UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 28, 2018
or
o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 001-33072
Leidos Holdings, Inc. | ||
(Exact name of registrant as specified in its charter) | ||
Delaware | 20-3562868 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |
11951 Freedom Drive, Reston, Virginia | 20190 | |
(Address of principal executive office) | (Zip Code) | |
(571) 526-6000 | ||
(Registrant's telephone number, including area code) | ||
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 x 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 (§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 x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer | x | Accelerated filer | o | ||||||
Non-accelerated filer | o | Smaller reporting company | o | ||||||
Emerging growth company | o | ||||||||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The number of shares issued and outstanding of each issuer’s classes of common stock as of October 16, 2018, was 149,760,061 shares of common stock ($.0001 par value per share).
LEIDOS HOLDINGS, INC.
FORM 10-Q
TABLE OF CONTENTS
Part I | Page | |
Item 1. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
Part II | ||
Item 1. | ||
Item 1A. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
Item 5. | ||
Item 6. | ||
PART I—FINANCIAL INFORMATION
Item 1. Financial Statements.
LEIDOS HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
September 28, 2018 | December 29, 2017 | |||||||
(in millions) | ||||||||
ASSETS | ||||||||
Cash and cash equivalents | $ | 515 | $ | 390 | ||||
Receivables, net | 1,812 | 1,831 | ||||||
Inventory, prepaid expenses and other current assets | 456 | 453 | ||||||
Assets held for sale | 98 | — | ||||||
Total current assets | 2,881 | 2,674 | ||||||
Property, plant and equipment, net | 230 | 232 | ||||||
Intangible assets, net | 702 | 856 | ||||||
Goodwill | 4,881 | 4,974 | ||||||
Other assets | 214 | 254 | ||||||
$ | 8,908 | $ | 8,990 | |||||
LIABILITIES AND EQUITY | ||||||||
Accounts payable and accrued liabilities | $ | 1,590 | $ | 1,639 | ||||
Accrued payroll and employee benefits | 410 | 487 | ||||||
Dividends payable | 11 | 17 | ||||||
Income taxes payable | 2 | 4 | ||||||
Long-term debt, current portion | 56 | 55 | ||||||
Liabilities held for sale | 24 | — | ||||||
Total current liabilities | 2,093 | 2,202 | ||||||
Long-term debt, net of current portion | 2,985 | 3,056 | ||||||
Deferred tax liabilities | 232 | 220 | ||||||
Other long-term liabilities | 141 | 129 | ||||||
Commitments and contingencies (Notes 20 and 21) | ||||||||
Stockholders’ equity: | ||||||||
Common stock, $.0001 par value, 500 million shares authorized, 150 million and 151 million shares issued and outstanding at September 28, 2018 and December 29, 2017, respectively | — | — | ||||||
Additional paid-in capital | 3,210 | 3,344 | ||||||
Accumulated earnings (deficit) | 231 | (7 | ) | |||||
Accumulated other comprehensive income | 13 | 33 | ||||||
Total Leidos stockholders’ equity | 3,454 | 3,370 | ||||||
Non-controlling interest | 3 | 13 | ||||||
Total equity | 3,457 | 3,383 | ||||||
$ | 8,908 | $ | 8,990 | |||||
See accompanying notes to condensed consolidated financial statements.
1
LEIDOS HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
Three Months Ended | Nine Months Ended | |||||||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||||||
(in millions, except per share amounts) | ||||||||||||||||
Revenues | $ | 2,575 | $ | 2,503 | $ | 7,547 | $ | 7,654 | ||||||||
Cost of revenues | 2,174 | 2,136 | 6,412 | 6,559 | ||||||||||||
Selling, general and administrative expenses | 195 | 194 | 547 | 561 | ||||||||||||
Integration and restructuring costs | 7 | 27 | 32 | 81 | ||||||||||||
Asset impairment charges | — | — | 7 | — | ||||||||||||
Equity earnings of non-consolidated subsidiaries | (4 | ) | (5 | ) | (12 | ) | (5 | ) | ||||||||
Operating income | 203 | 151 | 561 | 458 | ||||||||||||
Non-operating expense: | ||||||||||||||||
Interest expense, net | (35 | ) | (35 | ) | (104 | ) | (105 | ) | ||||||||
Other income, net | 2 | — | 3 | 6 | ||||||||||||
Income before income taxes | 170 | 116 | 460 | 359 | ||||||||||||
Income tax expense | (23 | ) | (37 | ) | (66 | ) | (108 | ) | ||||||||
Net income | 147 | 79 | 394 | 251 | ||||||||||||
Less: net (loss) income attributable to non-controlling interest | — | (3 | ) | 1 | (1 | ) | ||||||||||
Net income attributable to Leidos common stockholders | $ | 147 | $ | 82 | $ | 393 | $ | 252 | ||||||||
Earnings per share: | ||||||||||||||||
Basic | $ | 0.97 | $ | 0.54 | $ | 2.59 | $ | 1.67 | ||||||||
Diluted | 0.96 | 0.53 | 2.55 | 1.65 | ||||||||||||
Cash dividends declared per share | $ | 0.32 | $ | 0.32 | $ | 0.96 | $ | 0.96 | ||||||||
See accompanying notes to condensed consolidated financial statements.
2
LEIDOS HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
Three Months Ended | Nine Months Ended | |||||||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||||||
(in millions) | ||||||||||||||||
Net income | $ | 147 | $ | 79 | $ | 394 | $ | 251 | ||||||||
Foreign currency translation adjustments | (8 | ) | 21 | (41 | ) | 34 | ||||||||||
Unrecognized (loss) gain on derivative instruments (Note 15) | (2 | ) | 3 | 12 | 2 | |||||||||||
Pension adjustments | — | (1 | ) | — | (1 | ) | ||||||||||
Total other comprehensive (loss) income, net of taxes | (10 | ) | 23 | (29 | ) | 35 | ||||||||||
Comprehensive income | 137 | 102 | 365 | 286 | ||||||||||||
Less: comprehensive (loss) income attributable to non-controlling interest | — | (3 | ) | 1 | (1 | ) | ||||||||||
Comprehensive income attributable to Leidos common stockholders | $ | 137 | $ | 105 | $ | 364 | $ | 287 | ||||||||
See accompanying notes to condensed consolidated financial statements.
3
LEIDOS HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF EQUITY (UNAUDITED)
Shares of common stock | Additional paid-in capital | Accumulated earnings (deficit) | Accumulated other comprehensive income | Leidos Holdings, Inc. stockholders' equity | Non-controlling interest | Total | |||||||||||||||||||||
(in millions, except for per share amounts) | |||||||||||||||||||||||||||
Balance at December 30, 2016 | 150 | $ | 3,316 | $ | (177 | ) | $ | (4 | ) | $ | 3,135 | $ | 12 | $ | 3,147 | ||||||||||||
Net income (loss) | — | — | 252 | — | 252 | (1 | ) | 251 | |||||||||||||||||||
Other comprehensive income, net of taxes | — | — | — | 35 | 35 | — | 35 | ||||||||||||||||||||
Issuances of stock | 1 | 13 | — | — | 13 | — | 13 | ||||||||||||||||||||
Repurchases of stock and other | — | (26 | ) | — | — | (26 | ) | — | (26 | ) | |||||||||||||||||
Dividends declared | — | — | (147 | ) | — | (147 | ) | — | (147 | ) | |||||||||||||||||
Stock-based compensation | — | 32 | — | — | 32 | — | 32 | ||||||||||||||||||||
Adjustment to original purchase price allocation | — | — | — | — | — | 3 | 3 | ||||||||||||||||||||
Other | — | — | — | — | — | (1 | ) | (1 | ) | ||||||||||||||||||
Balance at September 29, 2017 | 151 | $ | 3,335 | $ | (72 | ) | $ | 31 | $ | 3,294 | $ | 13 | $ | 3,307 | |||||||||||||
Balance at December 29, 2017 | 151 | $ | 3,344 | $ | (7 | ) | $ | 33 | $ | 3,370 | $ | 13 | $ | 3,383 | |||||||||||||
Cumulative adjustments related to ASU adoptions (Note 2) | — | — | (8 | ) | 9 | 1 | — | 1 | |||||||||||||||||||
Balance at December 30, 2017 | 151 | 3,344 | (15 | ) | 42 | 3,371 | 13 | 3,384 | |||||||||||||||||||
Net income | — | — | 393 | — | 393 | 1 | 394 | ||||||||||||||||||||
Other comprehensive loss, net of taxes (Note 15) | — | — | — | (29 | ) | (29 | ) | — | (29 | ) | |||||||||||||||||
Issuances of stock | 1 | 16 | — | — | 16 | — | 16 | ||||||||||||||||||||
Repurchases of stock and other | (2 | ) | (182 | ) | — | — | (182 | ) | — | (182 | ) | ||||||||||||||||
Dividends declared | — | — | (147 | ) | — | (147 | ) | — | (147 | ) | |||||||||||||||||
Stock-based compensation | — | 33 | — | — | 33 | — | 33 | ||||||||||||||||||||
Purchase of a non-controlling interest | — | (1 | ) | — | — | (1 | ) | (10 | ) | (11 | ) | ||||||||||||||||
Other | — | — | — | — | — | (1 | ) | (1 | ) | ||||||||||||||||||
Balance at September 28, 2018 | 150 | $ | 3,210 | $ | 231 | $ | 13 | $ | 3,454 | $ | 3 | $ | 3,457 | ||||||||||||||
See accompanying notes to condensed consolidated financial statements.
