrence of additional indebtedness. Negative covenants include, among other things, limitations on additional debt, liens, negative pledges, investments, dividends, stock repurchases, asset sales and affiliate transactions. Events of default include, among other events, non-performance of covenants, breach of representations, cross-default to other material debt, bankruptcy, insolvency, material judgments and changes in control. As of September 30, 2012, the Company was in compliance with the covenants contained in the Indenture governing the Notes.
 
On or after June 1, 2014, the Company may redeem some or all of the Notes at 105% of the aggregate principal amount of such notes through June 1, 2015, 102.5% of the aggregate principal amount of such notes through June 1, 2016 and 100% of the aggregate principal amount of such notes thereafter, plus accrued and unpaid interest to the date of redemption. Prior to June 1, 2013, the Company may redeem up to 35% of the aggregate principal amount of the Notes at 110% of the aggregate principal amount of the Notes, plus accrued and unpaid interest to the date of redemption, with the net cash proceeds of certain equity offerings. In addition, the Company may, at its option, redeem some or all of the Notes at any time prior to June 1, 2014 by paying a “make whole” premium, plus accrued and unpaid interest, if any, to the date of redemption. The Company may also purchase outstanding Notes traded on the open market at any time.

(b)
Other Indebtedness
 
$110.0 Million Credit Facility

On July 27, 2011, the Company entered into a credit and security agreement with KeyBank National Association (“KeyBank”), as lead arranger, sole book runner and administrative agent, and East West Bank and Bank of the West, as the lenders (the “2011 Credit Agreement”). The 2011 Credit Agreement amends and restates in its entirety the credit and security agreement, dated as of May 19, 2010, by and among the Company, KeyBank and the lenders named therein (as amended). The 2011 Credit Agreement established a five-year senior secured revolving credit facility in the amount of $65.0 million (as amended and described below, the “Amended Revolver”). The Amended Revolver is secured by a lien on substantially all of the Company's assets and the assets of the guarantors thereunder, subject to certain exceptions and permitted liens. The Amended Revolver has a first priority lien on accounts receivable, inventory, deposit accounts, securities accounts, cash, securities and general intangibles (other than intellectual property). On all other assets, the Amended Revolver has a second priority lien junior to the lien securing the Notes.

Borrowings under the Amended Revolver are subject to mandatory prepayment upon the occurrence of certain events, including the issuance of certain securities, the incurrence of certain debt and the sale or other disposition of certain assets. The Amended Revolver includes customary affirmative and negative covenants and events of default, as well as a financial covenant relating to a minimum fixed charge coverage ratio of 1.25. Negative covenants include, among other things, limitations on additional debt, liens, negative pledges, investments, dividends, stock repurchases, asset sales and affiliate transactions. Events of default include, among other events, non-performance of covenants, breach of representations, cross-default to other material debt, bankruptcy and insolvency, material judgments and changes in control.

On November 14, 2011, the Company entered into a first amendment (the “First Amendment”) with certain lenders and KeyBank which amended the 2011 Credit Agreement. Among other things, the First Amendment: (i) increased the amount of the Amended Revolver from $65.0 million to $90.0 million; (ii) added to and modified the definitions of certain terms contained in the 2011 Credit Agreement; (iii) added PNC Bank, National Association as a lender under the 2011 Credit Agreement; and (iv) updated certain schedules to the 2011 Credit Agreement.

 On May 4, 2012, the Company entered into a second amendment (the "Second Amendment") to the 2011 Credit Agreement. Among other things, the Second Amendment (i) increased the amount of the Amended Revolver from $90.0 million to $110.0 million, (ii) added to and modified the definitions of certain terms contained in the 2011 Credit Agreement, (iii) added Cathay Bank as a lender under the 2011 Credit Agreement, (iv) increased the maximum available to be borrowed under the 2011 Credit Agreement to $135.0 million subject to KeyBank's approval, and (v) updated certain schedules to the Credit Agreement.

On May 8, 2012, the Company entered into a third amendment (the "Third Amendment") to the 2011 Credit Agreement. Under the terms of the Third Amendment, the definitions of certain terms of the 2011 Credit Agreement were modified and the acquisition of CEI was approved. The Company used the net proceeds from the sale of 20.0 million shares of its common stock, together with the borrowings under its credit facility, to fund the purchase of CEI on July 2, 2012 and to pay related fees and expenses.

The amounts of borrowings that may be made under the Amended Revolver are based on a borrowing base and are

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comprised of specified percentages of eligible receivables, eligible unbilled receivables and eligible inventory. If the amount of borrowings outstanding under the Amended Revolver exceeds the borrowing base then in effect, the Company is required to repay such borrowings in an amount sufficient to eliminate such excess. The Amended Revolver includes $50.0 million of availability for letters of credit and $10.0 million of availability for swing line loans.

The Company may borrow funds under the Amended Revolver at a rate based either on LIBOR or a base rate established by KeyBank. Base rate borrowings bear interest at an applicable margin of 1.00% to 1.75% over the base rate (which will be the greater of the prime rate or 0.5% over the federal funds rate, with a floor of 1.0% over one month LIBOR). LIBOR rate borrowings will bear interest at an applicable margin of 3.00% to 3.75% over the LIBOR rate. The applicable margin for base rate borrowings and LIBOR borrowings will depend on the average monthly revolving credit availability. The Amended Revolver also has a commitment fee of 0.50% to 0.75%, depending on the average monthly revolving credit availability. As of September 30, 2012, there were no outstanding borrowings on the Amended Revolver and $13.0 million was outstanding on letters of credit resulting in net borrowing base availability of $88.9 million. The Company was in compliance with the financial covenants as of September 30, 2012.
 
Debt Acquired in Acquisition of Herley
 
The Company assumed a $10.0 million 10-year term loan with a bank in Israel that Herley entered into on September 16, 2008 in connection with the acquisition of one of its wholly owned subsidiaries. The balance as of September 30, 2012 was $6.0 million, and the loan is payable in quarterly installments of $0.3 million plus interest at LIBOR plus a margin of 1.5%. The loan agreement contains various covenants, including a minimum net equity covenant as defined in the loan agreement. The Company was in compliance with all covenants, including the minimum net equity covenant, as of September 30, 2012.

Fair Value of Long-term Debt
 
Carrying amounts and the related estimated fair values of the Company’s long-term debt financial instruments not measured at fair value on a recurring basis at December 25, 2011 and September 30, 2012 are presented in the following table:
 
 
 
As of December 25, 2011
 
As of September 30, 2012
$ in millions
 
Principal
 
Carrying
Amount
 
Fair Value
 
Principal
 
Carrying
Amount
 
Fair Value
Long-term debt
 
$
631.8

 
$
654.6

 
$
642.7

 
$
631.0

 
$
650.7

 
$
678.2

 
The fair value of the Company’s long-term debt was based upon actual trading activity (Level 1, Observable inputs —quoted prices in active markets) and is the estimated amount the Company would have to pay to repurchase its debt, including any premium or discount attributable to the difference between the stated interest rate and market value of interest at the balance sheet date.
 
The net unamortized debt premium of $19.7 million as of September 30, 2012, which is the difference between the carrying amount of $650.7 million and the principal amount of $631.0 million represented in the previous table, is being amortized to interest expense over the terms of the related debt.
 
Note 10. Fair Value of Financial Instruments
 
The carrying amounts and the related estimated fair values of the Company's long-term debt financial instruments not measured at fair value on a recurring basis at December 25, 2011 and September 30, 2012 are presented in Note 9. The carrying value of all other financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and short-term debt, approximated their estimated fair values at December 25, 2011 and September 30, 2012.

Note 11. Derivatives
 
The Company used derivative financial instruments, in particular, interest rate swaps, to reduce the it’s exposure to certain previously outstanding variable rate debt. The primary objective of the interest rate swaps was to eliminate the variability of cash flows and interest rate risk for payments made on variable rate debt, the sole source of which is due to changes in the benchmark three month LIBOR interest rate. Changes in the cash flows of the interest rate swap were expected to exactly offset the changes in cash flows (i.e., changes in interest rate payments) attributable to fluctuations in the three-month LIBOR on certain previously outstanding variable-rate debt.