4
Nine Months Ended | ||||||||
September 28, 2018 | September 29, 2017 | |||||||
(in millions) | ||||||||
Cash flows from operations: | ||||||||
Net income | $ | 394 | $ | 251 | ||||
Adjustments to reconcile net income to net cash provided by operations: | ||||||||
Depreciation and amortization | 193 | 254 | ||||||
Stock-based compensation | 33 | 32 | ||||||
Asset impairment charges | 7 | — | ||||||
Bad debt expense and other | 17 | 34 | ||||||
Change in assets and liabilities, net of effects of acquisitions: | ||||||||
Receivables | 2 | (155 | ) | |||||
Inventory, prepaid expenses and other current assets | (24 | ) | (46 | ) | ||||
Accounts payable and accrued liabilities | 61 | 5 | ||||||
Accrued payroll and employee benefits | (71 | ) | (44 | ) | ||||
Deferred income taxes and income taxes receivable/payable | 3 | (50 | ) | |||||
Other long-term assets/liabilities | 49 | 81 | ||||||
Net cash provided by operating activities | 664 | 362 | ||||||
Cash flows from investing activities: | ||||||||
Payments for property, plant and equipment | (53 | ) | (42 | ) | ||||
Acquisitions of businesses | (81 | ) | — | |||||
Collections on promissory note | 40 | 2 | ||||||
Proceeds from sale of assets | — | 7 | ||||||
Net cash used in investing activities | (94 | ) | (33 | ) | ||||
Cash flows from financing activities: | ||||||||
Payments of long-term debt | (59 | ) | (194 | ) | ||||
Proceeds from issuances of stock | 13 | 10 | ||||||
Repurchases of stock and other | (182 | ) | (26 | ) | ||||
Dividend payments | (151 | ) | (150 | ) | ||||
Payment of tax indemnification liability | (23 | ) | — | |||||
Payments for non-controlling interest acquired | (8 | ) | — | |||||
Payments for debt issuance and modification costs | (6 | ) | (4 | ) | ||||
Other | (1 | ) | — | |||||
Net cash used in financing activities | (417 | ) | (364 | ) | ||||
Net increase (decrease) in cash, cash equivalents and restricted cash | 153 | (35 | ) | |||||
Cash, cash equivalents and restricted cash at beginning of period | 422 | 396 | ||||||
Cash, cash equivalents and restricted cash at end of period | $ | 575 | $ | 361 | ||||
See accompanying notes to condensed consolidated financial statements.
5
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 1–Nature of Operations and Basis of Presentation
Leidos Holdings, Inc. ("Leidos"), a Delaware corporation is a holding company whose direct 100%-owned subsidiaries and principal operating companies are Leidos, Inc. and Leidos Innovations Corporation ("Leidos Innovations"). Leidos is a FORTUNE 500® science, engineering and information technology company that provides services and solutions in the defense, intelligence, civil and health markets. Leidos' domestic customers include the U.S. Department of Defense ("DoD"), the U.S. Intelligence Community, the U.S. Department of Homeland Security, the Federal Aviation Administration, the Department of Veterans Affairs, several other U.S. government civil agencies and state and local government agencies. Leidos' international customers include foreign governments and their agencies, primarily located in Australia and the United Kingdom. Unless indicated otherwise, references to the "Company," "we," "us" and "our" refer collectively to Leidos Holdings, Inc. and its consolidated subsidiaries. The Company operates in three reportable segments: Defense Solutions, Civil and Health. Additionally, the Company separately presents the costs associated with corporate functions as Corporate.
The Company has a controlling interest in Mission Support Alliance, LLC ("MSA"), a joint venture with Centerra Group, LLC. On January 26, 2018, the Company entered into a Membership Interest Purchase Agreement with Jacobs Engineering Group, Inc. ("Jacobs Group"), whereby the Company purchased 100% of Jacobs Group's 41% outstanding membership interest in MSA. As a result, Leidos increased its controlling ownership in MSA from 47% to 88%. The Company consolidates the financial results for MSA into its unaudited condensed consolidated financial statements.
The unaudited condensed consolidated financial statements also include the balances of all voting interest entities in which Leidos has a controlling voting interest (“subsidiaries”) and a variable interest entity ("VIE") in which Leidos is the primary beneficiary. The consolidated balances of the Company’s VIE are not material to the Company’s unaudited condensed consolidated financial statements for the periods presented. Intercompany accounts and transactions between consolidated companies have been eliminated in consolidation.
The accompanying unaudited condensed financial information has been prepared in accordance with the rules of the U.S. Securities and Exchange Commission ("SEC") and accounting principles generally accepted in the United States of America ("GAAP"). Certain disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingencies at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Management evaluates these estimates and assumptions on an ongoing basis, including those relating to estimated profitability of long-term contracts, indirect billing rates, allowances for doubtful accounts, inventories, fair value and impairment of intangible assets and goodwill, income taxes, stock-based compensation expense and contingencies. These estimates have been prepared by management on the basis of the most current and best available information; however, actual results could differ materially from those estimates.
In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments, which consist of normal recurring adjustments, necessary for a fair presentation thereof. The results reported in these unaudited condensed consolidated financial statements are not necessarily indicative of the results that may be expected for the entire year. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K filed on February 23, 2018.
Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation. The Company classifies indirect costs incurred within or allocated to its U.S. government customers as overhead (included in "Cost of revenues") or general administrative expenses in the same manner as such costs are defined in the Company's disclosure statements under U.S. Government Cost Accounting Standards ("CAS"). Effective the beginning of fiscal 2018, the Company established a new CAS structure and revised its disclosure statements accordingly to reflect the related cost accounting practice changes. Consequently, $53 million and $133 million was reclassified from "Cost of revenues" to "Selling, general and administrative expenses" on the condensed consolidated statement of income for the quarter and nine months ended September 29, 2017, respectively.
6
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The Company aggregated "Interest income" and "Interest expense" into "Interest expense, net" and "Acquisition and integration costs" and "Restructuring expenses" into "Integration and restructuring costs" on the condensed consolidated statements of income. Additionally, the Company aggregated "Bad debt expense" and "Other" into "Bad debt expense and other" on the Company's condensed consolidated statements of cash flows.
Note 2–Accounting Standards
Accounting Standards Updates Adopted
ASU 2014-09, Revenue from Contracts with Customers (Topic 606)
In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09 ("ASC 606") and related amendments, which superseded all prior revenue recognition methods and industry-specific guidance. The core principle of ASC 606 is an entity should recognize revenue to depict the transfer of control for promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In applying the revenue principles, an entity is required to identify the contract(s) with a customer, identify the performance obligations, determine the transaction price, allocate the transaction price to the performance obligations and recognize revenue when the performance obligation is satisfied (i.e., either over time or point in time). ASC 606 further requires that companies disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.
ASC 606 provided companies an option of two transition methods, the full retrospective method, in which case the standard would be applied to each prior reporting period presented and the cumulative effect of applying the standard would be recognized at the earliest period shown, or the modified retrospective method, in which case the cumulative effect of applying the standard would be recognized at the date of initial application. The ASU was effective for annual reporting periods beginning after December 15, 2017.