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The Company records derivatives at their fair value. The classification of gains and losses resulting from changes in the fair values of derivatives is dependent on the Company’s intended use of the derivative and its resulting designation as effective or ineffective. Adjustments to reflect changes in fair values of derivatives that the Company considers highly effective hedges are either reflected in earnings and largely offset by corresponding adjustments to the hedged items, or reflected net of income taxes in accumulated other comprehensive income (loss) until the hedged transaction is recognized in earnings, to the extent these derivatives are effective hedges. Changes in the fair value of these derivatives that are attributable to the ineffective portion of the hedges, or of derivatives that are not considered to be highly effective hedges, if any, are immediately recognized in earnings. There were no interest rate swaps outstanding as of and for the nine months ended September 30, 2012.
 
The Company's derivative financial instruments, which were cash flow hedges, were considered ineffective as a result of the interest rate floor that occurred with the first amendment of the first credit facility with KeyBank of $85.0 million in March 2008. The effect of marking the derivative instruments to market for the nine months ended September 25, 2011 was income of $0.3 million. There were no derivative liabilities outstanding as of December 25, 2011 or September 30, 2012.

 
Note 12. Significant Customers
 
Revenue from the U.S. Government, which includes foreign military sales, includes revenue from contracts for which the Company is the prime contractor as well as those for which the Company is a subcontractor and the ultimate customer is the U.S. Government. The KGS segment has substantial revenue from the U.S. Government. Sales to the U.S. Government amounted to approximately $157.9 million and $162.9 million, or 75% and 59%, of total revenue for the three months ended September 25, 2011 and September 30, 2012, respectively, and approximately $374.4 million and $443.8 million, or 74% and 63%, of total revenue for the nine months ended September 25, 2011 and September 30, 2012, respectively.
 
The U.S. Government continues to focus on developing and implementing spending, tax, and other initiatives to reduce the deficit, create jobs, and stimulate the economy. Although defense spending is expected to remain a national priority within future federal budgets, the Budget Control Act of 2011 (“Budget Control Act”) committed the U.S. Government to reduce the federal deficit over the next ten years. Under the Budget Control Act, the Bi-Partisan Congressional Joint Select Committee on Deficit Reduction (“the Joint Committee”) was responsible for identifying $1.2 to $1.5 trillion in deficit reductions by November 30, 2011. The Joint Committee was unable to identify the reductions by this deadline and thereby triggered a provision of the Budget Control Act called “sequestration,” which requires very substantial automatic spending cuts that will start in 2013 and be split between defense and non-defense programs and continue over a nine-year period. Any automatic reductions in national defense programs could impact the Company's significant customers. The impact of the Budget Control Act remains unknown, and the Company's business and industry could be adversely affected.
 
Note 13. Segment Information
 
The Company operates in two principal business segments: Kratos Government Solutions and Public Safety & Security. The Company organizes its business segments based on the nature of the services offered. In the following table, total operating income of the business segments is reconciled to the corresponding consolidated amount. The reconciling item “Unallocated corporate expense, net” includes costs for certain stock-based compensation programs (including stock-based compensation costs for stock options, employee stock purchase plan shares and restricted stock units), the effects of items not considered part of management’s evaluation of segment operating performance, merger and acquisition expenses, corporate costs not allocated to the operating segments, and other miscellaneous corporate activities. Transactions between segments are generally negotiated and accounted for under terms and conditions similar to other government and commercial contracts.
 
Revenues, operating income, and assets generated or held by the Company’s current reporting segments for the three and nine months ended September 25, 2011 and September 30, 2012 are as follows (in millions):
 

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Three Months Ended
 
Nine Months Ended
 
September 25,
2011
 
September 30,
2012
 
September 25,
2011
 
September 30,
2012
Revenues:
 

 
 

 
 

 
 

Kratos Government Solutions
$
174.2

 
$
223.5

 
$
416.9

 
$
568.2

Public Safety & Security
32.4

 
52.8

 
83.6

 
137.4

Total revenues
$
206.6

 
$
276.3

 
$
500.5

 
$
705.6

Operating income:
 

 
 

 
 

 
 

Kratos Government Solutions
$
10.5

 
$
14.0

 
$
26.8

 
$
32.4

Public Safety & Security
3.7

 
3.3

 
6.6

 
7.3

Unallocated corporate expense, net
(4.5
)
 
(3.2
)
 
(13.6
)
 
(9.1
)
Total operating income
$
9.7

 
$
14.1

 
$
19.8

 
$
30.6

 
 
As of
 
As of
 
December 25,
2011
 
September 30,
2012
Assets:
 

 
 

Kratos Government Solutions
$
1,028.8

 
$
1,187.8

Public Safety & Security
88.6

 
127.7

Discontinued operations
12.2

 
6.8

Corporate activities
86.4

 
50.6

Total assets
$
1,216.0

 
$
1,372.9


The increase in the assets in the KGS and PSS segments are primarily attributable to the acquisitions of CEI on July 2, 2012 and the Critical Infrastructure Business on December 30, 2011.

Note 14. Commitments and Contingencies
 
(a)
Legal Matters
 
For additional information regarding the Company's legal proceedings, see Item 3, “Legal Proceedings” in the Form 10-K.

Integral, which we acquired on July 27, 2011, was previously the subject of a SEC investigation. On July 30, 2009, the SEC and Integral each announced that an administrative settlement had been reached concluding the SEC's investigation.

In conjunction with its announcement of the administrative settlement, the SEC disclosed that it was instituting separate civil actions against three former officers of Integral, Steven R. Chamberlain (now deceased), Elaine M. Brown and Gary A. Prince in a case filed July 30, 2009 captioned United States Securities and Exchange Commission v. Steven R. Chamberlain, Elaine M. Brown, and Gary A. Prince, Case No. 09-CV-01423, pending in the United States District Court for the District of Columbia. The SEC's complaint alleges that from 1999 through August 2006, Chamberlain, Brown and Prince made materially false and misleading statements and omitted material information in various filings with the SEC by failing to disclose the role of Prince, who had been convicted of engaging in securities fraud while at another company, at Integral and his legal background in its filings. The SEC sought permanent injunctions against each defendant, as well as court orders imposing officer and director bars and civil penalties. Integral has indemnification obligations to these individuals, as well as other former directors and officers of Integral who may incur indemnifiable costs in connection with these actions, pursuant to the terms of separate indemnification agreements entered into with each of them effective as of December 4, 2002. As a result of the acquisition of Integral, we have assumed these indemnification obligations. The indemnification agreements each provide, subject to certain terms and conditions, that we shall indemnify the individual to the fullest extent permissible by Maryland law against judgments, penalties, fines, settlements and reasonable expenses actually incurred in the event that the individual is made a party to a legal proceeding by reason of his or her present or prior service as an officer or employee of Integral, and shall also advance reasonable litigation expenses actually incurred subject to, among other conditions, receipt of a written undertaking to repay any costs or expenses advanced if it shall ultimately be determined that the individual has not met the standard of conduct required for indemnification under Maryland law. Certain costs and expenses were previously covered under Integral's applicable directors and officers liability insurance policy. The policy limits were exhausted in December 2011, and we are

24
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advancing payment of indemnifiable costs pursuant to the indemnification agreements. The case is scheduled for trial in December 2012.


From time to time, the Company may become involved in various claims, lawsuits and legal proceedings that arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company's business. The Company is currently not aware of any such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on the Company's business, financial condition, operating results or cash flows. The aggregate amounts accrued related to these matters are not material to the total liabilities of the Company.
 
(b)
Warranty
 
Certain of the Company’s products, product finishes, and services are covered by a warranty to be free from defects in material and workmanship for periods ranging from one to ten years. Optional extended warranty contracts can also be purchased with the revenue deferred and amortized over the extended warranty period. The Company accrues a warranty liability for estimated costs to provide products, parts or services to repair or replace products in satisfaction of warranty obligations. Warranty revenues related to extended warranty contracts are amortized to income, over the life of the contract, using the straight-line method. Costs under extended warranty contracts are expensed as incurred.
 
The Company’s estimate of costs to service its warranty obligations is based upon historical experience and expectations of future conditions. To the extent that the Company experiences any changes in warranty claim activity or costs associated with servicing those claims, its warranty liability is adjusted accordingly.
 