Effective December 30, 2017 (the beginning of fiscal 2018), the Company adopted the requirements of ASC 606 using the modified retrospective method. The guidance was not applied to contracts that were complete at December 30, 2017, and the comparative information for the prior fiscal year has not been retrospectively adjusted.
As a result of the adoption the Company recorded a $1 million decrease to its beginning accumulated deficit as the cumulative impact of adoption of the new revenue standard. The primary impact was on certain units-of-delivery contracts, as the Company previously recognized revenue at a point in time when the customer accepted delivery of the product or service. Under ASC 606, revenues on certain units-of-delivery contracts are now recognized using an over-time model. The adoption of ASC 606 did not have a significant impact on the Company's revenue recognition policy as revenues on substantially all of the Company's contracts continue to be recognized over time.
In adopting ASC 606, the Company elected to use certain practical expedients permitted by the standard including using the portfolio approach where contracts with similar characteristics were assessed collectively to evaluate risk over the impact of ASC 606. The Company also elected to adopt the right-to-invoice practical expedient on certain cost-reimbursable contracts where the Company recognizes revenues as it is contractually able to invoice the customer based on the control transferred to the customer.
ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedge Activities
In August 2017, the FASB issued ASU 2017-12, which simplifies the application of hedge accounting and improves the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities. The ASU is effective for public companies for annual reporting periods beginning after December 15, 2018, and should be applied on a modified retrospective basis. Early adoption is permitted.
The Company early adopted the provisions of ASU 2017-12 using the modified retrospective method during the quarter ended March 30, 2018, and recorded a $3 million increase to accumulated other comprehensive income and a corresponding increase to beginning accumulated deficit for the cumulative ineffectiveness gains related to the cash flow hedges.
7
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
ASU 2018-02, Income Statement–Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income
In February 2018, the FASB issued ASU 2018-02, which allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act ("Tax Act"). This ASU is effective for all entities for annual reporting periods beginning after December 15, 2018, and should be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the U.S. federal corporate income tax rate due to the Tax Act is recognized. Early adoption is permitted.
The Company early adopted the provisions of ASU 2018-02 during the quarter ended March 30, 2018 (applied in the period of adoption), and recorded a $6 million increase to accumulated other comprehensive income and a corresponding increase to beginning accumulated deficit to reflect the changes in the U.S. federal corporate income tax rate as a result of the Tax Act. As a result of the adoption of ASU 2018-02, the Company's policy to release income tax effects in accumulated other comprehensive income is consistent with the underlying book method.
The cumulative effect of the changes made to the Company's condensed consolidated balance sheet for the adoptions of the ASUs above was as follows:
Balance at December 29, 2017 | Adjustments due to ASU 2014-09 | Adjustments due to ASU 2017-12 | Adjustments due to ASU 2018-02 | Balance at December 30, 2017 | ||||||||||||||||
(in millions) | ||||||||||||||||||||
Assets: | ||||||||||||||||||||
Receivables, net | $ | 1,831 | $ | 4 | $ | — | $ | — | $ | 1,835 | ||||||||||
Inventory, prepaid expenses and other current assets | 453 | (3 | ) | — | — | 450 | ||||||||||||||
Equity: | ||||||||||||||||||||
Accumulated deficit | $ | (7 | ) | $ | 1 | $ | (3 | ) | $ | (6 | ) | $ | (15 | ) | ||||||
Accumulated other comprehensive income | 33 | — | 3 | 6 | 42 | |||||||||||||||
Accounting Standards Updates Issued But Not Yet Adopted
ASU 2016-02 and ASU 2018-10, Leases (Topic 842)
In February 2016, the FASB issued ASU 2016-02, which supersedes the current lease guidance under Leases (Topic 840) and makes several changes, such as requiring an entity to recognize a right-of-use asset and corresponding lease obligation on the balance sheet, classified as financing or operating, as appropriate. The update is effective for public companies for annual and interim reporting periods beginning after December 15, 2018, and should be adopted under the modified retrospective approach.
In July 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842, Leases, to add clarity to certain areas within ASU 2016-02 and ASU 2018-11 "Targeted Improvements", to add an additional and optional transition method to adopt the new leases standard by allowing recognition of a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. The effective date and transition requirements will be the same as ASU 2016-02.
The Company plans to adopt the new lease accounting standards in fiscal 2019 using the proposed optional transition method and is currently in the process of reviewing lease and other service based contracts, implementing a new lease accounting and administration software solution, establishing new processes and internal controls. The Company has elected to adopt certain practical expediencies provided under ASC 842, including the option to not apply lease recognition for short-term leases, reassessment of whether expired or existing contracts contain leases, reassessment of lease classification for expired or existing leases, applying single discount rate to a portfolio of leased assets with similar durations, reassessing initial direct costs and combining lease and non-lease components in revenue arrangements. The potential impact on the consolidated financial statements will largely be based on the present value of future minimum lease payments, the amount of which will depend upon the population of leases in effect at the date of adoption.
8
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 3–Significant Accounting Policies
Revenue Recognition
The Company's revenues from contracts with customers are from offerings including cybersecurity; data analytics; enterprise IT modernization; operations and logistics; sensors, collection and phenomenology; software development; and systems engineering, primarily with the U.S. government and its agencies. The Company also serves various state and local governments, foreign governments and U.S. commercial customers.
The Company performs under various types of contracts, which include firm-fixed-price ("FFP"), time-and-materials ("T&M"), fixed-price-level-of-effort ("FP-LOE"), cost-plus-fixed-fee, cost-plus-award-fee, cost-plus-incentive-fee and fixed-price-incentive-fee ("FP-IF") contracts.
To determine the proper revenue recognition, the Company first evaluates whether it has a duly approved and enforceable contract with a customer, in which the rights of the parties and payment terms are identified, and collectability is probable. The Company also evaluates whether two or more contracts should be combined and accounted for as a single contract, including the task orders issued under an indefinite delivery/indefinite quantity ("IDIQ") award. In addition, the Company assesses contract modifications to determine whether changes to existing contracts should be accounted for as part of the original contract or as a separate contract. Contract modifications for the Company generally relate to changes in contract specifications and requirements and do not add distinct services, and therefore are accounted for as part of the original contract. If contract modifications add distinct goods or services and increase the contract value by an amount that reflects the standalone selling price, those modifications are accounted for as separate contracts.
Most of the Company's contracts are comprised of multiple promises including the design and build of software-based systems, integration of hardware and software solutions, running and maintaining of IT infrastructure and procurement services. In all cases, the Company assesses if the multiple promises should be accounted for as separate performance obligations or combined into a single performance obligation. The Company generally separates multiple promises in a contract as separate performance obligations if those promises are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or require significant integration or customization within a group, they are combined and accounted for as a single performance obligation.
The Company's contracts with the U.S. government often contain options to renew existing contracts for an additional period of time (generally a year at a time) under the same terms and conditions as the original contract, and generally do not provide the customer any material rights under the contract. The Company accounts for renewal options as separate contracts when they include distinct goods or services at standalone selling prices.
Contracts with the U.S. government are subject to the Federal Acquisition Regulation ("FAR") and priced on estimated or actual costs of providing the goods or services. The FAR provides guidance on types of costs that are allowable in establishing prices for goods and services provided to the U.S. government and its agencies. Each contract is competitively priced and bid separately. Pricing for non-U.S. government agencies and commercial customers is based on specific negotiations with each customer. The Company excludes any taxes collected or imposed when determining the transaction price.
Certain of the Company's cost-plus and fixed-price contracts contain award fees, incentive fees or other provisions that may either increase or decrease the transaction price. These variable amounts generally are awarded upon achievement of certain performance metrics, program milestones or cost targets and can be based upon customer discretion. The Company estimates variable consideration at the most probable amount that it expects to be entitled to, based on the assessment of the contractual variable fee criteria, complexity of work and related risks, extent of customer discretion, amount of variable consideration received historically and the potential of significant reversal of revenue.
The Company allocates the transaction price of a contract to its performance obligations in the proportion of its respective standalone selling prices. The standalone selling price of the Company's performance obligations is generally based on an expected cost-plus margin approach, in accordance with the FAR. For certain product sales, the Company uses prices from other standalone sales. Substantially all of the Company's contracts do not contain a significant financing component, which would require an adjustment to the transaction price of the contract.
9
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The Company recognizes revenue on its service based contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the Company performs the promised services. For U.S. government contracts, continuous transfer of control to the customer is evidenced by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay for costs incurred plus a reasonable profit and take control of any work-in-process. Similarly, for non-U.S. government contracts, the customer typically controls the work-in-process as evidenced by rights to payment for work performed to date plus a reasonable profit to deliver products or services that do not have an alternate use to the Company. Anticipated losses on service based contracts are recognized as incurred. In certain product sales, where the products have an alternate use, the Company recognizes revenue at a point in time when the customer takes control of the asset usually denoted by possession and legal title.
On FFP contracts, revenue recognized over time generally uses a method that measures the extent of progress towards completion of a performance obligation, principally using a cost-input method (referred to as the cost-to-cost method). Under the cost-to-cost method, revenue is recognized based on the proportion of total costs incurred to estimated total costs-at-completion ("EAC"). A performance obligation's EAC includes all direct costs such as materials, labor, subcontract costs, overhead, and a ratable portion of general and administrative costs. In addition, the Company includes in an EAC of a performance obligation future losses estimated to be incurred on onerous contracts, as and when known. On certain other contracts, principally T&M, FP-LOE, and cost-plus, revenue is recognized using the right-to-invoice practical expedient as the Company is contractually able to invoice the customer based on the control transferred to the customer. Additionally, on maintenance (generally FFP) performance obligations, revenue is recognized over time using a straight-line method as the control of the services is provided to the customer evenly over the period of performance.
For certain performance obligations, the Company is not primarily responsible for fulfilling the promise to provide the goods or service to the customer, does not have inventory risk and does not have discretion in establishing the price for the goods or service. In such cases, the Company recognizes revenue on a net basis.
Contract costs generally include direct costs such as materials, labor, subcontract costs, and indirect costs identifiable with or allocable to a specific contract. Costs are expensed as incurred except for costs incurred during the transition phase of a new contract, which are capitalized and amortized on a straight-line basis over the expected life of that contract. The Company does not incur significant incremental costs to acquire contracts. Contract costs incurred for U.S. government contracts, including indirect costs, are subject to audit and adjustment by the Defense Contract Audit Agency ("DCAA") (see "Note 20–Contingencies").
Changes in Estimates on Contracts
Changes in estimates related to contracts accounted for using the cost-to-cost method of accounting are recognized in the period in which such changes are made for the inception-to-date effect of the changes, with the exception of contracts acquired through the acquisition of Lockheed Martin's Information Systems & Global Solutions business ("IS&GS Business") (see "Note 6–Acquisitions"), where the adjustment is made for the period commencing from the date of acquisition.
Changes in estimates on contracts for the periods presented were as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||||||
(in millions, except per share amounts) | ||||||||||||||||
Net favorable impact to income before income taxes | $ | 17 | $ | 9 | $ | 86 | $ | 71 | ||||||||
Impact on diluted EPS attributable to Leidos common stockholders | $ | 0.07 | $ | 0.04 | $ | 0.41 | $ | 0.32 | ||||||||
The impact on diluted EPS attributable to Leidos common stockholders is calculated using the Company's statutory tax rate.
During the quarter and nine months ended September 28, 2018, revenue recognized from performance obligations satisfied in previous periods was $18 million and $84 million, respectively. The changes primarily relate to revisions of variable consideration, including award fees, and revisions to estimates at completion resulting from changes in contract scope, mitigation of contract risks or due to true-ups of contract estimates at the end of contract performance.
10
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Cash and Cash Equivalents
The Company's cash equivalents are primarily comprised of investments in several large institutional money market funds and bank deposits, with original maturity of three months or less. The Company includes outstanding payments within "Cash and cash equivalents" and correspondingly increases "Accounts payable and accrued liabilities" on the condensed consolidated balance sheets. At September 28, 2018, and December 29, 2017, the Company included $46 million and $169 million, respectively, of outstanding payments within "Cash and cash equivalents."
Receivables
The Company's receivables include amounts billed and currently due from customers, amounts billable where the right to consideration is unconditional and amounts unbilled. Amounts billable and unbilled amounts are recognized at estimated realizable value and consist of costs and fees, substantially all of which are expected to be billed and collected generally within one year. Unbilled amounts also include rate variances that are billable upon negotiation of final indirect rates with the DCAA.
The typical billing for the Company's cost-reimbursable and T&M contracts is as costs are incurred. FFP contracts are billed either based on milestones, which are the achievement of specific events as defined in the contract, or based on progress payments, which are interim payments up to a designated amount of costs incurred as work progresses. On certain contracts, the customer withholds a certain percentage of the contract price (retainage). These withheld amounts are included within the Company's unbilled receivables and are billed upon contract completion or the occurrence of a specified event, and when negotiation of final indirect rates with the U.S. government is complete. Based on the Company's historical experience, the write-offs of retention balances have not been significant.
When events or conditions indicate that amounts outstanding from customers may become uncollectible, an allowance is estimated and recorded.
Amounts billed and collected on contracts but not yet recorded as revenue because the Company has not performed its obligation under the arrangement with a customer are deferred and included within "Accounts payable and accrued liabilities" or "Other long-term liabilities" on the condensed consolidated balance sheets.
Note 4–Revenues
Dual Reporting
The effects to the condensed consolidated financial statements at and as of September 28, 2018, as a result of applying ASC 606, rather than previous GAAP ("ASC 605"), were the following:
Balance Sheet
As Reported (ASC 606) | As Adjusted (ASC 605) | |||||||
(in millions) | ||||||||
Receivables, net | $ | 1,812 | $ | 1,807 | ||||
Inventory, prepaid expenses and other current assets | 456 | 458 | ||||||
Accumulated earnings (deficit) | 231 | 228 | ||||||
Income Statement
Three Months Ended September 28, 2018 | Nine Months Ended September 28, 2018 | |||||||||||||||
As Reported (ASC 606) | As Adjusted (ASC 605) | As Reported (ASC 606) | As Adjusted (ASC 605) | |||||||||||||
(in millions) | ||||||||||||||||
Revenues | $ | 2,575 | $ | 2,574 | $ | 7,547 | $ | 7,542 | ||||||||
Cost of revenues | 2,174 | 2,175 | 6,412 | 6,410 | ||||||||||||
Operating income | 203 | 201 | 561 | 558 | ||||||||||||
11
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The changes reflected above were primarily due to the Company's units-of-delivery contracts, which were recognized at a point in time under ASC 605 and are recognized using an over-time model under ASC 606.
Remaining Performance Obligations
Remaining performance obligations represent the expected value of exercised contracts, both funded and unfunded, less revenue recognized to date. Remaining performance obligations do not include unexercised option periods and future potential task orders expected to be awarded under IDIQ contracts.
As of September 28, 2018, the Company had $10.8 billion of remaining performance obligations, which are expected to be recognized as revenue in the amounts of $2.4 billion, $5.2 billion and $3.2 billion for the remainder of fiscal 2018, fiscal 2019 and fiscal 2020 and thereafter, respectively.
Disaggregation of Revenues
The Company disaggregates revenues by customer-type, contract-type and geographic location for each of its reportable segments. These categories represent how the nature, timing and uncertainty of revenues and cash flows are affected by the U.S. government procurement environment.
Disaggregated revenues by customer-type were as follows:
Three Months Ended September 28, 2018 | ||||||||||||||||
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
DoD | $ | 1,091 | $ | 40 | $ | 88 | $ | 1,219 | ||||||||
Other government agencies(1) | 49 | 610 | 312 | 971 | ||||||||||||
Commercial and non-U.S. customers | 109 | 232 | 44 | 385 | ||||||||||||
Total | $ | 1,249 | $ | 882 | $ | 444 | $ | 2,575 | ||||||||
Nine Months Ended September 28, 2018 | ||||||||||||||||
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
DoD | $ | 3,222 | $ | 89 | $ | 262 | $ | 3,573 | ||||||||
Other government agencies(1) | 144 | 1,773 | 937 | 2,854 | ||||||||||||
Commercial and non-U.S. customers | 317 | 682 | 121 | 1,120 | ||||||||||||
Total | $ | 3,683 | $ | 2,544 | $ | 1,320 | $ | 7,547 | ||||||||
(1) Includes non-DoD federal government agencies, state and local government agencies.