The changes in the Company's aggregate product warranty liabilities, which are included in other current liabilities and other long term-liabilities on the Company's Condensed Consolidated Balance Sheets, were as follows (in millions):
 
 
Nine Months Ended
 
September 25,
2011
 
September 30,
2012
Balance, at beginning of the period
$
1.9

 
$
4.6

Costs accrued and revenues deferred
0.4

 
—

Warranty liabilities assumed from acquisitions
—

 
1.2

Settlements made (in cash or kind) and revenues recognized
(0.4
)
 
(0.7
)
Balance, at end of period
1.9

 
5.1

Less: Current portion
1.6

 
—

Non-current accrued product warranty and deferred warranty revenue
$
0.3

 
$
5.1


Note 15. Condensed Consolidating Financial Statements

The Company has $625.0 million in outstanding Senior Secured Notes see Note 9. The Notes are guaranteed by all of the Company's 100% owned domestic subsidiaries (the "Subsidiary Guarantors") and are collateralized by the assets of all of the Company's 100% owned subsidiaries. The Notes are fully and unconditionally guaranteed on a joint and several basis by each guarantor subsidiary and the Company. There are no contractual restrictions limiting cash transfers from guarantor subsidiaries by dividends, loans or advances to the Company. The Senior Secured Notes are not guaranteed by the Company's foreign subsidiaries (the “Non-Guarantor Subsidiaries”).

The following tables present condensed consolidated financial statements for the parent company, the Subsidiary Guarantors and the Non-Guarantor Subsidiaries, respectively. The consolidating financial information below follows the same accounting policies as described in the consolidated financial statements, except for the use of the equity method of accounting to reflect ownership interests in wholly-owned subsidiaries, which are eliminated upon consolidation.


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Condensed Consolidating Balance Sheet
December 25, 2011
(Unaudited)
 
Parent Company
 
Guarantors on a Combined Basis
 
Non-Guarantors on a Combined Basis
 
Eliminations
 
Consolidated
Assets
 
 
 
 
 
 
 
 
 
Current Assets:
 
 
 
 
 
 
 
 
 
  Cash and cash equivalents
$
52.6

 
$
2.8

 
$
14.2

 
$
—

 
$
69.6

  Accounts receivable, net
—

 
225.4

 
19.9

 
—

 
245.3

  Amounts due from affiliated companies
449.3

 
—

 
—

 
(449.3
)
 
—

  Inventoried costs
—

 
64.2

 
12.4

 
—

 
76.6

  Other current assets
3.3

 
22.1

 
4.1

 
—

 
29.5

    Total current assets
505.2

 
314.5

 
50.6

 
(449.3
)
 
421.0

Property, plant and equipment, net
1.2

 
62.2

 
9.1

 
—

 
72.5

Goodwill
—

 
551.1

 
20.5

 
—

 
571.6

Intangible assets, net
—

 
119.8

 
4.8

 
—

 
124.6

Investment in subsidiaries
466.0

 
8.8

 
—

 
(474.8
)
 
—

Amounts due from affiliated companies
—

 
26.0

 
—

 
(26.0
)
 
—

Other assets
21.5

 
4.0

 
0.8

 
—

 
26.3

    Total assets
$
993.9

 
$
1,086.4

 
$
85.8

 
$
(950.1
)
 
$
1,216.0

Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
 
  Accounts payable
$
8.5

 
$
37.5

 
$
2.8

 
$
—

 
$
48.8

  Accrued expenses
2.4

 
50.4

 
3.0

 
—

 
55.8

  Accrued compensation
3.7

 
33.3

 
2.8

 
—

 
39.8

  Billings in excess of costs and earnings on uncompleted contracts
—

 
34.3

 
1.9

 
—

 
36.2

  Amounts due to affiliated companies
—

 
418.9

 
30.4

 
(449.3
)
 
—

  Other current liabilities
13.5

 
17.4

 
2.3

 
—

 
33.2

    Total current liabilities
28.1

 
591.8

 
43.2

 
(449.3
)
 
213.8

Long-term debt, net of current portion
647.8

 
—

 
5.8

 
—

 
653.6

Amounts due to affiliated companies
—

 
—

 
26.0

 
(26.0
)
 