The majority of the Company's revenues is generated from U.S. government contracts, either as a prime contractor or as a subcontractor to other contractors. Revenues from the U.S. government can be adversely impacted by spending caps or changes in budgetary priorities of the U.S. government, as well as delays in program start dates or the award of a contract. Government spending levels for the DoD may be impacted by spending priorities as a result of competing demands for federal funds.
12
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Disaggregated revenues by contract-type were as follows:
Three Months Ended September 28, 2018 | ||||||||||||||||
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
Cost-reimbursement and fixed-price-incentive fee | $ | 919 | $ | 465 | $ | 42 | $ | 1,426 | ||||||||
Firm-fixed-price | 211 | 279 | 277 | 767 | ||||||||||||
Time and materials and fixed-price-level-of-effort | 119 | 138 | 125 | 382 | ||||||||||||
Total | $ | 1,249 | $ | 882 | $ | 444 | $ | 2,575 | ||||||||
Nine Months Ended September 28, 2018 | ||||||||||||||||
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
Cost-reimbursement and fixed-price-incentive fee | $ | 2,550 | $ | 1,379 | $ | 134 | $ | 4,063 | ||||||||
Firm-fixed-price | 753 | 738 | 814 | 2,305 | ||||||||||||
Time and materials and fixed-price-level-of-effort | 380 | 427 | 372 | 1,179 | ||||||||||||
Total | $ | 3,683 | $ | 2,544 | $ | 1,320 | $ | 7,547 | ||||||||
Cost-reimbursement and FP-IF contracts are generally lower risk and have lower profits. T&M and FP-LOE contracts are also low risk but profits may vary depending on actual labor costs compared to negotiated contract billing rates. FFP contracts offer the potential for higher profits while increasing the Company’s exposure to risk of cost overruns.
Disaggregated revenues by geographic location were as follows:
Three Months Ended September 28, 2018 | ||||||||||||||||
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
United States | $ | 1,156 | $ | 739 | $ | 444 | $ | 2,339 | ||||||||
International | 93 | 143 | — | 236 | ||||||||||||
Total | $ | 1,249 | $ | 882 | $ | 444 | $ | 2,575 | ||||||||
Nine Months Ended September 28, 2018 | ||||||||||||||||
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
United States | $ | 3,408 | $ | 2,128 | $ | 1,320 | $ | 6,856 | ||||||||
International | 275 | 416 | — | 691 | ||||||||||||
Total | $ | 3,683 | $ | 2,544 | $ | 1,320 | $ | 7,547 | ||||||||
The Company's international business operations are subject to additional and different risks than its U.S. business. Failure to comply with U.S government laws and regulations applicable to international business, such as the Foreign Corrupt Practices Act or U.S. export control regulations, could have an adverse impact on the Company's business with the U.S. government.
In some countries, there is an increased chance for economic, legal or political changes that may adversely affect the performance of the Company's services, sales of products or repatriation of profits. International transactions can also involve increased financial and legal risks arising from foreign exchange variability, imposition of tariffs or additional taxes and restrictive trade policies, and delays or failure to collect amounts due to differing legal systems.
13
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 5–Contract Assets and Liabilities
The Company’s performance obligations are satisfied either over time as work progresses or at a point in time. Fixed-price contracts are typically billed to the customer using milestone payments while cost-reimbursable and T&M contracts are typically billed to the customer on a monthly or bi-weekly basis as indicated by the negotiated billing terms and conditions of the contract. As a result, for each of the company’s contracts, the timing of revenue recognition, customer billings and cash collections results in a net contract asset or liability at the end of each reporting period.
Contract assets include unbilled receivables, which is the amount of revenue recognized that exceeds the amount billed to the customer, where right to payment is not just subject to the passage of time. Contract assets also include transition costs and project assets. Transition costs represent costs that are incurred under certain service based contracts, usually at the beginning of the contract performance, to transition the services, employees and equipment from the customer or prior contractor. Project assets represent assets that are specific to contracts.
Contract liabilities consist of deferred revenue.
The components of contract assets and contract liabilities consisted of the following:
Balance sheet line item | September 28, 2018 | December 30, 2017(1) | ||||||||
(in millions) | ||||||||||
Contract assets - current: | ||||||||||
Unbilled receivables(2) | Receivables, net | $ | 711 | $ | 844 | |||||
Transition costs and project assets | Inventory, prepaid expenses and other current assets | 102 | 59 | |||||||
$ | 813 | $ | 903 | |||||||
Contract assets - non-current: | ||||||||||
Transition costs | Other assets | $ | 11 | $ | 13 | |||||
Contract liabilities - current: | ||||||||||
Deferred revenue | Accounts payable and accrued liabilities | $ | 362 | $ | 293 | |||||
Contract liabilities - non-current: | ||||||||||
Deferred revenue | Other long-term liabilities | $ | 12 | $ | 17 | |||||
(1) Includes the cumulative effect of the changes made to the Company's opening balance sheet at December 30, 2017, as a result of the adoption of ASU 2014-09, Revenue from Contracts with Customers (Topic 606).
(2) Balances exclude $506 million and $234 million determined to be billable at September 28, 2018, and December 30, 2017, respectively.
The decrease in unbilled receivables was primarily due to the timing of billings and revenue recognized on certain contracts. The increase in transition costs and project assets was primarily due to purchases on certain contracts partially offset by amortization. The increase in deferred revenue was primarily due to timing of advance payments from customers partially offset by revenue recognized during the period.
During the quarter and nine months ended September 28, 2018, the Company recognized revenue of $37 million and $164 million, respectively, relating to amounts that were included as a contract liability at December 30, 2017.
During the quarter and nine months ended September 28, 2018, the Company recognized $43 million and $83 million of amortization, respectively, related to its transition costs and project assets. The Company did not recognize any impairment losses on contract assets for the quarter and nine months ended September 28, 2018.
Note 6–Acquisitions
On August 16, 2016, a wholly-owned subsidiary of Leidos Holdings, Inc. merged with the IS&GS Business in a Reverse Morris Trust transaction (the "Transactions"). The acquired IS&GS Business was renamed Leidos Innovations Corporation.
14
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
On January 10, 2018, the final amount of the net working capital of the IS&GS Business was determined through a binding arbitration proceeding in accordance with the Separation Agreement with Lockheed Martin. On January 18, 2018, the final working capital amount of $105 million was paid to Lockheed Martin, of which $24 million and $81 million was presented as cash flows from operating and investing activities, respectively, in the Company's condensed consolidated statement of cash flows.
During the quarter ended June 29, 2018, a tax indemnification liability of $23 million was paid to Lockheed Martin in accordance with the Tax Matters Agreement, which was presented as cash flows from financing activities in the Company's condensed consolidated statement of cash flows.
The Company incurred the following expenses related to the acquisition and integration of the IS&GS Business:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||||||
(in millions) | ||||||||||||||||
Acquisition costs | $ | — | $ | — | $ | — | $ | 1 | ||||||||
Integration costs | 4 | 21 | 26 | 55 | ||||||||||||
Total acquisition and integration costs | $ | 4 | $ | 21 | $ | 26 | $ | 56 | ||||||||
These acquisition and integration costs have been recorded within Corporate and presented in "Integration and restructuring costs" on the condensed consolidated statements of income.
Note 7–Divestitures
Commercial Cybersecurity Business
On June 5, 2018, the Company entered into a Stock and Asset Purchase Agreement to sell the Company's commercial cybersecurity business, included within the Company's Civil segment, in order to focus on providing solutions, including cybersecurity, to the Company's core markets of governments and highly regulated industries. The sale is expected to be completed during fiscal 2018 and is not expected to result in a loss. The Company has presented the associated assets and liabilities of the business as held for sale in the Company's condensed consolidated balance sheet as of September 28, 2018. The major classes of assets and liabilities classified as held for sale were as follows:
September 28, 2018 | ||||
(in millions) | ||||
Receivables, net | $ | 21 | ||
Inventory, prepaid expenses and other current assets | 3 | |||
Property, plant and equipment, net | 3 | |||
Intangible assets, net | 5 | |||
Goodwill | 57 | |||
Deferred tax assets | 9 | |||
Total assets held for sale | $ | 98 | ||
Accounts payable and accrued liabilities | $ | 14 | ||
Accrued payroll and employee benefits | 5 | |||
Other long-term liabilities | 5 | |||
Total liabilities held for sale | $ | 24 | ||
The planned disposition does not represent a strategic shift in operations that will have a material effect on the Company's operations and financial results, and accordingly was not presented as discontinued operations.