—

Other long-term liabilities
5.4

 
28.6

 
2.0

 
—

 
36.0

    Total liabilities
681.3

 
620.4

 
77.0

 
(475.3
)
 
903.4

 Total stockholders' equity
312.6

 
466.0

 
8.8

 
(474.8
)
 
312.6

    Total liabilities and stockholders' equity
$
993.9

 
$
1,086.4

 
$
85.8

 
$
(950.1
)
 
$
1,216.0




26
Table of Contents

Condensed Consolidating Balance Sheet
September 30, 2012
(Unaudited)
 
Parent Company
 
Guarantors on a Combined Basis
 
Non-Guarantors on a Combined Basis
 
Eliminations
 
Consolidated
Assets
 
 
 
 
 
 
 
 
 
Current Assets:
 
 
 
 
 
 
 
 
 
  Cash and cash equivalents
$
20.9

 
$
(1.3
)
 
$
18.0

 
$
—

 
$
37.6

  Accounts receivable, net
—

 
262.7

 
18.7

 
—

 
281.4

  Amounts due from affiliated companies
509.9

 
—

 
—

 
(509.9
)
 
—

  Inventoried costs
—

 
82.1

 
17.8

 
—

 
99.9

  Other current assets
10.9

 
23.5

 
3.3

 
—

 
37.7

    Total current assets
541.7

 
367.0

 
57.8

 
(509.9
)
 
456.6

Amounts due from affiliated companies, long-term
—

 
26.0

 
—

 
(26.0
)
 
—

Property, plant and equipment, net
1.3

 
73.9

 
9.4

 
—

 
84.6

Goodwill
—

 
658.0

 
20.5

 
—

 
678.5

Intangible assets, net
—

 
129.1

 
3.1

 
—

 
132.2

Investment in subsidiaries
542.2

 
14.6

 
—

 
(556.8
)
 
—

Other assets
18.5

 
1.7

 
0.8

 
—

 
21.0

    Total assets
$
1,103.7

 
$
1,270.3

 
$
91.6

 
$
(1,092.7
)
 
$
1,372.9

Liabilities and Stockholders' Equity
 
 
 
 
 
 
 
 
 
Current liabilities:
 
 
 
 
 
 
 
 
 
  Accounts payable
$
5.0

 
$
70.0

 
$
6.0

 
$
—

 
$
81.0

  Accrued expenses
$
3.0

 
$
67.8

 
$
2.6

 
$
—

 
$
73.4

  Accrued compensation
3.8

 
36.0

 
2.1

 
—

 
41.9

  Billings in excess of costs and earnings on uncompleted contracts
—

 
40.0

 
4.0

 
—

 
44.0

  Amounts due to affiliated companies
—

 
480.7

 
29.2

 
(509.9
)
 
—

  Other current liabilities
32.5

 
1.3

 
—

 
—

 
33.8

    Total current liabilities
44.3

 
695.8

 
43.9

 
(509.9
)
 
274.1

Long-term debt, net of current portion
644.7

 
—

 
5.0

 
—

 
649.7

Amounts due to affiliated companies
—

 
—

 
26.0

 
(26.0
)
 
—

Other long-term liabilities
2.1

 
32.3

 
2.1

 
—

 
36.5

    Total liabilities
691.1

 
728.1

 
77.0

 
(535.9
)
 
960.3

Total stockholders' equity
412.6

 
542.2

 
14.6

 
(556.8
)
 
412.6

    Total liabilities and stockholders' equity
$
1,103.7

 
$
1,270.3

 
$
91.6

 
$
(1,092.7
)
 
$
1,372.9


27
Table of Contents

Condensed Consolidating Statement of Operations and Comprehensive Income
Three Months Ended September 25, 2011
(Unaudited)
 
Parent Company
 
Guarantors on a Combined Basis
 
Non-Guarantors on a Combined Basis
 
Eliminations
 
Consolidated
Service revenues
$
—

 
$
92.4

 
$
0.8

 
$
—

 
$
93.2

Product sales
—

 
101.4

 
15.7

 
(3.7
)
 
113.4

  Total revenues
—

 
193.8

 
16.5

 
(3.7
)
 
206.6

Cost of service revenues
—

 
68.0

 
0.6

 
—

 
68.6