15
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Plainfield Renewable Energy Holdings LLC
On July 24, 2015, the Company completed the sale of its equity interest in Plainfield Renewable Energy Holdings LLC ("Plainfield") for an aggregate consideration of $102 million, subject to certain adjustments and contingent earn-out payments. The consideration received by the Company at closing consisted of a cash payment of $29 million and a secured promissory note for $73 million, net of discount (the "Note"). During the quarter ended March 31, 2017, the Company collected $6 million of principal and interest on the Note.
During the quarter ended June 30, 2017, Plainfield exercised the first of three one-year term extension options available under the original credit agreement, thereby extending the maturity date of the Note to July 24, 2018. Concurrent with this extension, the interest rate on the Note increased from 6% to 8%. Also, during the quarter ended June 30, 2017, Leidos and Plainfield entered into an amendment to the Note allowing Plainfield to defer up to $4 million of the interest and principal payments due in July 2017 and January 2018 until July 2018. In consideration of this deferment, Leidos received certain concessions and releases from obligations under the original transaction documents.
In January 2018, the Company entered into negotiations with the equity owners of Plainfield regarding the Plainfield Recapitalization Plan ("Plan"). The Plan envisioned raising new equity combined with reduction of Plainfield's debt. The net realizable value of the Note at December 29, 2017, was estimated to be approximately $40 million, compared to its carrying value of $73 million, including accrued interest. As a result, the Company recorded a $33 million impairment of its Note during the quarter ended December 29, 2017, which was presented within "Other income, net" in the Company's condensed consolidated statement of income.
On July 12, 2018, Leidos and Plainfield entered into an additional amendment to the Note, allowing Plainfield to defer the maturity of the Note until the earlier of August 24, 2018, or the date Plainfield successfully closed on a refinancing agreement with a third party. Under the terms of the agreement, if Plainfield successfully refinanced the Note prior to August 24, 2018, Leidos would allow Plainfield to settle the Note in full for $40 million plus 50% of additional net proceeds obtained by Plainfield. On August 23, 2018, Leidos and Plainfield entered into an agreement with respect to the final payoff of the Note. As a result, the Company received proceeds of $40 million in full satisfaction of Plainfield’s obligations under the Note.
Note 8–Restructuring Expenses
After the acquisition of the IS&GS Business, the Company began an initiative to reduce its cost structure, which includes optimization of its real estate portfolio by vacating certain facilities and consolidating others, and by reducing headcount.
The restructuring expenses related to this program were as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||||||
(in millions) | ||||||||||||||||
Severance costs | $ | 1 | $ | 2 | $ | 2 | $ | 14 | ||||||||
Lease termination expenses | 2 | 4 | 4 | 11 | ||||||||||||
Restructuring expenses related to the IS&GS Business | $ | 3 | $ | 6 | $ | 6 | $ | 25 | ||||||||
As of September 28, 2018, Leidos has recognized a total of $55 million of expense in connection with these restructuring activities. These restructuring expenses have been recorded within Corporate and presented in "Integration and restructuring costs" on the condensed consolidated statements of income.
16
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The restructuring liability related to this program was as follows:
Severance Costs | Lease Termination Expenses | Total | ||||||||||
(in millions) | ||||||||||||
Balance as of December 30, 2016 | $ | 7 | $ | 1 | $ | 8 | ||||||
Charges | 18 | 19 | 37 | |||||||||
Cash payments | (20 | ) | (16 | ) | (36 | ) | ||||||
Balance as of December 29, 2017 | 5 | 4 | 9 | |||||||||
Charges | 2 | 4 | 6 | |||||||||
Cash payments | (7 | ) | (4 | ) | (11 | ) | ||||||
Balance as of September 28, 2018 | $ | — | $ | 4 | $ | 4 | ||||||
Note 9–Goodwill
The following table presents changes in the carrying amount of goodwill by reportable segment:
Defense Solutions | Civil | Health | Total | |||||||||||||
(in millions) | ||||||||||||||||
Goodwill at December 30, 2016 | $ | 1,954 | $ | 1,731 | $ | 937 | $ | 4,622 | ||||||||
Adjustment to original purchase price allocation | 94 | 259 | (16 | ) | 337 | |||||||||||
Foreign currency translation adjustments | 7 | 8 | — | 15 | ||||||||||||
Goodwill at December 29, 2017 | 2,055 | 1,998 | 921 | 4,974 | ||||||||||||
Foreign currency translation adjustments | (31 | ) | (5 | ) | — | (36 | ) | |||||||||
Transfers to assets held for sale | — | (57 | ) | — | (57 | ) | ||||||||||
Goodwill at September 28, 2018 | $ | 2,024 | $ | 1,936 | $ | 921 | $ | 4,881 | ||||||||
Accumulated goodwill impairment losses were $369 million and $117 million included within the Health and Civil segments, respectively, at September 28, 2018, December 29, 2017, and December 30, 2016.
Goodwill is tested for impairment at the beginning of the fourth quarter and during interim periods whenever events or circumstances indicate that the carrying value may not be recoverable. There were no goodwill impairments during the nine months ended September 28, 2018, and September 29, 2017.
Note 10–Intangible Assets
Intangible assets consisted of the following:
September 28, 2018 | December 29, 2017 | |||||||||||||||||||||||
Gross carrying value | Accumulated amortization | Net carrying value | Gross carrying value | Accumulated amortization | Net carrying value | |||||||||||||||||||
(in millions) | ||||||||||||||||||||||||
Finite-lived intangible assets: | ||||||||||||||||||||||||
Program and contract intangibles | $ | 1,004 | $ | (327 | ) | $ | 677 | $ | 1,013 | $ | (187 | ) | $ | 826 | ||||||||||
Software and technology | 92 | (71 | ) | 21 | 89 | (64 | ) | 25 | ||||||||||||||||
Customer relationships | 4 | (4 | ) | — | 4 | (3 | ) | 1 | ||||||||||||||||
Backlog | — | — | — | 158 | (158 | ) | — | |||||||||||||||||
Total finite-lived intangible assets | 1,100 | (402 | ) | 698 | 1,264 | (412 | ) | 852 | ||||||||||||||||
Indefinite-lived intangible assets: | ||||||||||||||||||||||||
Trade names | 4 | — | 4 | 4 | — | 4 | ||||||||||||||||||
Total intangible assets | $ | 1,104 | $ | (402 | ) | $ | 702 | $ | 1,268 | $ | (412 | ) | $ | 856 | ||||||||||
17
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Amortization expense was $50 million and $151 million for the quarter and nine months ended September 28, 2018, respectively, and $76 million and $212 million for the quarter and nine months ended September 29, 2017, respectively.
Program and contract intangible assets are amortized over their respective estimated useful lives in proportion to the pattern of economic benefit based on expected future discounted cash flows. Customer relationships and backlog intangible assets are amortized on a straight-line basis over their estimated useful lives. Software and technology intangible assets are amortized either on a straight-line basis over their estimated useful lives or over their respective estimated useful lives in proportion to the pattern of economic benefit based on expected future discounted cash flows, as deemed appropriate.
The estimated annual amortization expense as of September 28, 2018, was as follows:
Fiscal Year Ending | ||||
(in millions) | ||||
2018 (remainder of year) | $ | 50 | ||
2019 | 171 | |||
2020 | 126 | |||
2021 | 106 | |||
2022 | 92 | |||
2023 and thereafter | 153 | |||
$ | 698 | |||
Note 11–Property, Plant and Equipment
Property, plant and equipment, net consisted of the following:
September 28, 2018 | December 29, 2017 | |||||||
(in millions) | ||||||||
Computers and other equipment | $ | 195 | $ | 194 | ||||
Leasehold improvements | 195 | 171 | ||||||
Buildings and improvements | 56 | 54 | ||||||
Construction in progress | 50 | 44 | ||||||
Land | 40 | 49 | ||||||
Office furniture and fixtures | 35 | 34 | ||||||
571 | 546 | |||||||
Less: accumulated depreciation | (341 | ) | (314 | ) | ||||
$ | 230 | $ | 232 | |||||
Depreciation expense was $14 million and $42 million for the quarter and nine months ended September 28, 2018, respectively, and $16 million and $42 million for the quarter and nine months ended September 29, 2017, respectively.
On July 23, 2018, the Company entered into a Contract of Sale to sell and lease back one of its properties included within Corporate. The sale is expected to be completed during fiscal 2018 at which time the leaseback term will begin. The term of the lease is expected to end during fiscal 2020.
During the quarter ended March 30, 2018, the Company determined that the carrying amount of a real estate property may not be recoverable and as a result recorded an impairment charge of $7 million, which was recorded within Corporate.
18
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 12–Fair Value Measurements
The accounting standard for fair value measurements establishes a three-level fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: observable inputs such as quoted prices in active markets (Level 1); inputs other than quoted prices in active markets for identical assets or liabilities that are observable either directly or indirectly or quoted prices that are not active (Level 2); and unobservable inputs in which there is little or no market data (e.g., discounted cash flow and other similar pricing models), which requires the Company to develop its own assumptions (Level 3).
The accounting guidance for fair value measurements requires that the Company maximize the use of observable inputs and minimize the use of unobservable inputs in determining fair value. The accounting guidance provides for the irrevocable option to elect, on a contract-by-contract basis, to measure certain financial assets and liabilities at fair value at inception of the contract and record any subsequent changes in fair value in earnings. The Company has not made fair value option elections on any of its financial assets and liabilities.
The Company's financial instruments measured at fair value on a recurring basis consisted of the following:
September 28, 2018 | December 29, 2017 | |||||||||||||||
Carrying value | Fair value | Carrying value | Fair value | |||||||||||||
(in millions) | ||||||||||||||||
Financial assets: | ||||||||||||||||
Derivatives | $ | — | $ | — | $ | 37 | $ | 37 | ||||||||
Financial liabilities: | ||||||||||||||||
Derivatives | 14 | 14 | — | — | ||||||||||||
The Company's derivatives consisted of the fair value interest rate swaps on its $450 million, fixed rate 4.45% senior secured notes maturing in December 2020 and cash flow interest rate swaps on $1.5 billion of the Company's variable rate senior secured term loans (see "Note 13–Derivative Instruments"). The fair value of the fair value interest rate swaps and cash flow interest rate swaps is determined based on observed values for underlying interest rates on the LIBOR yield curve and the underlying interest rate, respectively (Level 2 inputs).
The carrying amounts of the Company's financial instruments, other than derivatives, which include cash equivalents, accounts receivable, accounts payable and accrued expenses, are reasonable estimates of their related fair values. The carrying value of the Company's notes receivable of $24 million and $63 million as of September 28, 2018, and December 29, 2017, respectively, approximates fair value as the stated interest rates within the agreements are consistent with the current market rates used in notes with similar terms in the market (Level 2 inputs).
As of September 28, 2018, and December 29, 2017, the fair value of debt was $3.1 billion and $3.2 billion, respectively, and the carrying amount was $3.0 billion and $3.1 billion, respectively (see "Note 14–Debt"). The fair value of long-term debt is determined based on current interest rates available for debt with terms and maturities similar to the Company’s existing debt arrangements (Level 2 inputs).
At March 30, 2018, the Company had a real estate property measured at fair value (Level 2), which resulted in an impairment charge of $7 million (see "Note 11–Property, Plant and Equipment"). The Company did not have any assets or liabilities measured at fair value on a non-recurring basis at September 28, 2018.
Note 13–Derivative Instruments
The Company manages its risk to changes in interest rates through the use of derivative instruments. The Company does not hold derivative instruments for trading or speculative purposes. For fixed rate borrowings, the Company uses variable interest rate swaps, effectively converting fixed rate borrowings to variable rate borrowings. These swaps are designated as fair value hedges. For variable rate borrowings, the Company uses fixed interest rate swaps, effectively converting a portion of the variable interest rate payments to fixed interest rate payments. These swaps are designated as cash flow hedges.
19
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
The fair value of the Company's interest rate swaps was as follows:
Asset Derivatives | ||||||||||
Balance sheet line item | September 28, 2018 | December 29, 2017 | ||||||||
(in millions) | ||||||||||
Cash flow interest rate swaps | Other assets | $ | — | $ | 37 | |||||
Liability Derivatives | ||||||||||
Balance sheet line item | September 28, 2018 | December 29, 2017 | ||||||||
(in millions) | ||||||||||
Fair value interest rate swaps | Other long-term liabilities | $ | 8 | $ | — | |||||
Cash flow interest rate swaps | Other long-term liabilities | 6 | — | |||||||
$ | 14 | $ | — | |||||||
The cash flows associated with the interest rate swaps are classified as operating activities in the condensed consolidated statements of cash flows.
Fair Value Hedge
The Company has interest rate swap agreements to hedge the fair value of the $450 million fixed rate 4.45% senior secured notes maturing in December 2020 (the "Notes"). The objective of these instruments is to hedge the Notes against changes in fair value due to the variability in the six-month LIBOR rate (the benchmark interest rate). Under the terms of the interest rate swap agreements, the Company will receive semi-annual interest payments at the coupon rate of 4.45% and will pay variable interest based on the six-month LIBOR rate.
The interest rate swaps were accounted for as a fair value hedge of the Notes and qualified for the shortcut method of hedge accounting, which allows for the assumption of no ineffectiveness. The resulting changes in the fair value of the interest rate swaps are fully offset by the changes in the fair value of the underlying debt (the hedged item) (See "Note 14–Debt").
The fair value of the Notes is stated at an amount that reflects changes in the six-month LIBOR rate subsequent to the inception of the interest rate swaps through the reporting date.
The following amounts were recorded on the condensed consolidated balance sheets related to cumulative basis adjustments for fair value hedges:
Carrying amount of hedged item | Cumulative amount of fair value adjustment included within the hedged item | |||||||||||||||
Balance sheet line item of hedged item | September 28, 2018 | December 29, 2017 | September 28, 2018 | December 29, 2017 | ||||||||||||
(in millions) | ||||||||||||||||
Long-term debt, net of current portion | $ | 441 | $ | 449 | $ | (8 | ) | $ | — | |||||||
Cash Flow Hedges
The Company has interest rate swap agreements to hedge the cash flows of a portion of its variable rate senior secured term loans (the "Variable Rate Loans"). The objective of these instruments is to reduce variability in the forecasted interest payments of the Company's Variable Rate Loans, which are based on the LIBOR rate. Under the terms of the interest rate swap agreements, the Company will receive monthly variable interest payments based on the one-month LIBOR rate and will pay interest at a fixed rate. In February 2018, the Company entered into interest rate swap agreements to hedge the cash flows of an additional $250 million of its Variable Rate Loans. The interest rate swap agreements on $1.1 billion of the Company's Variable Rate Loans had a maturity date of December 2021 and a fixed interest rate of 1.08%. The interest rate swap agreements on $300 million and $250 million of the Company's Variable Rate Loans both had a maturity date of August 2022 and fixed interest rates of 1.66% and 2.59%, respectively.
20
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In September 2018, the Company terminated its existing interest rate swaps. The net derivative gain of $60 million related to the discontinued cash flow hedge will continue to be reported within accumulated other comprehensive income and will be reclassified into earnings over the remaining life of the original hedge as the hedged variable rate debt impacts earnings.
Additionally, in September 2018, the Company entered into new interest rate swap agreements to hedge the cash flows of $1.5 billion of the Company's Variable Rate Loans. These interest rate swap agreements have a maturity date of August 2025 and a fixed interest rate of 3.00%. The interest rate swap transactions were accounted for as cash flow hedges. The gain/loss on the swap is reported as a component of other comprehensive income/loss and is reclassified into earnings when the interest payments on the underlying hedged items impact earnings. A qualitative assessment of hedge effectiveness is performed on a quarterly basis, unless facts and circumstances indicate the hedge may no longer be highly effective.
The effect of the Company's cash flow hedges on other comprehensive income and earnings for the periods presented was as follows:
Three Months Ended | Nine Months Ended | |||||||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||||||
(in millions) | ||||||||||||||||
Total interest expense, net presented in the condensed consolidated statements of income in which the effects of cash flow hedges are recorded | $ | 35 | $ | 35 | $ | 104 | $ | 105 | ||||||||
Amount recognized in other comprehensive income | 1 | 3 | 22 | — | ||||||||||||
Amount reclassified from accumulated other comprehensive income to interest expense, net | (3 | ) | — | (6 | ) | 1 | ||||||||||
The Company expects to reclassify gains of $11 million from accumulated other comprehensive income into earnings during the next 12 months.
21
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 14–Debt
The Company's debt consisted of the following:
Stated interest rate | Effective interest rate | September 28, 2018(1) | December 29, 2017(1) | |||||||||
(in millions) | ||||||||||||
Senior secured notes: | ||||||||||||
$450 million notes, due December 2020 | 4.45% | 4.53% | $ | 441 | $ | 449 | ||||||
$300 million notes, due December 2040 | 5.95% | 6.03% | 216 | 216 | ||||||||
Senior secured term loans: | ||||||||||||
$690 million Term Loan A, due August 2023 | 3.75% | 4.19% | 617 | 644 | ||||||||
$310 million Term Loan A, due August 2023 | 3.75% | 4.18% | 258 | 270 | ||||||||
$1,131 million Term Loan B, due August 2025 | 4.00% | 4.34% | 1,086 | 1,101 | ||||||||
Senior unsecured notes: | ||||||||||||
$250 million notes, due July 2032 | 7.13% | 7.43% | 246 | 246 | ||||||||
$300 million notes, due July 2033 | 5.50% | 5.88% | 158 | 158 | ||||||||
Capital leases and notes payable due on various dates through fiscal 2022 | 0%-5.55% | Various | 19 | 27 | ||||||||
Total long-term debt | 3,041 | 3,111 | ||||||||||
Less: current portion | 56 | 55 | ||||||||||
Total long-term debt, net of current portion | $ | 2,985 | $ | 3,056 | ||||||||
(1) The carrying amounts of the senior secured term loans and notes and unsecured notes as of September 28, 2018, and December 29, 2017, include the remaining principal outstanding of $3,073 million and $3,129 million, respectively, less total unamortized debt discounts and deferred debt issuances costs of $43 million and $45 million, respectively, less $8 million related to the fair value interest rate swaps (see "Note 13–Derivative Instruments") as of September 28, 2018.
In August 2018, Leidos amended its senior secured term loans and revolving credit facility agreements. These amendments modified the margin range for the revolving credit facility and Term Loan A loans and extended their maturity dates by one year to August 2023. The amendments also extended the maturity date of Term Loan B by two years to August 2025 and delayed the scheduled increase in quarterly principal payments for Term Loan A by one year to March 2021. Additionally, the Senior Secured Leverage ratio calculation was amended and now excludes the lesser of $350 million and the Company's unrestricted cash and cash equivalents.
In March 2018, Leidos amended the terms of its senior secured $1.1 billion Term Loan B. As a result, the margin on Term Loan B was reduced by 25 basis points to 1.75%. The repricing of the term loan became effective March 15, 2018.
The interest rate on the Company's senior secured term loans is determined based on the LIBOR rate plus a margin. The margin for the Term Loan A loans ranges from 1.25% to 2.00%, depending on the Company's senior secured leverage ratio, and is computed on a quarterly basis. At September 28, 2018, the current margin on Term Loan A was 1.50%.
The Company made required quarterly principal payments on its senior secured term loans of $15 million and $46 million during the quarter and nine months ended September 28, 2018, respectively, and $20 million and $61 million during the quarter and nine months ended September 29, 2017, respectively. In April 2018, the Company made a required debt prepayment of $10 million on its senior secured term loans. The prepayment was a result of the annual excess cash flow calculation clause in the Company's credit agreements. In addition to the required payments on its term loans, the Company prepaid $105 million and $130 million during the quarter and nine months ended September 29, 2017.
The Company has a revolving credit facility providing up to $750 million in secured borrowing capacity at interest rates determined based upon the LIBOR rate plus a margin that is subject to step-down provisions based on the Company's senior secured leverage ratio. The maturity date of this credit facility is August 2023. As of September 28, 2018, and December 29, 2017, there were no borrowings outstanding under the credit facility.
22
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
In connection with the August 2018 amendments, the Company incurred $5 million of debt issuance costs related to the senior secured term loans and revolving credit facility, which were recorded as an offset against the carrying value of debt and capitalized within "Other assets", respectively, in the condensed consolidated balance sheets. Amortization of the debt discount and deferred debt issuance costs related to the senior secured term loans and notes, unsecured notes and revolving credit facility was $2 million and $8 million for the quarter and nine months ended September 28, 2018, respectively, and $3 million and $10 million for the quarter and nine months ended September 29, 2017, respectively.
The senior secured term loans and notes, unsecured notes and revolving credit facility are fully and unconditionally guaranteed and contain certain customary restrictive covenants, including among other things, restrictions on the Company's ability to create liens and enter into sale and leaseback transactions under certain circumstances. The Company was in compliance with all covenants as of September 28, 2018.
Note 15–Accumulated Other Comprehensive Income
Changes in the components of accumulated other comprehensive income were as follows:
Foreign currency translation adjustments | Unrecognized gain on derivative instruments | Pension adjustments | Total accumulated other comprehensive income | |||||||||||||
(in millions) | ||||||||||||||||
Balance at December 30, 2016 | $ | (7 | ) | $ | 10 | $ | (7 | ) | $ | (4 | ) | |||||
Other comprehensive income | 36 | 10 | 9 | 55 | ||||||||||||
Taxes | (12 | ) | (6 | ) | — | (18 | ) | |||||||||
Balance at December 29, 2017 | 17 | 14 | 2 | 33 | ||||||||||||
Cumulative adjustments related to ASU adoptions (Note 2) | 3 | 10 | (4 | ) | 9 | |||||||||||
Balance at December 30, 2017 | 20 | 24 | (2 | ) | 42 | |||||||||||
Other comprehensive (loss) income | (46 | ) | 22 | — | (24 | ) | ||||||||||
Taxes | 5 | (4 | ) | — | 1 | |||||||||||
Reclassification from accumulated other comprehensive income | — | (6 | ) | — | (6 | ) | ||||||||||
Balance at September 28, 2018 | $ | (21 | ) | $ | 36 | $ | (2 | ) | $ | 13 | ||||||
Reclassifications from unrecognized gain on derivative instruments are recorded in "Interest expense, net" in the Company's condensed consolidated statements of income.
Note 16–Earnings Per Share ("EPS")
The following table provides a reconciliation of the weighted average number of shares outstanding used to compute basic and diluted EPS for the periods presented:
Three Months Ended | Nine Months Ended | |||||||||||
September 28, 2018 | September 29, 2017 | September 28, 2018 | September 29, 2017 | |||||||||
(in millions) | ||||||||||||
Basic weighted average number of shares outstanding | 151 | 152 | 152 | 151 | ||||||||
Dilutive common share equivalents—stock options and other stock awards | 2 | 2 | 2 | 2 | ||||||||
Diluted weighted average number of shares outstanding | 153 | 154 | 154 | 153 | ||||||||
During the quarter and nine months ended September 28, 2018, the Company made open market repurchases of its common stock for an aggregate purchase price of $62 million and $162 million, respectively. All shares repurchased were immediately retired.
23
LEIDOS HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 17–Supplementary Cash Flow Information and Restricted Cash
Supplementary cash flow information, and non-cash activities, for the periods presented was as follows:
Nine Months Ended | ||||||||
September 28, 2018 | September 29, 2017 | |||||||
(in millions) | ||||||||
Supplementary cash flow information: | ||||||||
Cash paid for interest | $ | 101 | $ | 78 | ||||
Cash paid for income taxes, net of refunds | 68 | 158 | ||||||
Non-cash financing activity: | ||||||||
Purchase of a non-controlling interest | 3 | — | ||||||
Capital lease obligation | — | 6 | ||||||
The following is a reconciliation of cash and cash equivalents, as reported within the condensed consolidated balance sheets, to the total cash, cash equivalents and restricted cash, as reported within the condensed consolidated statements of cash flows: