COMTECH TELECOMMUNICATIONS CORP /DE/ - Quarter Report: 2019 October (Form 10-Q)
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q |
(Mark One)
 | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
For the quarterly period ended October 31, 2019
 | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 |
Commission File Number: 0-7928
(Exact name of registrant as specified in its charter)
Delaware | 11-2139466 | |
(State or other jurisdiction of incorporation /organization) | (I.R.S. Employer Identification Number) | |
68 South Service Road, Suite 230, Melville, NY | 11747 | |
(Address of principal executive offices) | (Zip Code) | |
(631) 962-7000 |
(Registrant’s telephone number, including area code) |
Securities registered pursuant to Section 12(b) of the Act: | ||
Title of each class | Trading Symbol(s) | Name of exchange on which registered |
Common Stock, par value $0.10 per share | CMTL | NASDAQ Stock Market LLC |
Series A Junior Participating Cumulative Preferred Stock, par value $0.10 per share | ||
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 NoIndicate by check mark whether the registrant has submitted electronically, every Interactive Data file required to be submitted 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 such files).
Yes NoIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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 | | Accelerated filer | | Emerging growth company | |
Non-accelerated filer | | Smaller reporting company | | ||
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes NoAs of November 29, 2019, the number of outstanding shares of Common Stock, par value $0.10 per share, of the registrant was 24,389,774 shares.
COMTECH TELECOMMUNICATIONS CORP. INDEX | |||
Page | |||
PART I. FINANCIAL INFORMATION | |||
Item 1. | |||
Item 2. | |||
Item 3. | |||
Item 4. | |||
PART II. OTHER INFORMATION | |||
Item 1. | |||
Item 1A. | |||
Item 2. | |||
Item 4. | |||
Item 6. | |||
1
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
October 31, 2019 | July 31, 2019 | ||||||
Assets | |||||||
Current assets: | |||||||
Cash and cash equivalents | $ | 46,873,000 | 45,576,000 | ||||
Accounts receivable, net | 161,044,000 | 145,032,000 | |||||
Inventories, net | 71,810,000 | 74,839,000 | |||||
Prepaid expenses and other current assets | 15,995,000 | 14,867,000 | |||||
Total current assets | 295,722,000 | 280,314,000 | |||||
Property, plant and equipment, net | 26,873,000 | 28,026,000 | |||||
Operating lease right-of-use assets, net | 34,148,000 | — | |||||
Finance lease right-of-use assets, net | 447,000 | — | |||||
Goodwill | 309,871,000 | 310,489,000 | |||||
Intangibles with finite lives, net | 256,684,000 | 261,890,000 | |||||
Deferred financing costs, net | 2,943,000 | 3,128,000 | |||||
Other assets, net | 4,334,000 | 3,864,000 | |||||
Total assets | $ | 931,022,000 | 887,711,000 | ||||
Liabilities and Stockholders’ Equity | |||||||
Current liabilities: | |||||||
Accounts payable | $ | 29,380,000 | 24,330,000 | ||||
Accrued expenses and other current liabilities | 72,807,000 | 78,584,000 | |||||
Operating lease liabilities, current | 9,248,000 | — | |||||
Finance lease and other obligations, current | 567,000 | 757,000 | |||||
Dividends payable | 2,428,000 | 2,406,000 | |||||
Contract liabilities | 36,989,000 | 38,682,000 | |||||
Interest payable | 447,000 | 588,000 | |||||
Total current liabilities | 151,866,000 | 145,347,000 | |||||
Non-current portion of long-term debt | 169,000,000 | 165,000,000 | |||||
Operating lease liabilities, non-current | 27,725,000 | — | |||||
Income taxes payable | 2,298,000 | 325,000 | |||||
Deferred tax liability, net | 13,768,000 | 12,481,000 | |||||
Long-term contract liabilities | 11,457,000 | 10,654,000 | |||||
Other liabilities | 17,264,000 | 18,822,000 | |||||
Total liabilities | 393,378,000 | 352,629,000 | |||||
Commitments and contingencies (See Note 19) | |||||||
Stockholders’ equity: | |||||||
Preferred stock, par value $0.10 per share; shares authorized and unissued 2,000,000 | — | — | |||||
Common stock, par value $0.10 per share; authorized 100,000,000 shares; issued 39,402,226 shares and 39,276,161 shares at October 31, 2019 and July 31, 2019, respectively | 3,940,000 | 3,928,000 | |||||
Additional paid-in capital | 551,316,000 | 552,670,000 | |||||
Retained earnings | 424,237,000 | 420,333,000 | |||||
979,493,000 | 976,931,000 | ||||||
Less: | |||||||
Treasury stock, at cost (15,033,317 shares at October 31, 2019 and July 31, 2019) | (441,849,000 | ) | (441,849,000 | ) | |||
Total stockholders’ equity | 537,644,000 | 535,082,000 | |||||
Total liabilities and stockholders’ equity | $ | 931,022,000 | 887,711,000 | ||||
See accompanying notes to condensed consolidated financial statements.
2
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Net sales | $ | 170,267,000 | 160,844,000 | ||||
Cost of sales | 106,700,000 | 103,075,000 | |||||
Gross profit | 63,567,000 | 57,769,000 | |||||
Expenses: | |||||||
Selling, general and administrative | 31,851,000 | 31,847,000 | |||||
Research and development | 14,861,000 | 13,210,000 | |||||
Amortization of intangibles | 5,206,000 | 4,289,000 | |||||
Acquisition plan expenses | 2,389,000 | 1,130,000 | |||||
54,307,000 | 50,476,000 | ||||||
Operating income | 9,260,000 | 7,293,000 | |||||
Other expenses: | |||||||
Interest expense | 1,804,000 | 2,669,000 | |||||
Write-off of deferred financing costs | — | 3,217,000 | |||||
Interest (income) and other | (77,000 | ) | 66,000 | ||||
Income before provision for (benefit from) income taxes | 7,533,000 | 1,341,000 | |||||
Provision for (benefit from) income taxes | 1,145,000 | (2,127,000 | ) | ||||
Net income | $ | 6,388,000 | 3,468,000 | ||||
Net income per share (See Note 6): | |||||||
Basic | $ | 0.26 | 0.14 | ||||
Diluted | $ | 0.26 | 0.14 | ||||
Weighted average number of common shares outstanding – basic | 24,555,000 | 23,999,000 | |||||
Weighted average number of common and common equivalent shares outstanding – diluted | 24,737,000 | 24,375,000 | |||||
See accompanying notes to condensed consolidated financial statements.
3
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
THREE MONTHS ENDED OCTOBER 31, 2019 AND 2018
(Unaudited)
Common Stock | Additional Paid-in Capital | Retained Earnings | Treasury Stock | Stockholders' Equity | ||||||||||||||||||||||
Shares | Amount | Shares | Amount | |||||||||||||||||||||||
Balance as of July 31, 2018 | 38,860,571 | $ | 3,886,000 | $ | 538,453,000 | $ | 405,194,000 | 15,033,317 | $ | (441,849,000 | ) | $ | 505,684,000 | |||||||||||||
Equity-classified stock award compensation | — | — | 1,046,000 | — | — | — | 1,046,000 | |||||||||||||||||||
Proceeds from exercises of stock options | 6,100 | 1,000 | 173,000 | — | — | — | 174,000 | |||||||||||||||||||
Proceeds from issuance of employee stock purchase plan shares | 8,861 | 1,000 | 240,000 | — | — | — | 241,000 | |||||||||||||||||||
Issuance of restricted stock | 10,386 | 1,000 | (1,000 | ) | — | — | — | — | ||||||||||||||||||
Net settlement of stock-based awards | 52,926 | 5,000 | (2,059,000 | ) | — | — | — | (2,054,000 | ) | |||||||||||||||||
Cash dividends declared ($0.10 per share) | — | — | — | (2,381,000 | ) | — | — | (2,381,000 | ) | |||||||||||||||||
Accrual of dividend equivalents, net of reversal ($0.10 per share) | — | — | — | (82,000 | ) | — | — | (82,000 | ) | |||||||||||||||||
Net income | — | — | — | 3,468,000 | — | — | 3,468,000 | |||||||||||||||||||
Balance as of October 31, 2018 | 38,938,844 | $ | 3,894,000 | $ | 537,852,000 | $ | 406,199,000 | 15,033,317 | $ | (441,849,000 | ) | $ | 506,096,000 | |||||||||||||
Balance as of July 31, 2019 | 39,276,161 | $ | 3,928,000 | $ | 552,670,000 | $ | 420,333,000 | 15,033,317 | $ | (441,849,000 | ) | $ | 535,082,000 | |||||||||||||
Equity-classified stock award compensation | — | — | 879,000 | — | — | — | 879,000 | |||||||||||||||||||
Proceeds from exercises of stock options | 10,600 | 1,000 | 305,000 | — | — | — | 306,000 | |||||||||||||||||||
Proceeds from issuance of employee stock purchase plan shares | 10,135 | 1,000 | 245,000 | — | — | — | 246,000 | |||||||||||||||||||
Issuance of restricted stock | 21,510 | 2,000 | (2,000 | ) | — | — | — | — | ||||||||||||||||||
Net settlement of stock-based awards | 83,820 | 8,000 | (2,781,000 | ) | — | — | — | (2,773,000 | ) | |||||||||||||||||
Cash dividends declared ($0.10 per share) | — | — | — | (2,428,000 | ) | — | — | (2,428,000 | ) | |||||||||||||||||
Accrual of dividend equivalents, net of reversal ($0.10 per share) | — | — | — | (56,000 | ) | — | — | (56,000 | ) | |||||||||||||||||
Net income | — | — | — | 6,388,000 | — | — | 6,388,000 | |||||||||||||||||||
Balance as of October 31, 2019 | 39,402,226 | $ | 3,940,000 | $ | 551,316,000 | $ | 424,237,000 | 15,033,317 | $ | (441,849,000 | ) | $ | 537,644,000 | |||||||||||||
See accompanying notes to condensed consolidated financial statements.
4
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) | |||||||
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Cash flows from operating activities: | |||||||
Net income | $ | 6,388,000 | 3,468,000 | ||||
Adjustments to reconcile net income to net cash provided by (used in) operating activities: | |||||||
Depreciation and amortization of property, plant and equipment | 2,651,000 | 2,851,000 | |||||
Amortization of intangible assets with finite lives | 5,206,000 | 4,289,000 | |||||
Amortization of stock-based compensation | 879,000 | 1,046,000 | |||||
Amortization of deferred financing costs | 185,000 | 548,000 | |||||
Estimated contract settlement costs | 230,000 | — | |||||
Write-off of deferred financing costs | — | 3,217,000 | |||||
Changes in other liabilities | (1,033,000 | ) | — | ||||
(Gain) loss on disposal of property, plant and equipment | (3,000 | ) | 32,000 | ||||
Benefit from allowance for doubtful accounts | (343,000 | ) | (7,000 | ) | |||
Provision for excess and obsolete inventory | 373,000 | 747,000 | |||||
Deferred income tax expense | 2,286,000 | 2,273,000 | |||||
Changes in assets and liabilities, net of effects of business acquisitions: | |||||||
Accounts receivable | (15,947,000 | ) | (12,267,000 | ) | |||
Inventories | 2,656,000 | (15,240,000 | ) | ||||
Prepaid expenses and other current assets | 930,000 | 3,054,000 | |||||
Other assets | (44,000 | ) | 64,000 | ||||
Accounts payable | 4,299,000 | (9,180,000 | ) | ||||
Accrued expenses and other current liabilities | (1,095,000 | ) | 8,526,000 | ||||
Contract liabilities | (822,000 | ) | (2,947,000 | ) | |||
Other liabilities, non-current | 3,000 | 275,000 | |||||
Interest payable | (133,000 | ) | (455,000 | ) | |||
Income taxes payable | (1,221,000 | ) | (4,424,000 | ) | |||
Net cash provided by (used in) operating activities | 5,445,000 | (14,130,000 | ) | ||||
Cash flows from investing activities: | |||||||
Purchases of property, plant and equipment | (1,250,000 | ) | (1,645,000 | ) | |||
Net cash used in investing activities | (1,250,000 | ) | (1,645,000 | ) | |||
Cash flows from financing activities: | |||||||
Net borrowings of long-term debt under Credit Facility | 4,000,000 | 193,400,000 | |||||
Net payments under Revolving Loan portion of Prior Credit Facility | — | (48,603,000 | ) | ||||
Repayment of debt under Term Loan portion of Prior Credit Facility | — | (120,121,000 | ) | ||||
Remittance of employees' statutory tax withholdings for stock awards | (4,560,000 | ) | (5,017,000 | ) | |||
Cash dividends paid | (2,692,000 | ) | (2,615,000 | ) | |||
Payment of deferred financing costs | — | (1,771,000 | ) | ||||
Repayment of principal amounts under finance lease and other obligations | (198,000 | ) | (454,000 | ) | |||
Proceeds from issuance of employee stock purchase plan shares | 246,000 | 241,000 | |||||
Proceeds from exercises of stock options | 306,000 | 174,000 | |||||
Net cash (used in) provided by financing activities | (2,898,000 | ) | 15,234,000 | ||||
Net increase (decrease) in cash and cash equivalents | 1,297,000 | (541,000 | ) | ||||
Cash and cash equivalents at beginning of period | 45,576,000 | 43,484,000 | |||||
Cash and cash equivalents at end of period | $ | 46,873,000 | 42,943,000 | ||||
See accompanying notes to condensed consolidated financial statements. (Continued) | |||||||
5
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) (Unaudited) | |||||||
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Supplemental cash flow disclosures: | |||||||
Cash paid during the period for: | |||||||
Interest | $ | 1,701,000 | 2,470,000 | ||||
Income taxes, net | $ | 79,000 | 25,000 | ||||
Non-cash investing and financing activities: | |||||||
Reclass of finance lease right-of-use assets to property, plant and equipment | $ | 295,000 | — | ||||
Cash dividends declared but unpaid (including dividend equivalents) | $ | 2,484,000 | 2,463,000 | ||||
Accrued additions to property, plant and equipment | $ | 692,000 | 795,000 | ||||
Accrued deferred financing costs | $ | — | 41,000 | ||||
See accompanying notes to condensed consolidated financial statements.
6
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(1) General
The accompanying condensed consolidated financial statements of Comtech Telecommunications Corp. and its subsidiaries ("Comtech," "we," "us," or "our") as of and for the three months ended October 31, 2019 and 2018 are unaudited. In the opinion of management, the information furnished reflects all material adjustments (which include normal recurring adjustments) necessary for a fair presentation of the results for the unaudited interim periods. Our results of operations for such periods are not necessarily indicative of the results of operations to be expected for the full fiscal year.
The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, and disclosure of contingent assets and liabilities, at the date of the condensed consolidated financial statements, and the reported amounts of net sales and expenses during the reported period. Actual results may differ from those estimates.
Our condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements, filed with the Securities and Exchange Commission ("SEC"), for the fiscal year ended July 31, 2019 and the notes thereto contained in our Annual Report on Form 10-K, and all of our other filings with the SEC.
As disclosed in more detail in Note (15) - "Segment Information," we manage our business in two reportable segments: Commercial Solutions and Government Solutions.
(2) Acquisitions
Solacom Technologies Inc.
On February 28, 2019, we completed our acquisition of Solacom Technologies Inc. ("Solacom"), pursuant to the Arrangement Agreement, dated as of January 7, 2019, by and among Solacom, Comtech and Solar Acquisition Corp., a Canadian corporation and a direct, wholly-owned subsidiary of Comtech. Solacom is a leading provider of Next Generation 911 ("NG-911") solutions for public safety agencies. The acquisition of Solacom was a significant step in our strategy of enhancing our public safety and location technologies.
The acquisition has an aggregate purchase price for accounting purposes of $32,934,000, of which $27,328,000 was settled in cash and $5,606,000 was settled with the issuance of 208,669 shares of Comtech’s common stock at a volume weighted average stock price of $26.86. The fair value of consideration transferred in connection with this acquisition was $31,489,000, which was net of $1,445,000 of cash acquired. The cash portion of the purchase price was funded principally through borrowings under our Credit Facility.
We are accounting for the acquisition of Solacom under the acquisition method of accounting in accordance with FASB ASC 805, "Business Combinations" ("ASC 805"). The purchase price was allocated to the assets acquired and liabilities assumed, based on their fair value as of February 28, 2019, pursuant to the business combination accounting rules. Acquisition plan expenses were not included as a component of consideration transferred and were expensed in the period incurred. Pro forma financial information is not disclosed, as the acquisition is not material.
7
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
The following table summarizes the fair value of the assets acquired and liabilities assumed in connection with the Solacom acquisition:
Purchase Price Allocation (1) | Measurement Period Adjustments | Purchase Price Allocation (as adjusted) | ||||||||||
Settled in cash | $ | 27,328,000 | — | $ | 27,328,000 | |||||||
Settled in common stock issued by Comtech | 5,606,000 | — | 5,606,000 | |||||||||
Aggregate purchase price at fair value | $ | 32,934,000 | — | $ | 32,934,000 | |||||||
Allocation of aggregate purchase price: | ||||||||||||
Cash and cash equivalents | $ | 1,445,000 | — | $ | 1,445,000 | |||||||
Current assets | 9,896,000 | 1,000 | 9,897,000 | |||||||||
Property, plant and equipment | 777,000 | — | 777,000 | |||||||||
Deferred tax assets | 5,059,000 | 419,000 | 5,478,000 | |||||||||
Accrued warranty obligations | (1,431,000 | ) | — | (1,431,000 | ) | |||||||
Current liabilities | (4,477,000 | ) | — | (4,477,000 | ) | |||||||
Contract liabilities, non-current | (1,604,000 | ) | — | (1,604,000 | ) | |||||||
Net tangible assets at fair value | $ | 9,665,000 | 420,000 | $ | 10,085,000 | |||||||
Identifiable intangibles, deferred taxes and goodwill: | Estimated Useful Lives | |||||||||||
Technology | $ | 6,779,000 | — | $ | 6,779,000 | 10 years | ||||||
Customer relationships | 7,007,000 | — | 7,007,000 | 20 years | ||||||||
Trade name | 1,828,000 | — | 1,828,000 | 20 years | ||||||||
Deferred tax liabilities | (4,153,000 | ) | — | (4,153,000 | ) | |||||||
Goodwill | 11,808,000 | (420,000 | ) | 11,388,000 | Indefinite | |||||||
Allocation of aggregate purchase price | $ | 32,934,000 | — | $ | 32,934,000 | |||||||
(1) As reported in the Company's Annual Report on Form 10-K for the fiscal year ended July 31, 2019.
The acquired identifiable intangible assets are being amortized on a straight-line basis, which we believe approximates the pattern in which the assets are utilized over their estimated useful lives. The fair value of customer relationships was estimated primarily based on the value of the discounted cash flows that the related intangible asset could be expected to generate in the future. The fair value of technology and trade name was estimated based on the discounted capitalization of royalty expense saved because we now own the assets. Among the factors contributing to the recognition of goodwill, as a component of the purchase price allocation, were synergies in products and technologies and the addition of a skilled, assembled workforce. This goodwill has been assigned to our Commercial Solutions segment based on specific identification and is generally not deductible for income tax purposes.
GD NG-911 Business
On April 29, 2019, we completed the acquisition of a state and local government NG-911 business pursuant to the Asset Purchase Agreement, dated as of April 29, 2019, by and among General Dynamics Information Technology, Inc., Comtech and Comtech NextGen LLC, a Delaware limited liability company and indirect, wholly-owned subsidiary of Comtech. The acquisition of this NG-911 business from GD (the "GD NG-911 business") has a preliminary cash purchase price of $10,000,000 (which is subject to a net working capital adjustment). In connection with this acquisition, we also announced an award of a five-year contract to develop, implement and operate a NG-911 emergency communications system for a Northeastern state. Immediately after our announcement of this acquisition, we hired approximately sixty GD NG-911 employees and completed the integration of this business into our Commercial Solutions segment’s public safety and location technologies product line. The acquisition, contract award and hiring of talented employees are expected to strengthen Comtech’s position in the growing NG-911 solutions market.
8
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
We are accounting for the acquisition of this business under the acquisition method of accounting in accordance with FASB ASC 805. The purchase price, which is subject to a pending closing date balance sheet adjustment process under the purchase agreement, was allocated to the assets acquired and liabilities assumed, based on their preliminary fair value as of April 29, 2019, pursuant to the business combination accounting rules. Acquisition plan expenses were not included as a component of consideration transferred and were expensed in the period incurred. Pro forma financial information is not disclosed, as the acquisition is not material.
The following table summarizes the preliminary fair value of the assets acquired and liabilities assumed in connection with the acquisition of the GD NG-911 business:
Purchase Price Allocation (1) | Measurement Period Adjustments | Purchase Price Allocation (as adjusted) | ||||||||||
Aggregate purchase price at fair value | $ | 10,000,000 | — | $ | 10,000,000 | |||||||
Allocation of aggregate purchase price: | ||||||||||||
Current assets | $ | 4,460,000 | 180,000 | $ | 4,640,000 | |||||||
Property, plant and equipment | 646,000 | — | 646,000 | |||||||||
Deferred tax assets | 3,426,000 | (50,000 | ) | 3,376,000 | ||||||||
Accrued warranty obligations | (5,000,000 | ) | — | (5,000,000 | ) | |||||||
Current liabilities | (3,162,000 | ) | 68,000 | (3,094,000 | ) | |||||||
Net tangible assets at preliminary fair value | $ | 370,000 | 198,000 | $ | 568,000 | |||||||
Identifiable intangibles, deferred taxes and goodwill: | Estimated Useful Lives | |||||||||||
Customer relationships | $ | 20,300,000 | — | $ | 20,300,000 | 10 years | ||||||
Technology | 3,500,000 | — | 3,500,000 | 15 years | ||||||||
Other liabilities | (21,700,000 | ) | — | (21,700,000 | ) | |||||||
Deferred tax liabilities | (518,000 | ) | — | (518,000 | ) | |||||||
Goodwill | 8,048,000 | (198,000 | ) | 7,850,000 | Indefinite | |||||||
Allocation of aggregate purchase price | $ | 10,000,000 | — | $ | 10,000,000 | |||||||
(1) As reported in the Company's Annual Report on Form 10-K for the fiscal year ended July 31, 2019.
The acquired identifiable intangible assets are being amortized on a straight-line basis, which we believe approximates the pattern in which the assets are utilized over their estimated useful lives. The fair value of customer relationships was estimated based on the value of the discounted cash flows that the related intangible asset could be expected to generate in the future. The fair value of technology was estimated based on the discounted capitalization of royalty expense saved because we now own the assets. The preliminary fair value of other liabilities was based on the difference in discounted cash flows related to remaining performance obligations under a certain acquired contract as compared to current market terms for similar arrangements that a market participant would expect. Other liabilities will be credited against cost of sales over the remaining performance of the contract, which was 5.25 years as of the acquisition date.
Among the factors contributing to the recognition of goodwill, as a component of the purchase price allocation, were synergies in solution offerings and the addition of a skilled, assembled workforce. We currently estimate that approximately $7,100,000 of goodwill resulting from the acquisition will be tax deductible. This goodwill has been assigned to our Commercial Solutions segment based on specific identification.
We are currently finalizing a net working capital adjustment, pursuant to the terms of the purchase agreement. In August 2019, the seller proposed and requested an approximate $2,900,000 upward adjustment to the preliminary purchase price. We do not agree with their proposed adjustment and believe that we are entitled to a reduction of approximately $1,000,000 to the preliminary purchase price. As the parties could not reach an agreement during the stipulated period of time, the matter is now in arbitration.
9
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
The allocation of the preliminary purchase price shown in the above table was based on a valuation and estimates and assumptions that are subject to change within the purchase price allocation period (generally one year from the acquisition date). The primary areas of the purchase price allocation not yet finalized include the purchase price (due to a pending closing date balance sheet adjustment process under the purchase agreement) and residual goodwill.
Subsequent Event
On November 14, 2019, we entered into an agreement to acquire UHP Networks Inc. and its sister company (together, "UHP"), a leading provider of innovative and disruptive satellite ground station solutions, for a purchase price of approximately $40,000,000, of which we anticipate $5,000,000 to be paid in Comtech common stock with the remaining balance payable in cash. The purchase agreement also provides an earn-out up to an additional $10,000,000 payable, at our election, in cash and or shares of Comtech common stock, if certain agreed upon sales milestones are reached in the twelve-month period following completion of the acquisition. We believe that our acquisition of UHP will be a significant step in enhancing our solutions offerings for the satellite ground station market. The transaction is subject to customary closing conditions and is expected to occur late in the second half of our fiscal 2020.
(3) Adoption of Accounting Standards and Updates
We are required to prepare our condensed consolidated financial statements in accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") which is the source for all authoritative U.S. generally accepted accounting principles, which is commonly referred to as "GAAP." The FASB ASC is subject to updates by the FASB, which are known as Accounting Standards Updates ("ASUs"). During the three months ended October 31, 2019, we adopted:
• | FASB ASU No. 2016-02 Leases (Topic 842). See Note (12) - "Leases" for further information. |
• | FASB ASU No. 2017-11, which provides guidance on the accounting for certain financial instruments with embedded features that result in the strike price of the instrument or embedded conversion option being reduced on the basis of the pricing of future equity offerings (commonly referred to as "down round" features). On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we did not have any financial instruments with such "down round" features. |
• | FASB ASU No. 2017-12, which expands and refines hedge accounting for both non-financial and financial risk components and simplifies and aligns the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we are not a party to any such hedging transactions. |
• | FASB ASU No. 2018-07, which expands the scope of Topic 718 to include certain share-based payment transactions for acquiring goods and services from nonemployees. On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we did not have any outstanding share-based awards with nonemployees that required remeasurement. |
• | FASB ASU No. 2018-16, which expands the list of eligible U.S. benchmark interest rates permitted in the application of hedge accounting due to broad concerns about the long-term sustainability of the LIBO Rate. This ASU adds the Overnight Index Swap ("OIS") rate, based on the Secured Overnight Financing Rate ("SOFR"), as an eligible U.S. benchmark interest rate. On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we are not a party to any such hedging transactions. |
10
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
(4) Revenue
In accordance with FASB ASC 606 - Revenue from Contracts with Customers ("ASC 606"), we record revenue in an amount that reflects the consideration to which we expect to be entitled in exchange for goods or services promised to customers. Under ASC 606, we follow a five-step model to: (1) identify the contract with our customer; (2) identify our performance obligations in our contract; (3) determine the transaction price for our contract; (4) allocate the transaction price to our performance obligations; and (5) recognize revenue using one of the following two methods:
• | Over time - We recognize revenue using the over time method when there is a continuous transfer of control to the customer over the contractual period of performance. This generally occurs when we enter into a long-term contract relating to the design, development or manufacture of complex equipment or technology platforms to a buyer’s specification (or to provide services related to the performance of such contracts). Continuous transfer of control is typically supported by contract clauses which allow our customers to unilaterally terminate a contract for convenience, pay for costs incurred plus a reasonable profit and take control of work-in-process. Revenue recognized over time is generally based on the extent of progress toward completion of the related performance obligations. The selection of the method to measure progress requires judgment and is based on the nature of the products or services provided. In certain instances, typically for firm fixed-price contracts, we use the cost-to-cost measure because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion, including warranty costs. Revenues, including estimated fees or profits, are recorded proportionally as costs are incurred. Costs to fulfill generally include direct labor, materials, subcontractor costs, other direct costs and an allocation of indirect costs. When these contracts are modified, the additional goods or services are generally not distinct from those already provided. As a result, these modifications form part of an existing contract and we must update the transaction price and our measure of progress for the single performance obligation and recognize a cumulative catch-up to revenue and gross profits. |
For over time contracts using a cost-to-cost measure of progress, we have an estimate at completion ("EAC") process in which management reviews the progress and execution of our performance obligations. This EAC process requires management judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Since certain contracts extend over a long period of time, the impact of revisions in revenue and or cost estimates during the progress of work may impact current period earnings through a cumulative adjustment. Additionally, if the EAC process indicates a loss, a provision is made for the total anticipated loss in the period that it becomes evident. Contract revenue and cost estimates for significant contracts are generally reviewed and reassessed at least quarterly.
The cost-to-cost method is principally used to account for contracts in our mission-critical technologies and high-performance transmission technologies product lines and, to a lesser extent, certain location-based and messaging infrastructure contracts in our public safety and location technologies product line. For service-based contracts in our public safety and location technologies product line, we recognize revenue over time. These services are typically recognized as a series of services performed over the contract term using the straight-line method, or based on our customers’ actual usage of the networks and platforms which we provide.
• | Point in time - When a performance obligation is not satisfied over time, we must record revenue using the point in time accounting method which generally results in revenue being recognized upon shipment or delivery of a promised good or service to a customer. This generally occurs when we enter into short term contracts or purchase orders where items are provided to customers with relatively quick turn-around times. Modifications to such contracts and or purchase orders, which typically provide for additional quantities or services, are accounted for as a new contract because the pricing for these additional quantities or services are based on standalone selling prices. |
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Point in time accounting is principally applied to contracts in our satellite ground station technologies product line (which includes satellite modems, solid-state and traveling wave tube amplifiers) and certain contracts for our solid-state, high-power amplifiers in our high-performance transmission technologies product line. Point in time accounting is also applied to certain contracts in our mission-critical technologies product line. The contracts related to these product lines do not meet the requirements for over time revenue recognition because our customers cannot utilize the equipment for its intended purpose during any phase of our manufacturing process; customers do not simultaneously receive and or consume the benefits provided by our performance; customers do not control the asset (i.e., prior to delivery, customers cannot direct the use of the asset, sell or exchange the equipment, etc.); and, although many of our contracts have termination for convenience clauses and or an enforceable right to payment for performance completed to date, our performance creates an asset with an alternative use through the point of delivery.
In determining that our equipment has alternative use, we considered the underlying manufacturing process for our products. In the early phases of manufacturing, raw materials and work in process (including subassemblies) consist of common parts that are highly fungible among many different types of products and customer applications. Finished products are either configured to our standard configuration or based on our customers’ specifications. Finished products, whether built to our standard specification or to a customers’ specification, can be sold to a variety of customers and across many different end use applications with minimal rework, if needed, and without incurring a significant economic loss.
When identifying a contract with our customer, we consider when it has approval and commitment from both parties, if the rights of the parties are identified, if the payment terms are identified, if it has commercial substance and if collectability is probable.
When identifying performance obligations, we consider whether there are multiple promises and how to account for them. In our contracts, multiple promises are separated if they are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or comprise a series of distinct services performed over time, they are combined into a single performance obligation. In some cases, we may also provide the customer with an additional service-type warranty, which we recognize as a separate performance obligation. Service-type warranties do not represent a significant portion of our consolidated net sales. When service-type warranties represent a separate performance obligation, the revenue is deferred and recognized ratably over the extended warranty period. Our contracts, from time-to-time, may also include options for additional goods and services. To date, these options have not represented material rights to the customer as the pricing for them reflects standalone selling prices. As a result, we do not consider options we offer to be performance obligations for which we must allocate a portion of the transaction price. In many cases, we provide assurance-type warranty coverage for some of our products for a period of at least one year from the date of delivery.
When identifying the transaction price, we typically utilize the contract's stated price as a starting point. The transaction price in certain arrangements may include estimated amounts of variable consideration, including award fees, incentive fees or other provisions that can either increase or decrease the transaction price. We estimate variable consideration as the amount to which we expect to be entitled, and we include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the estimation uncertainty is resolved. The estimation of this variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (e.g., historical, current and forecasted) that is reasonably available to us.
When allocating the contract’s transaction price, we consider each distinct performance obligation. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation using our best estimate of the standalone selling price of each distinct good or service in the contract. We determine standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as market conditions, including geographic or regional specific factors, competitive positioning, internal costs, profit objectives and internally approved pricing guidelines related to the performance obligations.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Almost all of our contracts with customers are denominated in U.S. dollars and typically are either firm fixed-price or cost reimbursable type contracts (including fixed-fee, incentive-fee and time-and-material type contracts). In almost all of our contracts with customers, we are the principal in the arrangement and report revenue on a gross basis. Transaction prices for contracts with U.S. domestic and international customers are usually based on specific negotiations with each customer and in the case of the U.S. government, sometimes based on estimated or actual costs of providing the goods or services in accordance with applicable regulations. Sales by geography and customer type, as a percentage of consolidated net sales, are as follows:
Three months ended October 31, | ||||||
2019 | 2018 | |||||
United States | ||||||
U.S. government | 40.8 | % | 44.2 | % | ||
Domestic | 36.1 | % | 31.4 | % | ||
Total United States | 76.9 | % | 75.6 | % | ||
International | 23.1 | % | 24.4 | % | ||
Total | 100.0 | % | 100.0 | % | ||
Sales to U.S. government customers include sales to the U.S. Department of Defense ("DoD"), intelligence and civilian agencies, as well as sales directly to or through prime contractors. Domestic sales include sales to commercial customers, as well as to U.S. state and local governments. Except for the U.S. government, there were no customers that represented more than 10.0% of consolidated net sales during the three months ended October 31, 2019 and 2018. International sales include sales to U.S. domestic companies for inclusion in products that are sold to international customers. Except for the U.S., no individual country (including sales to U.S. domestic companies for inclusion in products that are sold to a foreign country) represented more than 10.0% of consolidated net sales for the three months ended October 31, 2019 and 2018.
The following tables summarize our disaggregation of revenue consistent with information reviewed by our chief operating decision-maker ("CODM") for the three months ended October 31, 2019 and 2018. We believe these categories best depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors which impact our business:
Three months ended October 31, 2019 | |||||||||||
Commercial Solutions | Government Solutions | Total | |||||||||
Geographical region and customer type | |||||||||||
U.S. government | $ | 16,748,000 | 52,773,000 | $ | 69,521,000 | ||||||
Domestic | 53,354,000 | 8,041,000 | 61,395,000 | ||||||||
Total United States | 70,102,000 | 60,814,000 | 130,916,000 | ||||||||
International | 24,212,000 | 15,139,000 | 39,351,000 | ||||||||
Total | $ | 94,314,000 | 75,953,000 | $ | 170,267,000 | ||||||
Contract type | |||||||||||
Firm fixed price | $ | 92,548,000 | 50,724,000 | $ | 143,272,000 | ||||||
Cost reimbursable | 1,766,000 | 25,229,000 | 26,995,000 | ||||||||
Total | $ | 94,314,000 | 75,953,000 | $ | 170,267,000 | ||||||
Transfer of control | |||||||||||
Point in time | $ | 37,723,000 | 37,786,000 | $ | 75,509,000 | ||||||
Over time | 56,591,000 | 38,167,000 | 94,758,000 | ||||||||
Total | $ | 94,314,000 | 75,953,000 | $ | 170,267,000 | ||||||
13
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Three months ended October 31, 2018 | |||||||||||
Commercial Solutions | Government Solutions | Total | |||||||||
Geographical region and customer type | |||||||||||
U.S. government | $ | 14,220,000 | 56,824,000 | $ | 71,044,000 | ||||||
Domestic | 42,237,000 | 8,274,000 | 50,511,000 | ||||||||
Total United States | 56,457,000 | 65,098,000 | 121,555,000 | ||||||||
International | 21,516,000 | 17,773,000 | 39,289,000 | ||||||||
Total | $ | 77,973,000 | 82,871,000 | $ | 160,844,000 | ||||||
Contract type | |||||||||||
Firm fixed price | $ | 76,290,000 | 63,611,000 | $ | 139,901,000 | ||||||
Cost reimbursable | 1,683,000 | 19,260,000 | 20,943,000 | ||||||||
Total | $ | 77,973,000 | 82,871,000 | $ | 160,844,000 | ||||||
Transfer of control | |||||||||||
Point in time | $ | 37,945,000 | 52,623,000 | $ | 90,568,000 | ||||||
Over time | 40,028,000 | 30,248,000 | 70,276,000 | ||||||||
Total | $ | 77,973,000 | 82,871,000 | $ | 160,844,000 | ||||||
The timing of revenue recognition, billings and collections results in receivables, unbilled receivables and contract liabilities on our Condensed Consolidated Balance Sheet. Under typical payment terms for our contracts accounted for over time, amounts are billed as work progresses in accordance with agreed-upon contractual terms, either at periodic intervals (e.g., monthly) or upon achievement of contractual milestones. For certain contracts with provisions that are intended to protect customers in the event we do not satisfy our performance obligations, billings occur subsequent to revenue recognition, resulting in unbilled receivables. Under ASC 606, unbilled receivables constitute contract assets. There were no material impairment losses recognized on contract assets during the three months ended October 31, 2019 and 2018, respectively. On large long-term contracts, and for contracts with international customers that do not do business with us regularly, payment terms typically require advanced payments and deposits. Under ASC 606, payments received from customers in excess of revenue recognized to date results in a contract liability. These contract liabilities are not considered to represent a significant financing component of the contract because we believe these cash advances and deposits are generally used to meet working capital demands which can be higher in the earlier stages of a contract. Also, advanced payments and deposits provide us with some measure of assurance that the customer will perform on its obligations under the contract. Under the typical payment terms for our contracts accounted for at a point in time, costs are accumulated in inventory until the time of billing, which generally coincides with revenue recognition. Of the contract liability balance at July 31, 2019 and August 1, 2018, $18,609,000 and $23,127,000 was recognized as revenue during the three months ended October 31, 2019 and 2018, respectively.
We recognize the incremental costs to obtain or fulfill a contract as an expense when incurred if the amortization period of the asset is one year or less. Incremental costs to obtain or fulfill contracts with an amortization period greater than one year were not material.
As commissions payable to our internal sales and marketing employees or contractors are contingent upon multiple factors, such commissions are not considered direct costs to obtain or fulfill a contract with a customer and are expensed as incurred in selling, general and administrative expenses on our Condensed Consolidated Statements of Operations. As for commissions payable to our third-party sales representatives related to large long-term contracts, we do consider these types of commissions both direct and incremental costs to obtain and fulfill such contracts. Therefore, such commissions are included in total estimated costs at completion for such contracts and expensed over time through cost of sales on our Condensed Consolidated Statements of Operations.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Remaining performance obligations represent the transaction price of firm orders for which work has not been performed as of the end of a fiscal period. Remaining performance obligations, which we refer to as backlog, exclude unexercised contract options and potential orders under indefinite delivery / indefinite quantity ("IDIQ") contracts. As of October 31, 2019, the aggregate amount of the transaction price allocated to remaining performance obligations was $648,343,000 (which represents the amount of our consolidated backlog). We estimate that a substantial portion of our remaining performance obligations at October 31, 2019 will be completed and recognized as revenue during the next twenty-four month period, with the rest thereafter. During the three months ended October 31, 2019, revenue recognized from performance obligations satisfied, or partially satisfied, in previous periods (for example due to changes in the transaction price) was not material.
(5) Fair Value Measurements and Financial Instruments
Using the fair value hierarchy described in FASB ASC 820 "Fair Value Measurements and Disclosures," we valued our cash and cash equivalents using Level 1 inputs that were based on quoted market prices.
We believe that the carrying amounts of our other current financial assets (such as accounts receivable) and other current liabilities (including accounts payable, accrued expenses and the current portion of our favorable AT&T warranty settlement) approximate their fair values due to their short-term maturities. See Note (9) - "Accrued Expenses and Other Current Liabilities" for further discussion of the favorable AT&T warranty settlement.
We believe the fair values of our operating lease liabilities and our finance lease and other obligations, which currently reflect weighted-average discount rates of approximately 4.05% and 4.21%, respectively, would not be materially different than their carrying values as of October 31, 2019. See Note (12) - "Leases" for further information.
The fair value of our Credit Facility that we entered into on October 31, 2018 approximates its carrying amount due to its variable interest rate and pricing grid that is dependent upon our leverage ratio as of the end of each fiscal quarter.
As of October 31, 2019 and July 31, 2019, other than the financial instruments discussed above, we had no other significant assets or liabilities included in our Condensed Consolidated Balance Sheets recorded at fair value, as such term is defined by FASB ASC 820.
(6) Earnings Per Share
Our basic earnings per share ("EPS") is computed based on the weighted average number of common shares (including vested but unissued stock units, share units, performance shares and restricted stock units ("RSUs")), outstanding during each respective period. Our diluted EPS reflects the dilution from potential common stock issuable pursuant to the exercise of equity-classified stock-based awards, if dilutive, outstanding during each respective period. Pursuant to FASB ASC 260 "Earnings Per Share," equity-classified stock-based awards that are subject to performance conditions are not considered in our diluted EPS calculations until the respective performance conditions have been satisfied. When calculating our diluted earnings per share, we consider the amount an employee must pay upon assumed exercise of stock-based awards and the amount of stock-based compensation cost attributed to future services and not yet recognized.
There were no repurchases of our common stock during the three months ended October 31, 2019 or 2018. See Note (18) - "Stockholders’ Equity" for more information.
Weighted average stock options, RSUs and restricted stock outstanding of 382,000 and 279,000 for the three months ended October 31, 2019 and 2018, respectively, were not included in our diluted EPS calculation because their effect would have been anti-dilutive.
Our EPS calculations exclude 197,000 and 236,000 weighted average performance shares outstanding for the three months ended October 31, 2019 and 2018, respectively, as the performance conditions have not yet been satisfied. However, net income (the numerator) for EPS calculations for each respective period, is reduced by the compensation expense related to these awards.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
The following table reconciles the numerators and denominators used in the basic and diluted EPS calculations:
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Numerator: | |||||||
Net income for basic calculation | $ | 6,388,000 | 3,468,000 | ||||
Numerator for diluted calculation | $ | 6,388,000 | 3,468,000 | ||||
Denominator: | |||||||
Denominator for basic calculation | 24,555,000 | 23,999,000 | |||||
Effect of dilutive securities: | |||||||
Stock-based awards | 182,000 | 376,000 | |||||
Denominator for diluted calculation | 24,737,000 | 24,375,000 | |||||
(7) Accounts Receivable
Accounts receivable consist of the following at:
October 31, 2019 | July 31, 2019 | ||||||
Receivables from commercial and international customers | $ | 82,140,000 | 85,556,000 | ||||
Unbilled receivables from commercial and international customers | 22,824,000 | 20,469,000 | |||||
Receivables from the U.S. government and its agencies | 55,590,000 | 38,856,000 | |||||
Unbilled receivables from the U.S. government and its agencies | 1,955,000 | 2,018,000 | |||||
Total accounts receivable | 162,509,000 | 146,899,000 | |||||
Less allowance for doubtful accounts | 1,465,000 | 1,867,000 | |||||
Accounts receivable, net | $ | 161,044,000 | 145,032,000 | ||||
Unbilled receivables as of October 31, 2019 relate to contracts-in-progress for which revenue has been recognized, but for which we have not yet earned the right to bill the customer for work performed to date. Under ASC 606, unbilled receivables constitute contract assets. Management estimates that substantially all amounts not yet billed at October 31, 2019 will be billed and collected within one year.
As of October 31, 2019 and July 31, 2019, except for the U.S. government (and its agencies), which represented 35.4% and 27.8%, respectively, of total accounts receivable, there were no other customers which accounted for greater than 10.0% of total accounts receivable.
(8) Inventories
Inventories consist of the following at:
October 31, 2019 | July 31, 2019 | ||||||
Raw materials and components | $ | 52,423,000 | 53,959,000 | ||||
Work-in-process and finished goods | 38,867,000 | 40,576,000 | |||||
Total inventories | 91,290,000 | 94,535,000 | |||||
Less reserve for excess and obsolete inventories | 19,480,000 | 19,696,000 | |||||
Inventories, net | $ | 71,810,000 | 74,839,000 | ||||
As of October 31, 2019 and July 31, 2019, the amount of inventory directly related to long-term contracts (including contracts-in-progress) was $4,661,000 and $4,053,000, respectively, and the amount of inventory related to contracts from third-party commercial customers who outsource their manufacturing to us was $1,395,000 and $1,513,000, respectively.
16
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
(9) Accrued Expenses and Other Current Liabilities
Accrued expenses and other current liabilities consist of the following at:
October 31, 2019 | July 31, 2019 | ||||||
Accrued wages and benefits | $ | 21,261,000 | 23,295,000 | ||||
Accrued contract costs | 13,725,000 | 15,007,000 | |||||
Accrued warranty obligations | 16,068,000 | 15,968,000 | |||||
Accrued legal costs | 2,781,000 | 2,835,000 | |||||
Accrued commissions and royalties | 4,587,000 | 5,114,000 | |||||
Other | 14,385,000 | 16,365,000 | |||||
Accrued expenses and other current liabilities | $ | 72,807,000 | 78,584,000 | ||||
As discussed further in Note (12) - "Leases," on August 1, 2019, we adopted Topic 842 and, as required by the new standard, reclassified $2,934,000 of accrued expenses and other current liabilities as follows: (i) $2,366,000 of short-term deferred rent liabilities related to operating leases were offset against the respective operating lease right-of-use assets; and (ii) the remaining $568,000 of estimated facility exit costs were reclassified to the current portion of operating lease liabilities.
Accrued contract costs represent direct and indirect costs on contracts as well as estimates of amounts owed for invoices not yet received from vendors or reflected in accounts payable.
Accrued warranty obligations as of October 31, 2019 relate to estimated liabilities for assurance-type warranty coverage that we provide to our customers. We generally provide warranty coverage for some of our products for a period of at least one year from the date of delivery. We record a liability for estimated warranty expense based on historical claims, product failure rates, consideration of contractual obligations, future costs to resolve software issues and other factors. Some of our product warranties are provided under long-term contracts, the costs of which are incorporated into our estimates of total contract costs.
Changes in our accrued warranty obligations during the three months ended October 31, 2019 and 2018 were as follows:
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Balance at beginning of period | $ | 15,968,000 | 11,738,000 | ||||
Reclass to contract liabilities (see below) | — | (1,679,000 | ) | ||||
Provision for warranty obligations | 989,000 | 1,020,000 | |||||
Charges incurred | (1,191,000 | ) | (1,515,000 | ) | |||
Warranty settlement and reclass (see below) | 302,000 | 418,000 | |||||
Balance at end of period | $ | 16,068,000 | 9,982,000 | ||||
On August 1, 2018, in connection with our adoption of ASC 606, $1,679,000 of accrued warranty obligations presented in the above table were reclassified to contract liabilities, as they represented deferred revenue related to service-type warranty performance obligations.
17
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Our current accrued warranty obligations at October 31, 2019 and July 31, 2019 include $3,781,000 and $3,999,000, respectively, of warranty obligations for a small product line that we refer to as the TCS 911 call handling software solution. This solution was licensed to customers prior to our acquisition of TeleCommunication Systems, Inc. ("TCS"). During the fiscal year ended July 31, 2018, we entered into a full and final warranty settlement with AT&T, the largest customer/distributor of this product line, pursuant to which we issued thirty-six credits to AT&T of $153,000 which AT&T can apply on a monthly basis to purchases of solutions from us, beginning October 2017 through September 2020. As of October 31, 2019, the total present value of these monthly credits is $1,611,000, all of which is included in our current accrued warranty obligations on our Condensed Consolidated Balance Sheet.
In connection with our acquisition of Solacom and the GD NG-911 business during the fiscal year ended July 31, 2019, we assumed warranty obligations related to certain contracts acquired. See Note (2) - "Acquisitions" for further information pertaining to these acquisitions.
(10) | Cost Reduction Actions |
During the three months ended October 31, 2018, we took steps to improve our future operating results and successfully consolidated our Government Solutions segment’s manufacturing facility located in Tampa, Florida with another facility that we maintain in Orlando, Florida. In doing so, during the three months ended October 31, 2018, we recorded $1,373,000 of facility exit costs in selling, general and administrative expenses in our Condensed Consolidated Statements of Operations. As discussed further in Note (12) - "Leases," on August 1, 2019, we adopted Topic 842 and, as required by the new standard, reclassified $568,000 of estimated facility exit costs to the current portion of operating lease liabilities.
During the second quarter of fiscal 2019, we began an evaluation and repositioning of our public safety and location technologies solutions in order to focus on providing higher margin solution offerings. To date, we have ceased offering certain solutions, have worked with customers to wind-down certain legacy contracts and have not renewed certain contracts. In connection with this ongoing evaluation and repositioning, during the three months ended October 31, 2019, we recorded $230,000 of estimated contract settlement costs in our Commercial Solutions segment.
(11) Credit Facility
On October 31, 2018, we entered into a First Amended and Restated Credit Agreement (the "Credit Facility") with a syndicate of lenders, replacing our prior Credit Agreement dated as of February 23, 2016 (as amended by that certain First Amendment, dated as of June 6, 2017 (the "Prior Credit Facility")). In connection with the establishment of our new Credit Facility, during the three months ended October 31, 2018, we wrote-off $3,217,000 of deferred financing costs primarily related to the Term Loan Facility portion of our Prior Credit Facility and capitalized deferred financing costs of $1,813,000 related to the new Credit Facility.
The Credit Facility provides a senior secured loan facility of up to $550,000,000 consisting of: (i) a revolving loan facility ("Revolving Loan Facility") with a borrowing limit of $300,000,000; (ii) an accordion feature allowing us to borrow up to an additional $250,000,000; (iii) a $35,000,000 letter of credit sublimit; and (iv) a swingline loan credit sublimit of $25,000,000.
The Credit Facility matures on October 31, 2023 (the "Revolving Maturity Date"). If we issue new unsecured debt in excess of $5,000,000 with a maturity date that is less than 91 days from October 31, 2023, the Revolving Maturity Date would automatically accelerate so that it would be 91 days earlier than the maturity date of the new unsecured debt.
The proceeds of the Credit Facility were used, in part, to repay in full the outstanding borrowings under the Prior Credit Facility, and additional proceeds of the Credit Facility are expected to be used by us for working capital and other general corporate purposes. As of October 31, 2019, the amount outstanding under our Credit Facility was $169,000,000, which is reflected in the non-current portion of long-term debt on our Condensed Consolidated Balance Sheet. At October 31, 2019, we had $2,632,000 of standby letters of credit outstanding under our Credit Facility related to guarantees of future performance on certain customer contracts and no outstanding commercial letters of credit. During the three months ended October 31, 2019, we had outstanding balances under the Credit Facility ranging from $142,000,000 to $169,000,000.
18
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
As of October 31, 2019, total net deferred financing costs related to the Credit Facility were $2,943,000 and are being amortized over the term of our Credit Facility through October 31, 2023.
Interest expense related to our credit facilities, including amortization of deferred financing costs, recorded during the three months ended October 31, 2019 and 2018, was $1,753,000 and $2,542,000, respectively. The amount for the three months ended October 31, 2019 relates to our new Credit Facility; whereas, the amount for the three months ended October 31, 2018 relates to our Prior Credit Facility. During the three months ended October 31, 2019 and 2018, our blended interest rate approximated 4.70% and 6.00%, respectively.
Borrowings under the Credit Facility shall be either: (i) Alternate Base Rate borrowings, which bear interest from the applicable borrowing date at a rate per annum equal to (x) the greatest of (a) the Prime Rate (as defined) in effect on such day, (b) the Federal Funds Effective Rate (as defined) in effect on such day plus 1/2 of 1.00% per annum and (c) the Adjusted LIBO Rate (as defined) on such day (or, if such day is not a business day, the immediately preceding business day) plus 1.00% per annum, plus (y) the Applicable Rate (as defined), or (ii) Eurodollar borrowings, which bear interest from the applicable borrowing date at a rate per annum equal to (x) the Adjusted LIBO Rate for such interest period plus (y) the Applicable Rate. Determination of the Applicable Rate is based on a pricing grid that is dependent upon our Secured Leverage Ratio (as defined) as of the end of each fiscal quarter for which consolidated financial statements have been most recently delivered.
The Credit Facility contains customary representations, warranties and affirmative covenants. The Credit Facility also contains customary negative covenants, subject to negotiated exceptions, including but not limited to: (i) liens, (ii) investments, (iii) indebtedness, (iv) significant corporate changes, including mergers and acquisitions, (v) dispositions, (vi) restricted payments, including stockholder dividends, and (vii) certain other restrictive agreements. The Credit Facility also contains certain financial covenants and customary events of default (subject to grace periods, as appropriate), such as payment defaults, cross-defaults to other material indebtedness, bankruptcy and insolvency, the occurrence of a defined change in control and the failure to observe the negative covenants and other covenants related to the operation of our business. In addition, under certain circumstances, we may be required to enter into amendments to the Credit Facility in connection with any further syndication of the Credit Facility.
The Credit Facility provides for, among other things: (i) no scheduled payments of principal until maturity; (ii) a maximum Secured Leverage Ratio of 3.75x trailing twelve months ("TTM") Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA") and a Maximum Total Leverage Ratio of 4.50x TTM Adjusted EBITDA, each with no step downs; and (iii) a Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA.
As of October 31, 2019, our Secured Leverage Ratio was 1.75x TTM Adjusted EBITDA compared to the maximum allowable Secured Leverage Ratio of 3.75x TTM Adjusted EBITDA. Our Interest Expense Coverage Ratio as of October 31, 2019 was 13.07x TTM Adjusted EBITDA compared to the Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA. Given our expected future business performance, we anticipate maintaining compliance with the terms and financial covenants in our Credit Facility for the foreseeable future.
The obligations under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the "Guarantors"). As collateral security under the Credit Facility and the guarantees thereof, we and the Guarantors have granted to the administrative agent, for the benefit of the lenders, a lien on, and first priority security interest in, substantially all of our tangible and intangible assets.
On December 6, 2018, we entered into the first amendment to the Credit Facility. The purpose of the amendment is to provide for a mechanism to replace the LIBO Rate for Eurodollar borrowings with an alternative benchmark interest rate, should the LIBO Rate generally become unavailable in the future on an other-than-temporary basis.
Capitalized terms used but not defined herein have the meanings set forth for such terms in the Credit Facility and the Prior Credit Facility, which have been documented and filed with the SEC.
19
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
(12) Leases
On August 1, 2019, we adopted ASU No. 2016-02 - Leases (Topic 842), which requires the recognition of lease rights and obligations as assets and liabilities on the balance sheet. Previously, operating leases were not recognized on the balance sheet. As we elected the modified retrospective adoption method, prior-period information was not restated. We also elected the transition package of practical expedients available in the standard, which permits us to not reassess under the new standard our prior conclusions about lease identification, classification and initial direct costs. As part of our adoption, however, we did not elect to use the hindsight or land easements practical expedients.
On August 1, 2019, in connection with our adoption of Topic 842, we recognized $35,825,000 of operating lease right-of-use ("ROU") assets (net of a $3,023,000 deferred rent liability that existed as of August 1, 2019 under prior applicable GAAP) and $38,848,000 of related liabilities. Except for the recording of the ROU assets and lease liabilities on our Condensed Consolidated Balance Sheet, and the expanded disclosures about our leasing activities, our adoption did not have a material impact on our condensed consolidated financial statements. Our adoption also did not result in any cumulative-effect adjustment to opening retained earnings.
Our leases historically relate to the leasing of facilities and equipment. We determine at inception whether an arrangement is, or contains, a lease and whether the lease should be classified as an operating or a financing lease. At lease commencement, we recognize an ROU asset and lease liability based on the present value of the future lease payments over the estimated lease term. We have elected to not recognize an ROU asset or lease liability for any leases with terms of twelve months or less. Instead, for such short-term leases, we recognize lease expense on a straight-line basis over the lease term. Certain of our leases include options to extend the term of the lease or to terminate the lease early. When it is reasonably certain that we will exercise a renewal option or will not exercise a termination option, we include the impact of exercising or not exercising such option, respectively, in the estimate of the lease term. As our lease agreements do not explicitly state the discount rate implicit in the lease, we use our incremental borrowing rate ("IBR") on the commencement date to calculate the present value of future lease payments. Such IBR represents our estimated rate of interest to borrow on a collateralized basis over a term commensurate with the expected lease term.
Some of our leases include payments that are based on the Consumer Price Index ("CPI") or other similar indices. These variable lease payments are included in the calculation of the ROU asset and lease liability using the index as of the lease commencement date. Other variable lease payments, such as common area maintenance, property taxes, and usage-based amounts, are required by Topic 842 to be excluded from the ROU asset and lease liability and expensed as incurred. In addition to the present value of the future lease payments, the calculation of the ROU asset would also consider, to the extent applicable, any deferred rent upon adoption, lease pre-payments or initial direct costs of obtaining the lease (e.g., such as commissions).
For all classes of leased assets, we elected the practical expedient to not separate lease components (i.e., the actual item being leased, such as the facility or piece of equipment) from non-lease components (i.e., the distinct elements of a contract not related to securing the use of the leased asset, such as common area maintenance and consumable supplies).
Certain of our facility lease agreements (which are classified as operating leases) contain rent holidays or rent escalation clauses. For rent holidays and rent escalation clauses during the lease term, we record rental expense on a straight-line basis over the term of the lease. As of October 31, 2019, none of our leases contained a residual value guarantee and covenants included in our lease agreements are customary for the types of facilities and equipment being leased.
20
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
The components of lease expense are as follows:
Three months ended October 31, 2019 | |||
Finance lease expense: | |||
Amortization of ROU assets | $ | 108,000 | |
Interest on lease liabilities | 2,000 | ||
Operating lease expense | 2,637,000 | ||
Short-term lease expense | 863,000 | ||
Variable lease expense | 993,000 | ||
Sublease income | — | ||
Total lease expense | $ | 4,603,000 | |
Additional information related to leases is as follows:
Three months ended October 31, 2019 | |||
Cash paid for amounts included in the measurement of lease liabilities: | |||
Operating leases - Operating cash outflows | $ | 2,843,000 | |
Finance leases - Operating cash outflows | 2,000 | ||
Finance leases - Financing cash outflows | 198,000 | ||
ROU assets obtained in the exchange for lease liabilities: | |||
Operating leases | $ | 598,000 | |
The following table is a reconciliation of future cash flows relating to operating and finance lease liabilities presented on our Condensed Consolidated Balance Sheet as of October 31, 2019:
Operating | Finance | Total | ||||||||
Remaining portion of fiscal 2020 | $ | 8,192,000 | 109,000 | $ | 8,301,000 | |||||
Fiscal 2021 | 8,619,000 | — | 8,619,000 | |||||||
Fiscal 2022 | 7,387,000 | — | 7,387,000 | |||||||
Fiscal 2023 | 5,877,000 | — | 5,877,000 | |||||||
Fiscal 2024 | 4,170,000 | — | 4,170,000 | |||||||
Thereafter | 6,555,000 | — | 6,555,000 | |||||||
Total future undiscounted cash flows | 40,800,000 | 109,000 | 40,909,000 | |||||||
Less: Present value discount | 3,827,000 | 2,000 | 3,829,000 | |||||||
Lease liabilities | $ | 36,973,000 | 107,000 | $ | 37,080,000 | |||||
Weighted-average remaining lease terms (in years) | 4.59 | 0.22 | ||||||||
Weighted-average discount rate | 4.05 | % | 4.21 | % | ||||||
We lease our Melville, New York production facility from a partnership controlled by our President, CEO and Chairman. Lease payments made during the three months ended October 31, 2019 were $160,000. The current lease provides for our use of the premises as they exist through December 2021 with an option for an additional ten years. The annual rent of the facility for calendar year 2020 is $657,000 and is subject to customary adjustments. We have a right of first refusal in the event of a sale of the facility.
As of October 31, 2019, we do not have any rental commitments that have not commenced.
21
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
As we have not restated prior year information given our method of adopting the new standard, the following represents our future minimum lease payments for operating leases and capital leases as of July 31, 2019 under ASC Topic 840 and as reported in our Form 10-K filed with the SEC on September 24, 2019:
Operating | Capital | Total | |||||||||
Fiscal 2020 | $ | 11,812,000 | 789,000 | $ | 12,601,000 | ||||||
Fiscal 2021 | 8,723,000 | — | 8,723,000 | ||||||||
Fiscal 2022 | 7,343,000 | — | 7,343,000 | ||||||||
Fiscal 2023 | 5,776,000 | — | 5,776,000 | ||||||||
Fiscal 2024 | 3,430,000 | — | 3,430,000 | ||||||||
Thereafter | 7,130,000 | — | 7,130,000 | ||||||||
Total | $ | 44,214,000 | 789,000 | $ | 45,003,000 | ||||||
Less amount representing interest | * | 32,000 | 32,000 | ||||||||
Present value of net minimum lease payments | * | $ | 757,000 | $ | 44,971,000 | ||||||
*Not applicable for operating leases
(13) Income Taxes
At October 31, 2019 and July 31, 2019, total unrecognized tax benefits were $7,839,000 and $7,215,000, respectively, including interest of $31,000 and $12,000, respectively. At October 31, 2019 and July 31, 2019, $2,298,000 and $325,000, respectively, of our unrecognized tax benefits were recorded as non-current income taxes payable on our Condensed Consolidated Balance Sheets. The remaining unrecognized tax benefits of $5,541,000 and $6,890,000 at October 31, 2019 and July 31, 2019, respectively, were presented as an offset to the associated non-current deferred tax assets on our Condensed Consolidated Balance Sheets. Of the total unrecognized tax benefits, $7,259,000 and $6,670,000, at October 31, 2019 and July 31, 2019, respectively, net of the reversal of the federal benefit recognized as a deferred tax asset relating to state reserves, would favorably impact our effective tax rate, if recognized. Unrecognized tax benefits result from income tax positions taken or expected to be taken on our income tax returns for which a tax benefit has not been recorded in our condensed consolidated financial statements. We do not expect that there will be any significant changes to our total unrecognized tax benefits within the next twelve months.
Our federal income tax returns for fiscal 2017 and 2018 are subject to potential future Internal Revenue Service ("IRS") audit. None of our state income tax returns prior to fiscal 2015 are subject to audit. TCS's federal income tax return for the tax period from January 1, 2016 to February 23, 2016, the date we acquired TCS, is subject to potential future IRS audit. None of TCS's state income tax returns prior to calendar year 2015 are subject to audit. Future tax assessments or settlements could have a material adverse effect on our consolidated results of operations and financial condition.
(14) Stock-Based Compensation
Overview
We issue stock-based awards to certain of our employees and our Board of Directors pursuant to our 2000 Stock Incentive Plan, as amended, (the "Plan") and our 2001 Employee Stock Purchase Plan (the "ESPP"), and recognize related stock-based compensation in our condensed consolidated financial statements. The Plan provides for the granting to employees and consultants of Comtech (including prospective employees and consultants): (i) incentive and non-qualified stock options, (ii) restricted stock units ("RSUs"), (iii) RSUs with performance measures (which we refer to as "performance shares"), (iv) restricted stock, (v) stock units (reserved for issuance to non-employee directors) and share units (reserved for issuance to employees) (collectively, "share units") and (vi) stock appreciation rights ("SARs"), among other types of awards. Our non-employee directors are eligible to receive non-discretionary grants of stock-based awards, subject to certain limitations.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
As of October 31, 2019, the aggregate number of shares of common stock which may be issued, pursuant to the Plan, may not exceed 10,362,500. At the Fiscal 2019 Annual Meeting of Stockholders held on December 3, 2019, stockholders approved an amendment to our Plan to increase the share reserve under the Plan by 600,000 shares, to a total 10,962,500 shares. Stock options granted may not have a term exceeding ten years or, in the case of an incentive stock award granted to a stockholder who owns stock representing more than 10.0% of the voting power, no more than five years. We expect to settle all outstanding awards under the Plan and employee purchases under the ESPP with the issuance of new shares of our common stock.
As of October 31, 2019, we had granted stock-based awards pursuant to the Plan representing the right to purchase and/or acquire an aggregate of 8,723,732 shares (net of 4,031,305 expired and canceled awards), of which an aggregate of 6,286,882 have been exercised or settled.
As of October 31, 2019, the following stock-based awards, by award type, were outstanding:
October 31, 2019 | ||
Stock options | 1,503,295 | |
Performance shares | 217,839 | |
RSUs and restricted stock | 476,036 | |
Share units | 239,680 | |
Total | 2,436,850 | |
Our ESPP provides for the issuance of up to 1,050,000 shares of our common stock. Our ESPP is intended to provide our eligible employees the opportunity to acquire our common stock at 85% of fair market value at the date of issuance. Through October 31, 2019, we have cumulatively issued 797,186 shares of our common stock to participating employees in connection with our ESPP.
Stock-based compensation for awards issued is reflected in the following line items in our Condensed Consolidated Statements of Operations:
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Cost of sales | $ | 59,000 | 58,000 | ||||
Selling, general and administrative expenses | 743,000 | 905,000 | |||||
Research and development expenses | 77,000 | 83,000 | |||||
Stock-based compensation expense before income tax benefit | 879,000 | 1,046,000 | |||||
Estimated income tax benefit | (189,000 | ) | (228,000 | ) | |||
Net stock-based compensation expense | $ | 690,000 | 818,000 | ||||
Stock-based compensation for equity-classified awards is measured at the date of grant, based on an estimate of the fair value of the award and is generally expensed over the vesting period of the award. At October 31, 2019, unrecognized stock-based compensation of $11,885,000, net of estimated forfeitures of $1,085,000, is expected to be recognized over a weighted average period of 3.3 years. Total stock-based compensation capitalized and included in ending inventory at both October 31, 2019 and July 31, 2019 was $48,000. There are no liability-classified stock-based awards outstanding as of October 31, 2019 or July 31, 2019.
23
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Stock-based compensation expense (benefit), by award type, is summarized as follows:
Three months ended October 31, | |||||||
2019 | 2018 | ||||||
Stock options | $ | 82,000 | 171,000 | ||||
Performance shares | 352,000 | 406,000 | |||||
RSUs and restricted stock | 698,000 | 547,000 | |||||
ESPP | 57,000 | 52,000 | |||||
Share units | (310,000 | ) | (130,000 | ) | |||
Stock-based compensation expense before income tax benefit | 879,000 | 1,046,000 | |||||
Estimated income tax benefit | (189,000 | ) | (228,000 | ) | |||
Net stock-based compensation expense | $ | 690,000 | 818,000 | ||||
ESPP stock-based compensation expense primarily relates to the 15% discount offered to participants in the ESPP. During the three months ended October 31, 2019 and 2018, we recorded benefits of $310,000 and $130,000, respectively, which primarily represents the recoupment of certain share units.
The estimated income tax benefit as shown in the above table was computed using income tax rates expected to apply when the awards are settled. Such deferred tax asset was recorded net as part of our non-current deferred tax liability on our Condensed Consolidated Balance Sheet as of October 31, 2019 and July 31, 2019. The actual income tax benefit recognized for tax reporting is based on the fair market value of our common stock at the time of settlement and can significantly differ from the estimated income tax benefit recorded for financial reporting.
Stock Options
The following table summarizes the Plan's activity during the three months ended October 31, 2019:
Awards (in Shares) | Weighted Average Exercise Price | Weighted Average Remaining Contractual Term (Years) | Aggregate Intrinsic Value | ||||||||||
Outstanding at July 31, 2019 | 1,555,555 | $ | 28.72 | ||||||||||
Exercised | (51,460 | ) | 28.45 | ||||||||||
Expired/canceled | (800 | ) | 27.35 | ||||||||||
Outstanding at October 31, 2019 | 1,503,295 | $ | 28.73 | 3.27 | $ | 9,346,000 | |||||||
Exercisable at October 31, 2019 | 1,431,765 | $ | 28.83 | 3.14 | $ | 8,761,000 | |||||||
Vested and expected to vest at October 31, 2019 | 1,477,967 | $ | 28.76 | 3.23 | $ | 9,148,000 | |||||||
Stock options outstanding as of October 31, 2019 have exercise prices ranging from $20.90 - $33.94, representing the fair market value of our common stock on the date of grant, a contractual term of five or ten years and a vesting period of three or five years. The total intrinsic value relating to stock options exercised during the three months ended October 31, 2019 and 2018 was $305,000 and $561,000, respectively.
During the three months ended October 31, 2019 and 2018, at the election of certain holders of vested stock options, 40,860 and 72,830, respectively, of stock options were net settled upon exercise. As a result, 4,764 and 9,345 shares of our common stock were issued during the three months ended October 31, 2019 and 2018, respectively, net of shares retained to satisfy the exercise price and minimum statutory tax withholding requirements.
24
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Performance Shares, RSUs, Restricted Stock and Share Unit Awards
The following table summarizes the Plan's activity relating to performance shares, RSUs, restricted stock and share units:
Awards (in Shares) | Weighted Average Grant Date Fair Value | Aggregate Intrinsic Value | |||||||||
Outstanding at July 31, 2019 | 954,676 | $ | 22.40 | ||||||||
Granted | 219,425 | 27.69 | |||||||||
Settled | (199,466 | ) | 16.80 | ||||||||
Forfeited | (41,080 | ) | 21.00 | ||||||||
Outstanding at October 31, 2019 | 933,555 | $ | 24.91 | $ | 32,628,000 | ||||||
Vested at October 31, 2019 | 328,791 | $ | 24.92 | $ | 11,491,000 | ||||||
Vested and expected to vest at October 31, 2019 | 890,374 | $ | 25.06 | $ | 31,119,000 | ||||||
The total intrinsic value relating to fully-vested awards settled during the three months ended October 31, 2019 and 2018 was $5,806,000 and $4,210,000, respectively.
The performance shares granted to employees since fiscal 2014 principally vest over a three-year performance period, if pre-established performance goals are attained or as specified pursuant to the Plan and related agreements. As of October 31, 2019, the number of outstanding performance shares included in the above table, and the related compensation expense prior to consideration of estimated pre-vesting forfeitures, assume achievement of the pre-established goals at a target level.
RSUs and restricted stock granted to non-employee directors prior to July 31, 2019 have a vesting period of three years and are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. RSUs and restricted stock granted to non-employee directors after July 31, 2019 have a vesting period of five years. RSUs granted to employees have a vesting period of five years and are convertible into shares of our common stock, generally at the time of vesting, on a one-for-one basis for no cash consideration.
Share units granted prior to July 31, 2017 were vested when issued and are convertible into shares of our common stock, generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. Share units granted on or after July 31, 2017 were granted to certain employees in lieu of non-equity incentive compensation and are convertible into shares of our common stock on the one-year anniversary of the respective grant date. Cumulatively through October 31, 2019, 431,142 share units granted have been settled.
The fair value of performance shares, RSUs, restricted stock and share units is determined using the closing market price of our common stock on the date of grant, less the present value of any estimated future dividend equivalents such awards are not entitled to receive and an applicable estimated discount for any post vesting transfer restrictions. RSUs, performance shares and restricted stock granted since fiscal 2013 are entitled to dividend equivalents unless forfeited before vesting occurs. Share units granted since fiscal 2014 are entitled to dividend equivalents while the underlying shares are unissued.
Dividend equivalents are subject to forfeiture, similar to the terms of the underlying stock-based awards, and are payable in cash generally at the time of settlement of the underlying award. During the three months ended October 31, 2019, we accrued $56,000 of dividend equivalents (net of forfeitures) and paid out $285,000. Accrued dividend equivalents were recorded as a reduction to retained earnings. As of October 31, 2019 and July 31, 2019, accrued dividend equivalents were $548,000 and $777,000, respectively.
25
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
With respect to the actual settlement of stock-based awards for income tax reporting, during the three months ended October 31, 2019 and 2018, we recorded income tax benefits of $612,000 and $457,000, respectively, which primarily represent the net excess income tax benefits upon settlement of stock-based awards during each of the respective periods.
(15) Segment Information
Reportable operating segments are determined based on Comtech’s management approach. The management approach, as defined by FASB ASC 280 "Segment Reporting" is based on the way that the CODM organizes the segments within an enterprise for making decisions about resources to be allocated and assessing their performance. Our CODM, for purposes of FASB ASC 280, is our Chief Executive Officer and President.
Our Commercial Solutions segment offers satellite ground station technologies (such as modems and amplifiers) and public safety and location technologies (such as 911 call routing and mapping solutions) to commercial customers and smaller government customers, such as state and local governments. This segment also serves certain large government customers (including the U.S. government) that have requirements for off-the-shelf commercial equipment.
Our Government Solutions segment provides mission-critical technologies (such as tactical satellite-based networks and ongoing support for complicated communications networks) and high-performance transmission technologies (such as troposcatter systems and solid-state, high-power amplifiers) to large government end-users (including those of foreign countries), large international customers and domestic prime contractors.
Our CODM primarily uses a metric that we refer to as Adjusted EBITDA to measure an operating segment’s performance and to make decisions about resources to be allocated. Our Adjusted EBITDA metric for the Commercial Solutions and Government Solutions segments do not consider any allocation of indirect expense, or any of the following: income taxes, interest (income) and other, write-off of deferred financing costs, interest expense, amortization of stock-based compensation, amortization of intangible assets, depreciation expenses, estimated contract settlement costs, settlement of intellectual property litigation, acquisition plan expenses, facility exit costs or strategic alternatives analysis expenses and other expenses that relate to our Unallocated segment. These items, while periodically affecting our results, may vary significantly from period to period and may have a disproportionate effect in a given period, thereby affecting the comparability of results. Any amounts shown in the Adjusted EBITDA calculation for our Commercial Solutions and Government Solutions segments are directly attributable to those segments. Our Adjusted EBITDA is also used by our management in assessing the Company's operating results. Although closely aligned, the Company's definition of Adjusted EBITDA is different than the Consolidated EBITDA (as such term is defined in our Credit Facility) utilized for financial covenant calculations and also may differ from the definition of EBITDA or Adjusted EBITDA used by other companies and, therefore, may not be comparable to similarly titled measures used by other companies.
26
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Operating segment information, along with a reconciliation of segment net income (loss) and consolidated net income to Adjusted EBITDA is presented in the tables below:
Three months ended October 31, 2019 | ||||||||||||||
Commercial Solutions | Government Solutions | Unallocated | Total | |||||||||||
Net sales | $ | 94,314,000 | 75,953,000 | — | $ | 170,267,000 | ||||||||
Operating income (loss) | $ | 9,841,000 | 7,083,000 | (7,664,000 | ) | $ | 9,260,000 | |||||||
Net income (loss) | $ | 9,867,000 | 7,095,000 | (10,574,000 | ) | $ | 6,388,000 | |||||||
Provision for income taxes | 13,000 | — | 1,132,000 | 1,145,000 | ||||||||||
Interest (income) and other | (47,000 | ) | (13,000 | ) | (17,000 | ) | (77,000 | ) | ||||||
Interest expense | 8,000 | 1,000 | 1,795,000 | 1,804,000 | ||||||||||
Amortization of stock-based compensation | — | — | 879,000 | 879,000 | ||||||||||
Amortization of intangibles | 4,362,000 | 844,000 | — | 5,206,000 | ||||||||||
Depreciation | 2,196,000 | 313,000 | 142,000 | 2,651,000 | ||||||||||
Estimated contract settlement costs | 230,000 | — | — | 230,000 | ||||||||||
Acquisition plan expenses | — | — | 2,389,000 | 2,389,000 | ||||||||||
Adjusted EBITDA | $ | 16,629,000 | 8,240,000 | (4,254,000 | ) | $ | 20,615,000 | |||||||
Purchases of property, plant and equipment | $ | 1,000,000 | 224,000 | 26,000 | $ | 1,250,000 | ||||||||
Total assets at October 31, 2019 | $ | 675,344,000 | 211,125,000 | 44,553,000 | $ | 931,022,000 | ||||||||
Three months ended October 31, 2018 | ||||||||||||||
Commercial Solutions | Government Solutions | Unallocated | Total | |||||||||||
Net sales | $ | 77,973,000 | 82,871,000 | — | $ | 160,844,000 | ||||||||
Operating income (loss) | $ | 7,058,000 | 6,644,000 | (6,409,000 | ) | $ | 7,293,000 | |||||||
Net income (loss) | $ | 6,971,000 | 6,609,000 | (10,112,000 | ) | $ | 3,468,000 | |||||||
Provision for (benefit from) income taxes | 12,000 | — | (2,139,000 | ) | (2,127,000 | ) | ||||||||
Interest (income) and other | 53,000 | 32,000 | (19,000 | ) | 66,000 | |||||||||
Write-off of deferred financing costs | — | — | 3,217,000 | 3,217,000 | ||||||||||
Interest expense | 22,000 | 3,000 | 2,644,000 | 2,669,000 | ||||||||||
Amortization of stock-based compensation | — | — | 1,046,000 | 1,046,000 | ||||||||||
Amortization of intangibles | 3,445,000 | 844,000 | — | 4,289,000 | ||||||||||
Depreciation | 2,228,000 | 379,000 | 244,000 | 2,851,000 | ||||||||||
Acquisition plan expenses | — | — | 1,130,000 | 1,130,000 | ||||||||||
Facility exit costs | — | 1,373,000 | — | 1,373,000 | ||||||||||
Adjusted EBITDA | $ | 12,731,000 | 9,240,000 | (3,989,000 | ) | $ | 17,982,000 | |||||||
Purchases of property, plant and equipment | $ | 892,000 | 629,000 | 124,000 | $ | 1,645,000 | ||||||||
Total assets at October 31, 2018 | $ | 602,567,000 | 222,587,000 | 41,786,000 | $ | 866,940,000 | ||||||||
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
Unallocated expenses result from corporate expenses such as executive compensation, accounting, legal and other regulatory compliance related costs and also includes all of our amortization of stock-based compensation. During the three months ended October 31, 2019 and 2018, unallocated expenses also include $2,389,000 and $1,130,000 of acquisition plan expenses, respectively.
Interest expense in the tables above relate to our Prior Credit Facility and new Credit Facility, and includes the amortization of deferred financing costs. In addition, during the three months ended October 31, 2018, we recorded a $3,217,000 loss from the write-off of deferred financing costs primarily related to the Term Loan Facility portion of our Prior Credit Facility. See Note (11) - "Credit Facility" for further discussion.
Intersegment sales for the three months ended October 31, 2019 and 2018 by the Commercial Solutions segment to the Government Solutions segment were $1,899,000 and $8,540,000, respectively. There were nominal sales by the Government Solutions segment to the Commercial Solutions segment for these periods. All intersegment sales are eliminated in consolidation and are excluded from the tables above.
Unallocated assets at October 31, 2019 consist principally of cash and cash equivalents, income taxes receivable, corporate property, plant and equipment and deferred financing costs. Substantially all of our long-lived assets are located in the U.S.
(16) Goodwill
The following table represents goodwill by reportable operating segment, including the changes in the net carrying value of goodwill during the three months ended October 31, 2019:
Commercial Solutions | Government Solutions | Total | |||||||||
Balance as of July 31, 2019 | $ | 251,296,000 | 59,193,000 | $ | 310,489,000 | ||||||
Change resulting from Solacom acquisition | (420,000 | ) | — | (420,000 | ) | ||||||
Change resulting from the GD NG-911 acquisition | (198,000 | ) | — | (198,000 | ) | ||||||
Balance as of October 31, 2019 | $ | 250,678,000 | 59,193,000 | $ | 309,871,000 | ||||||
As discussed further in Note (2) -"Acquisitions," the goodwill resulting from the acquisitions of Solacom and the GD NG-911 business was based upon valuation and estimates and assumptions that are subject to change within the purchase price allocation period (generally one year from the acquisition date).
In accordance with FASB ASC 350 "Intangibles - Goodwill and Other," we perform a goodwill impairment analysis at least annually (in the first quarter of each fiscal year), unless indicators of impairment exist in interim periods. If we fail the quantitative assessment of goodwill impairment ("quantitative assessment"), we would be required to recognize an impairment loss equal to the amount that a reporting unit's carrying value exceeded its fair value; however, any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.
On August 1, 2019 (the first day of our fiscal 2020), we performed our annual quantitative assessment using market participant assumptions to determine if the fair value of each of our reporting units with goodwill exceeded its carrying value. In making this assessment, we considered, among other things, expectations of projected net sales and cash flows, assumptions impacting the weighted average cost of capital, trends in trading multiples of comparable companies, changes in our stock price and changes in the carrying values of our reporting units with goodwill. We also considered overall business conditions.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
In performing the quantitative assessment, we estimated the fair value of each of our reporting units using a combination of the income and market approaches. The income approach, also known as the discounted cash flow ("DCF") method, utilizes the present value of cash flows to estimate fair value. The future cash flows for our reporting units were projected based on our estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). For purposes of conducting our impairment analysis, we assumed revenue growth rates and cash flow projections that are below our actual long-term expectations. The discount rates used in our DCF method were based on a weighted-average cost of capital ("WACC") determined from relevant market comparisons, adjusted upward for specific reporting unit risks (primarily the uncertainty of achieving projected operating cash flows). A terminal value growth rate was applied to the final year of the projected period, which reflects our estimate of stable, perpetual growth. We then calculated a present value of the respective cash flows for each reporting unit to arrive at an estimate of fair value under the income approach. Under the market approach, we estimated a fair value based on comparable companies' market multiples of revenues and earnings before interest, taxes, depreciation and amortization and factored in a control premium. Finally, we compared our estimates of fair values to our August 1, 2019 total public market capitalization and assessed implied control premiums based on our common stock price of $29.54 as of August 1, 2019.
Based on our quantitative evaluation, we determined that our Commercial Solutions and Government Solutions reporting units had estimated fair values in excess of their carrying values of at least 29.0% and 122.2%, respectively, and concluded that our goodwill was not impaired and that neither of our two reporting units was at risk of failing the quantitative assessment. It is possible that, during fiscal 2020 or beyond, business conditions (both in the U.S. and internationally) could deteriorate from the current state, our current or prospective customers could materially postpone, reduce or even forgo purchases of our products and services to a greater extent than we currently anticipate, or our common stock price could decline. A significant decline in our customers' spending that is greater than we anticipate or a shift in funding priorities may also have a negative effect on future orders, sales, income and cash flows and we might be required to perform a quantitative assessment during fiscal 2020 or beyond. If assumed net sales and cash flow projections are not achieved in future periods or our common stock price significantly declines from current levels, our Commercial Solutions and Government Solutions reporting units could be at risk of failing the quantitative assessment and goodwill assigned to the respective reporting units could be impaired.
In any event, we are required to perform the next annual goodwill impairment analysis on August 1, 2020 (the start of our fiscal 2021). If our assumptions and related estimates change in the future, or if we change our reporting unit structure or other events and circumstances change (e.g., a sustained decrease in the price of our common stock (considered on both absolute terms and relative to peers)), we may be required to record impairment charges when we perform these tests, or in other future periods. Any impairment charges that we may record in the future could be material to our results of operations and financial condition.
(17) Intangible Assets
Intangible assets with finite lives are as follows:
As of October 31, 2019 | |||||||||||||
Weighted Average Amortization Period | Gross Carrying Amount | Accumulated Amortization | Net Carrying Amount | ||||||||||
Customer relationships | 20.5 | $ | 276,834,000 | 69,694,000 | $ | 207,140,000 | |||||||
Technologies | 12.7 | 92,649,000 | 60,948,000 | 31,701,000 | |||||||||
Trademarks and other | 16.7 | 31,026,000 | 13,183,000 | 17,843,000 | |||||||||
Total | $ | 400,509,000 | 143,825,000 | $ | 256,684,000 | ||||||||
As of July 31, 2019 | |||||||||||||
Weighted Average Amortization Period | Gross Carrying Amount | Accumulated Amortization | Net Carrying Amount | ||||||||||
Customer relationships | 20.5 | $ | 276,834,000 | 66,484,000 | $ | 210,350,000 | |||||||
Technologies | 12.7 | 92,649,000 | 59,522,000 | 33,127,000 | |||||||||
Trademarks and other | 16.7 | 31,026,000 | 12,613,000 | 18,413,000 | |||||||||
Total | $ | 400,509,000 | 138,619,000 | $ | 261,890,000 | ||||||||
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
The weighted average amortization period in the above table excludes fully amortized intangible assets.
Amortization expense for the three months ended October 31, 2019 and 2018 was $5,206,000 and $4,289,000, respectively.
The estimated amortization expense consists of the following for the fiscal years ending July 31:
2020 | $ | 20,700,000 | |
2021 | 19,563,000 | ||
2022 | 18,322,000 | ||
2023 | 18,322,000 | ||
2024 | 17,631,000 | ||
We review net intangible assets with finite lives for impairment when an event occurs indicating the potential for impairment. No such event has occurred during the three months ended October 31, 2019. We believe that the carrying values of our net intangible assets were recoverable as of October 31, 2019. Any impairment charges that we may record in the future could be material to our results of operations and financial condition.
(18) Stockholders’ Equity
Sale of Common Stock
In December 2018, we filed a $400,000,000 shelf registration statement with the SEC for the sale of various types of securities, including debt. The shelf registration was declared effective by the SEC as of December 14, 2018. To date, we have not issued any securities pursuant to our $400,000,000 shelf registration statement.
Stock Repurchase Program
As of October 31, 2019 and December 4, 2019, we were authorized to repurchase up to an additional $8,664,000 of our common stock, pursuant to our current $100,000,000 stock repurchase program. Our stock repurchase program has no time restrictions and repurchases may be made in open-market or privately negotiated transactions and may be made pursuant to SEC Rule 10b5-1 trading plans. There were no repurchases made during the three months ended October 31, 2019 or 2018.
Dividends
Since September 2010, we have paid quarterly dividends pursuant to an annual targeted dividend amount that was established by our Board of Directors. On September 24, 2019, our Board of Directors declared a dividend of $0.10 per common share, which was paid on November 15, 2019. On December 4, 2019, our Board of Directors declared a dividend of $0.10 per common share, payable on February 14, 2020 to stockholders of record at the close of business on January 15, 2020.
Future dividends remain subject to compliance with financial covenants under our Credit Facility as well as Board approval.
(19) Legal Proceedings and Other Matters
Legacy TCS 911 Call Handling Software Matter
A customer that purchased a TCS 911 call handling software solution in December 2014 (which was more than one year prior to our acquisition of TCS) (the "TCS Legacy Customer") informed us in fiscal 2019 that it experienced several network outages and that it would seek indemnification for any claims made against it as a result of such outages.
In connection with these outages, the TCS Legacy Customer informed us that it believed certain communication failover redundancies promised to it by former senior management of TCS were never completed and had originally demanded that we refund to it all amounts previously paid to us under the contract, which through October 31, 2019 exceeded $14,000,000. In response to such claim, we engaged legal counsel to review the claims made by our customer.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
In September 2019, the customer filed a lawsuit in the Sixth Judicial Circuit Court of the State of South Dakota alleging, among other things, our failure to provide them with certain system redundancies. We believe that TCS has complied with its contractual requirements, that the customer's allegations are baseless, and that it is not entitled to a return of any amounts previously paid to us under the contract. Our contract to provide services to this customer expires in December 2019 and the amount of annual revenue we generate from this customer is immaterial.
We have notified our insurance carriers of the lawsuit and are reviewing with counsel our multiple counter claims against this TCS Legacy Customer.
An agreement in principle has been reached with this TCS Legacy Customer and we are currently negotiating the terms of such settlement which is not expected to have a material impact on our condensed consolidated financial statements. However, if we are unable to reach a final settlement, the ultimate resolution of this matter could vary and possibly have a material adverse effect on our consolidated results of operations, financial position or cash flows in future periods.
Separately, we also filed a lawsuit in March 2019 against a former employee and her new employer arising from such former employee's violation of her obligation to TCS of confidentiality, non-competition and non-solicitation of customers, including the TCS Legacy Customer. The former employee has responded with her own lawsuit against us. The ultimate resolution of this lawsuit is not expected to have any material impact.
Other Matters
In October 2014, we disclosed to the U.S. Department of the Treasury, Office of Foreign Assets Control ("OFAC") that we learned during a self-assessment of our export transactions that a shipment of modems sent to a Canadian customer by Comtech EF Data Corp. was incorporated into a communication system, the ultimate end user of which was the Sudan Civil Aviation Authority. The sales value of this equipment was approximately $288,000. At the time of shipment, OFAC regulations prohibited U.S. persons from doing business directly or indirectly with Sudan. In late 2015, OFAC issued an administrative subpoena seeking information about the disclosed transaction. We responded to the subpoena, including alerting OFAC to Comtech’s repair of three modems for a customer in Lebanon who may have rerouted the modems from Lebanon to Sudan without the required U.S. licensing authorization. In September 2018, Comtech agreed to enter into a Tolling Agreement with OFAC, which extended the statute of limitations in this matter through December 31, 2019. The Tolling Agreement was shortly followed by a second administrative subpoena seeking additional information about the disclosed transaction. In December 2018, Comtech responded to a second administrative subpoena from OFAC, answering the questions it posed and providing all the documents it sought. In November 2019, Comtech agreed to enter into a second Tolling Agreement with OFAC, which extends the statute of limitations in this matter through June 30, 2020. U.S. sanctions with respect to Sudan were revoked in 2017 and we are in the process of responding to certain additional questions that OFAC asked of us based on its review. Consistent with the revocation of the Sudan Sanction Regulations ("SSR"), shipments to the Sudan Civil Aviation Authority by U.S. persons are now permissible. We are not able to predict whether OFAC will take any enforcement action against us in light of the revocation of the SSR. If OFAC determines that we have violated U.S. trade sanctions, civil and criminal penalties could apply, and we may suffer reputational harm. Even though we take precautions to avoid engaging in transactions that may violate U.S. trade sanctions, those measures may not be effective in every instance.
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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)
In May 2018, we were informed by the Office of Export Enforcement ("OEE") of the Department of Commerce ("DoC") that it was forwarding to the OEE's Office of Chief Counsel, the results of its audit of international shipments by Comtech Xicom Technology, Inc. for further review and possible determination of an administrative penalty. We fully cooperated with the OEE in their audit and, based on our self-assessment of the approximately 7,800 individual transactions audited, have determined that six (6) transactions may not have been fully in compliance with the Export Administration Regulations ("EAR"). These six (6) items, for which export licenses were not obtained, were either spares or repaired power amplifier subassembly components valued at less than $100,000 (in aggregate) and were shipped to Brazil, Italy, Russia, Thailand and the United Arab Emirates. The EAR provides an exception to the requirement to obtain an export license for the replacement of a defective or damaged component. During our self-assessment, we determined that we inadvertently did not obtain export licenses for the spares or evidence of the return or destruction of the defective or damaged components necessary to authorize our use of the export license exception for the replacements. Since discovering this issue, we have implemented additional controls and procedures and have increased awareness of these specific export requirements throughout the Company to help avoid similar occurrences in the future. Administrative penalties under the EAR can range from a warning letter to a denial of export privileges. A civil monetary penalty not to exceed the amount set forth in the Export Administration Act ("EAA") may be imposed for each violation, and in the event that any provision of the EAR is continued by any other authority, the maximum monetary civil penalty for each violation shall be that provided by such other authority. Administrative penalties under the EAR are currently determined pursuant to the International Emergency Economic Powers Act ("IEEPA"), which can reach the greater of twice the amount of the transaction that is the basis of the violation or approximately $300,000 per violation. We have not recorded an accrual related to a possible administrative penalty and continue to work cooperatively with the OEE.
In the ordinary course of business, we include indemnification provisions in certain of our customer contracts to indemnify, hold harmless and reimburse such customers for certain losses, including but not limited to losses related to third-party claims of intellectual property infringement arising from the customer’s use of our products or services. We may also, from time to time, receive indemnification requests from customers related to third-party claims that 911 calls were improperly routed during an emergency. We evaluate such claims as and when they arise. We do not always agree with customers that they are entitled to indemnification and in such cases reject their claims. Despite maintaining that we have properly carried out our duties, we may seek coverage under our various insurance policies; however, we cannot be sure that we will be able to maintain or obtain insurance coverage at acceptable costs or in sufficient amounts or that our insurer will not disclaim coverage as to such claims. Accordingly, pending or future claims asserted against us by a party that we agree to indemnify could result in legal costs and damages that could have a material adverse effect on our consolidated results of operations and financial condition.
There are certain other pending and threatened legal actions which arise in the normal course of business. Although the ultimate outcome of litigation is difficult to accurately predict, we believe that the outcome of these other pending and threatened actions will not have a material adverse effect on our consolidated financial condition or results of operations.
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ITEM 2. | |
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION | |
AND RESULTS OF OPERATIONS | |
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Certain information in this Quarterly Report on Form 10-Q contains forward-looking statements, including but not limited to, information relating to our future performance and financial condition, plans and objectives of our management and our assumptions regarding such future performance, financial condition, and plans and objectives that involve certain significant known and unknown risks and uncertainties and other factors not under our control which may cause our actual results, future performance and financial condition, and achievement of our plans and objectives to be materially different from the results, performance or other expectations implied by these forward-looking statements. These factors include, among other things: the risk that the acquisition of UHP Networks Inc. and its sister company (together, "UHP") may not be consummated for reasons including that the conditions precedent to the completion of the acquisition may not be satisfied or the occurrence of any event, change or circumstance could give rise to the termination of the agreement; the possibility that the expected synergies from recent or pending acquisitions will not be fully realized, or will not be realized within the anticipated time periods; the risk that acquired businesses will not be integrated with Comtech successfully; the possibility of disruption from recent or pending acquisitions, making it more difficult to maintain business and operational relationships or retain key personnel; the risk that Comtech will be unsuccessful in implementing a tactical shift in its Government Solutions segment away from bidding on large commodity service contracts and toward pursuing contracts for its niche products with higher margins; the risks associated with Comtech's ongoing evaluation and repositioning of its public safety and location technologies solutions offering in its Commercial Solutions segment; the nature and timing of our receipt of, and our performance on, new or existing orders that can cause significant fluctuations in net sales and operating results; the timing and funding of government contracts; adjustments to gross profits on long-term contracts; risks associated with international sales; rapid technological change; evolving industry standards; new product announcements and enhancements, including the risks associated with Comtech's launch of its HeightsTM Network Platform ("HEIGHTS"); changing customer demands and or procurement strategies; changes in prevailing economic and political conditions; changes in the price of oil in global markets; changes in foreign currency exchange rates; risks associated with Comtech's legal proceedings, customer claims for indemnification, and other similar matters; risks associated with our obligations under our Credit Facility; risks associated with our large contracts; and other factors described in this and our other filings with the Securities and Exchange Commission ("SEC").
OVERVIEW
We are a leading provider of advanced communications solutions for both commercial and government customers worldwide. Our solutions fulfill our customers' needs for secure wireless communications in some of the most demanding environments, including those where traditional communications are unavailable or cost-prohibitive, and in mission-critical and other scenarios where performance is crucial.
We manage our business through two reportable operating segments:
• | Commercial Solutions - offers satellite ground station technologies (such as modems and amplifiers), public safety and location technologies (such as 911 call routing and mapping solutions) to commercial customers and smaller government customers, such as state and local governments. This segment also serves certain large government customers (including the U.S. government) that have requirements for off-the-shelf commercial equipment. |
• | Government Solutions - provides mission-critical technologies (such as tactical satellite-based networks and ongoing support for complicated communication networks) and high-performance transmission technologies (such as troposcatter systems and solid-state, high-power amplifiers) to large government end-users (including those of foreign countries), large international customers and domestic prime contractors. |
In fiscal 2020, we have rebranded our operating segment product groups to better align with our end markets. Prior descriptions of these product lines were updated to reflect such changes.
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Our Quarterly Financial Information
Quarterly and period-to-period sales and operating results may be significantly affected by either short-term or long-term contracts with our customers. In addition, our gross profit is affected by a variety of factors, including the mix of products, systems and services sold, production efficiencies, estimates of warranty expense, price competition and general economic conditions. Our gross profit may also be affected by the impact of any cumulative adjustments to contracts that are accounted for over time.
Our contracts with the U.S. government can be terminated for convenience by it at any time and orders are subject to unpredictable funding, deployment and technology decisions by the U.S. government. Some of these contracts are indefinite delivery/indefinite quantity ("IDIQ") contracts and, as such, the U.S. government is not obligated to purchase any equipment or services under these contracts. We have, in the past, experienced and we continue to expect significant fluctuations in sales and operating results from quarter-to-quarter and period-to-period. As such, comparisons between periods and our current results may not be indicative of a trend or future performance.
CRITICAL ACCOUNTING POLICIES
We consider certain accounting policies to be critical due to the estimation process involved in each.
Revenue Recognition. In accordance with FASB ASC 606 - Revenue from Contracts with Customers ("ASC 606"), we record revenue in an amount that reflects the consideration to which we expect to be entitled in exchange for goods or services promised to customers. Under ASC 606, we follow a five-step model to: (1) identify the contract with our customer; (2) identify our performance obligations in our contract; (3) determine the transaction price for our contract; (4) allocate the transaction price to our performance obligations; and (5) recognize revenue using one of the following two methods:
• | Over time - We recognize revenue using the over time method when there is a continuous transfer of control to the customer over the contractual period of performance. This generally occurs when we enter into a long-term contract relating to the design, development or manufacture of complex equipment or technology platforms to a buyer’s specification (or to provide services related to the performance of such contracts). Continuous transfer of control is typically supported by contract clauses which allow our customers to unilaterally terminate a contract for convenience, pay for costs incurred plus a reasonable profit and take control of work-in-process. Revenue recognized over time is generally based on the extent of progress toward completion of the related performance obligations. The selection of the method to measure progress requires judgment and is based on the nature of the products or services provided. In certain instances, typically for firm fixed-price contracts, we use the cost-to-cost measure because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion, including warranty costs. Revenues, including estimated fees or profits, are recorded proportionally as costs are incurred. Costs to fulfill generally include direct labor, materials, subcontractor costs, other direct costs and an allocation of indirect costs. When these contracts are modified, the additional goods or services are generally not distinct from those already provided. As a result, these modifications form part of an existing contract and we must update the transaction price and our measure of progress for the single performance obligation and recognize a cumulative catch-up to revenue and gross profits. |
For over time contracts using a cost-to-cost measure of progress, we have an estimate at completion ("EAC") process in which management reviews the progress and execution of our performance obligations. This EAC process requires management judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Since certain contracts extend over a long period of time, the impact of revisions in revenue and or cost estimates during the progress of work may impact current period earnings through a cumulative adjustment. Additionally, if the EAC process indicates a loss, a provision is made for the total anticipated loss in the period that it becomes evident. Contract revenue and cost estimates for significant contracts are generally reviewed and reassessed at least quarterly.
The cost-to-cost method is principally used to account for contracts in our mission-critical technologies and high-performance transmission technologies product lines and, to a lesser extent, certain location-based and messaging infrastructure contracts in our public safety and location technologies product line. For service-based contracts in our public safety and location technologies product line, we recognize revenue over time. These services are typically recognized as a series of services performed over the contract term using the straight-line method, or based on our customers’ actual usage of the networks and platforms which we provide.
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• | Point in time - When a performance obligation is not satisfied over time, we must record revenue using the point in time accounting method which generally results in revenue being recognized upon shipment or delivery of a promised good or service to a customer. This generally occurs when we enter into short term contracts or purchase orders where items are provided to customers with relatively quick turn-around times. Modifications to such contracts and or purchase orders, which typically provide for additional quantities or services, are accounted for as a new contract because the pricing for these additional quantities or services are based on standalone selling prices. |
Point in time accounting is principally applied to contracts in our satellite ground station technologies product line (which includes satellite modems, solid-state and traveling wave tube amplifiers) and certain contracts for our solid-state, high-power amplifiers in our high-performance transmission technologies product line. Point in time accounting is also applied to certain contracts in our mission-critical technologies product line. The contracts related to these product lines do not meet the requirements for over time revenue recognition because our customers cannot utilize the equipment for its intended purpose during any phase of our manufacturing process; customers do not simultaneously receive and or consume the benefits provided by our performance; customers do not control the asset (i.e., prior to delivery, customers cannot direct the use of the asset, sell or exchange the equipment, etc.); and, although many of our contracts have termination for convenience clauses and or an enforceable right to payment for performance completed to date, our performance creates an asset with an alternative use through the point of delivery.
In determining that our equipment has alternative use, we considered the underlying manufacturing process for our products. In the early phases of manufacturing, raw materials and work in process (including subassemblies) consist of common parts that are highly fungible among many different types of products and customer applications. Finished products are either configured to our standard configuration or based on our customers’ specifications. Finished products, whether built to our standard specification or to a customers’ specification, can be sold to a variety of customers and across many different end use applications with minimal rework, if needed, and without incurring a significant economic loss.
When identifying a contract with our customer, we consider when it has approval and commitment from both parties, if the rights of the parties are identified, if the payment terms are identified, if it has commercial substance and if collectability is probable.
When identifying performance obligations, we consider whether there are multiple promises and how to account for them. In our contracts, multiple promises are separated if they are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or comprise a series of distinct services performed over time, they are combined into a single performance obligation. In some cases, we may also provide the customer with an additional service-type warranty, which we recognize as a separate performance obligation. Service-type warranties do not represent a significant portion of our consolidated net sales. When service-type warranties represent a separate performance obligation, the revenue is deferred and recognized ratably over the extended warranty period. Our contracts, from time-to-time, may also include options for additional goods and services. To date, these options have not represented material rights to the customer as the pricing for them reflects standalone selling prices. As a result, we do not consider options we offer to be performance obligations for which we must allocate a portion of the transaction price. In many cases, we provide assurance-type warranty coverage for some of our products for a period of at least one year from the date of delivery.
When identifying the transaction price, we typically utilize the contract's stated price as a starting point. The transaction price in certain arrangements may include estimated amounts of variable consideration, including award fees, incentive fees or other provisions that can either increase or decrease the transaction price. We estimate variable consideration as the amount to which we expect to be entitled, and we include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the estimation uncertainty is resolved. The estimation of this variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (e.g., historical, current and forecasted) that is reasonably available to us.
When allocating the contract’s transaction price, we consider each distinct performance obligation. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation using our best estimate of the standalone selling price of each distinct good or service in the contract. We determine standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as market conditions, including geographic or regional specific factors, competitive positioning, internal costs, profit objectives and internally approved pricing guidelines related to the performance obligations.
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Almost all of our contracts with customers are denominated in U.S. dollars and typically are either firm fixed-price or cost reimbursable type contracts (including fixed-fee, incentive-fee and time-and-material type contracts). In almost all of our contracts with customers, we are the principal in the arrangement and report revenue on a gross basis. Transaction prices for contracts with U.S. domestic and international customers are usually based on specific negotiations with each customer and in the case of the U.S. government, sometimes based on estimated or actual costs of providing the goods or services in accordance with applicable regulations.
The timing of revenue recognition, billings and collections results in receivables, unbilled receivables and contract liabilities on our Condensed Consolidated Balance Sheet. Under typical payment terms for our contracts accounted for over time, amounts are billed as work progresses in accordance with agreed-upon contractual terms, either at periodic intervals (e.g., monthly) or upon achievement of contractual milestones. For certain contracts with provisions that are intended to protect customers in the event we do not satisfy our performance obligations, billings occur subsequent to revenue recognition, resulting in unbilled receivables. Under ASC 606, unbilled receivables constitute contract assets. On large long term contracts, and for contracts with international customers that do not do business with us regularly, payment terms typically require advanced payments and deposits. Under ASC 606, payments received from customers in excess of revenue recognized to date results in a contract liability. These contract liabilities are not considered to represent a significant financing component of the contract because we believe these cash advances and deposits are generally used to meet working capital demands which can be higher in the earlier stages of a contract. Also, advanced payments and deposits provide us with some measure of assurance that the customer will perform on its obligations under the contract. Under the typical payment terms for our contracts accounted for at a point in time, costs are accumulated in inventory until the time of billing, which generally coincides with revenue recognition.
We recognize the incremental costs to obtain or fulfill a contract as an expense when incurred if the amortization period of the asset is one year or less. Incremental costs to obtain or fulfill contracts with an amortization period greater than one year were not material.
As commissions payable to our internal sales and marketing employees or contractors are contingent upon multiple factors, such commissions are not considered direct costs to obtain or fulfill a contract with a customer and are expensed as incurred in selling, general and administrative expenses on our Condensed Consolidated Statements of Operations. As for commissions payable to our third-party sales representatives related to large long-term contracts, we do consider these types of commissions both direct and incremental costs to obtain and fulfill such contracts. Therefore, such types of commissions are included in total estimated costs at completion for such contracts and expensed over time through cost of sales on our Condensed Consolidated Statements of Operations.
Remaining performance obligations represent the transaction price of firm orders for which work has not been performed as of the end of a fiscal period. Remaining performance obligations, which we refer to as backlog, exclude unexercised contract options and potential orders under indefinite delivery / indefinite quantity ("IDIQ") contracts.
Impairment of Goodwill and Other Intangible Assets. As of October 31, 2019, total goodwill recorded on our Condensed Consolidated Balance Sheet aggregated $309.9 million (of which $250.7 million relates to our Commercial Solutions segment and $59.2 million relates to our Government Solutions segment). Additionally, as of October 31, 2019, net intangibles recorded on our Condensed Consolidated Balance Sheet aggregated $256.7 million (of which $219.1 million relates to our Commercial Solutions segment and $37.6 million relates to our Government Solutions segment). Each of our two operating segments constitutes a reporting unit and we must make various assumptions in determining their estimated fair values.
In accordance with FASB ASC 350 "Intangibles - Goodwill and Other," we perform a goodwill impairment analysis at least annually (in the first quarter of each fiscal year), unless indicators of impairment exist in interim periods. If we fail the quantitative assessment of goodwill impairment ("quantitative assessment"), we would be required to recognize an impairment loss equal to the amount that a reporting unit's carrying value exceeded its fair value; however, any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.
On August 1, 2019 (the first day of our fiscal 2020), we performed our annual quantitative assessment using market participant assumptions to determine if the fair value of each of our reporting units with goodwill exceeded its carrying value. In making this assessment, we considered, among other things, expectations of projected net sales and cash flows, assumptions impacting the weighted average cost of capital, trends in trading multiples of comparable companies, changes in our stock price and changes in the carrying values of our reporting units with goodwill. We also considered overall business conditions.
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In performing the quantitative assessment, we estimated the fair value of each of our reporting units using a combination of the income and market approaches. The income approach, also known as the discounted cash flow ("DCF") method, utilizes the present value of cash flows to estimate fair value. The future cash flows for our reporting units were projected based on our estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). For purposes of conducting our impairment analysis, we assumed revenue growth rates and cash flow projections that are below our actual long-term expectations. The discount rates used in our DCF method were based on a weighted-average cost of capital ("WACC") determined from relevant market comparisons, adjusted upward for specific reporting unit risks (primarily the uncertainty of achieving projected operating cash flows). A terminal value growth rate was applied to the final year of the projected period, which reflects our estimate of stable, perpetual growth. We then calculated a present value of the respective cash flows for each reporting unit to arrive at an estimate of fair value under the income approach. Under the market approach, we estimated a fair value based on comparable companies' market multiples of revenues and earnings before interest, taxes, depreciation and amortization and factored in a control premium. Finally, we compared our estimates of fair values to our August 1, 2019 total public market capitalization and assessed implied control premiums based on our common stock price of $29.54 as of August 1, 2019.
Based on our quantitative evaluation, we determined that our Commercial Solutions and Government Solutions reporting units had estimated fair values in excess of their carrying values of at least 29.0% and 122.2%, respectively, and concluded that our goodwill was not impaired and that neither of our two reporting units was at risk of failing the quantitative assessment. It is possible that, during fiscal 2020 or beyond, business conditions (both in the U.S. and internationally) could deteriorate from the current state, our current or prospective customers could materially postpone, reduce or even forgo purchases of our products and services to a greater extent than we currently anticipate, or our common stock price could decline. A significant decline in our customers' spending that is greater than we anticipate or a shift in funding priorities may also have a negative effect on future orders, sales, income and cash flows and we might be required to perform a quantitative assessment during fiscal 2020 or beyond. If assumed net sales and cash flow projections are not achieved in future periods or our common stock price significantly declines from current levels, our Commercial Solutions and Government Solutions reporting units could be at risk of failing the quantitative assessment and goodwill and intangibles assigned to the respective reporting units could be impaired.
In any event, we are required to perform the next annual goodwill impairment analysis on August 1, 2020 (the start of our fiscal 2021). If our assumptions and related estimates change in the future, or if we change our reporting unit structure or other events and circumstances change (e.g., a sustained decrease in the price of our common stock (considered on both absolute terms and relative to peers)), we may be required to record impairment charges when we perform these tests, or in other future periods. In addition to our impairment analysis of goodwill, we also review net intangible assets with finite lives when an event occurs indicating the potential for impairment. We believe that the carrying values of our net intangible assets were recoverable as of October 31, 2019. Any impairment charges that we may record in the future could be material to our results of operations and financial condition.
Provision for Warranty Obligations. We provide warranty coverage for most of our products, including products under long-term contracts, for a period of at least one year from the date of shipment. We record a liability for estimated warranty expense based on historical claims, product failure rates and other factors. Costs associated with some of our warranties that are provided under long-term contracts are incorporated into our estimates of total contract costs. There exist inherent risks and uncertainties in estimating warranty expenses, particularly on larger or longer-term contracts. If we do not accurately estimate our warranty costs, any changes to our original estimates could be material to our results of operations and financial condition.
Accounting for Income Taxes. Our deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities, and applying enacted tax rates expected to be in effect for the year in which we expect the differences to reverse. Our provision for income taxes is based on domestic (including federal and state) and international statutory income tax rates in the tax jurisdictions where we operate, permanent differences between financial reporting and tax reporting and available credits and incentives. We recognize potential interest and penalties related to uncertain tax positions in income tax expense. The U.S. federal government is our most significant income tax jurisdiction.
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Significant judgment is required in determining income tax provisions and tax positions. We may be challenged upon review by the applicable taxing authority and positions taken by us may not be sustained. We recognize all or a portion of the benefit of income tax positions only when we have made a determination that it is more likely than not that the tax position will be sustained upon examination, based upon the technical merits of the position and other factors. For tax positions that are determined as more likely than not to be sustained upon examination, the tax benefit recognized is the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The development of valuation allowances for deferred tax assets and reserves for income tax positions requires consideration of timing and judgments about future taxable income, tax issues and potential outcomes, and are subjective critical estimates. A portion of our deferred tax assets consist of federal research and experimentation tax credit carryforwards, most of which was acquired in connection with our acquisition of TCS. No valuation allowance has been established on these deferred tax assets based on our evaluation that our ability to realize such assets has met the criteria of "more likely than not." We continuously evaluate additional facts representing positive and negative evidence in determining our ability to realize these deferred tax assets. In certain circumstances, the ultimate outcome of exposures and risks involves significant uncertainties. If actual outcomes differ materially from these estimates, they could have a material impact on our results of operations and financial condition.
Our federal income tax returns for fiscal 2017 and 2018 are subject to potential future Internal Revenue Service ("IRS") audit. None of our state income tax returns prior to fiscal 2015 are subject to audit. TCS's federal income tax return for the tax period from January 1, 2016 to February 23, 2016, the date we acquired TCS, is subject to potential future IRS audit. None of TCS's state income tax returns prior to calendar year 2015 are subject to audit. Future tax assessments or settlements could have a material adverse effect on our consolidated results of operations and financial condition.
Research and Development Costs. We generally expense all research and development costs. Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other personnel-related expenses associated with product development. Research and development expenses also include third-party development and programming costs. Costs incurred internally in researching and developing software to be sold are charged to expense until technological feasibility has been established for the software. Judgment is required in determining when technological feasibility of a product is established. Technological feasibility for our advanced communication software solutions is generally reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to customers and when we are able to validate the marketability of such product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. To date, capitalized internally developed software costs were not material.
Provisions for Excess and Obsolete Inventory. We record a provision for excess and obsolete inventory based on historical and projected usage trends. Other factors may also influence our provision, including decisions to exit a product line, technological change and new product development. These factors could result in a change in the amount of excess and obsolete inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if we determine that our inventory was overvalued, we would be required to recognize such costs in our financial statements at the time of such determination. Any such charge could be material to our results of operations and financial condition.
Allowance for Doubtful Accounts. We perform credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness, as determined by our review of our customers’ current credit information. Generally, we will require cash in advance or payment secured by irrevocable letters of credit before an order is accepted from an international customer that we do not do business with regularly. In addition, we seek to obtain insurance for certain domestic and international customers.
We monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. In light of ongoing tight credit market conditions, we continue to see requests from our customers for higher credit limits and longer payment terms. Because of our strong cash position and the nominal amount of interest we are earning on our cash and cash equivalents, we have, on a limited basis, approved certain customer requests.
We continue to monitor our accounts receivable credit portfolio. Our overall credit losses have historically been within our expectations of the allowances established; however, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Measurement of credit losses requires consideration of historical loss experience, including the need to adjust for changing business conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and the financial health of specific customers. Changes to the estimated allowance for doubtful accounts could be material to our results of operations and financial condition.
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Business Outlook for Fiscal 2020
Fiscal 2020 is off to a great start. Our first quarter results exceeded our expectations and we generated consolidated:
• | Net sales of $170.3 million; |
• | Operating income of $9.3 million (or $11.9 million excluding $2.4 million of acquisition plan expenses and $0.2 million of estimated contract settlement costs); |
• | Net income of $6.4 million (or $7.8 million excluding acquisition plan expenses of $1.8 million (net of tax), estimated contract settlement costs of $0.2 million (net of tax) and a net discrete tax benefit of $0.6 million); |
• | Cash flows from operating activities of $5.4 million; and |
• | Adjusted EBITDA (a Non-GAAP financial measure discussed below) of $20.6 million. |
Our business momentum remains strong and we achieved a consolidated book-to-bill ratio (a measure defined as bookings divided by net sales) of 0.80. We finished the first quarter with consolidated backlog of $648.3 million. We have a number of large opportunities in our pipeline and are targeting to achieve a fiscal 2020 book-to-bill ratio in excess of 1.0. Our backlog (sometimes referred to herein as orders or bookings) is more fully defined in our most recent Annual Report on Form 10-K and the total value of multi-year contracts that we have received is substantially higher than our reported backlog. As of October 31, 2019, our cash and cash equivalents were $46.9 million and total debt outstanding under our Credit Facility was $169.0 million.
Recent positive developments in our business include:
• | In October 2019, we announced that the U.S. Army awarded us a contract with a $98.6 million ceiling to provide global field support services for military satellite communication (“SATCOM”) terminals around the world. The field support contract covers diverse engineering and technical skills to support these SATCOM terminals, including logistics, help desk, network engineering, security engineering, RF and satellite system engineering and support. To date, the contract has been funded at $24.4 million with additional funding expected to occur across the twelve-month performance period. |
• | In November 2019, the U.S. government announced that our teaming partner on a U.S. Marine Corps troposcatter opportunity was awarded a 10-year $325.0 million “IDIQ” contract to provide 172 next-generation troposcatter systems and related services. Our teaming partner announced that it intends to subcontract the manufacture and delivery of these troposcatter systems to Comtech and we are currently negotiating contract terms and expect our initial order soon. We believe this multi-year opportunity validates Comtech’s market leading troposcatter technologies and expertise and bodes well for the future, as we continue to see strong demand for these products. |
• | In November 2019, we announced that we entered into an agreement to acquire UHP Networks Inc. and its sister company (together, “UHP”), a leading provider of innovative and disruptive satellite ground station technology solutions, for a purchase price of approximately $40.0 million. UHP is based in Canada and has developed revolutionary technology that is transforming the Very Small Aperture Terminal (“VSAT”) market. With end-markets for high-speed satellite-based networks significantly growing, our acquisition of UHP is a significant step in enhancing our solution offerings for the satellite ground station market. After months of extensive testing, we believe that UHP’s innovative implementation techniques for time division multiple access (“TDMA”) technology are best-in-class and provide the highest TDMA efficiency at the lowest cost available. We are very excited about UHP and expect the use of their incredible technology to expand globally for many years ahead. The acquisition of UHP is expected to close late in the second half of fiscal 2020. |
Based on our fiscal 2020 performance to date and our anticipated timing of performance related to orders currently in our backlog and the timing of expected new orders, we believe we are on track to making fiscal 2020 a very successful year. We have updated our fiscal 2020 consolidated financial targets as follows:
• | We are increasing our consolidated net sales target to a new range of approximately $712.0 million to $732.0 million as compared to the prior range of $710.0 million to $730.0 million. |
• | We are increasing our Adjusted EBITDA goal to a new range of $99.0 million to $103.0 million as compared to the prior range of $98.0 million to $102.0 million. Our Adjusted EBITDA goal reflects a target of approximately 14.0% of our expected fiscal 2020 consolidated net sales. |
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• | Despite incurring $2.4 million of actual acquisition plan expenses and $0.2 million of estimated contract settlement costs in the first quarter of fiscal 2020, as well as an additional $2.4 million of such costs expected during the second quarter of fiscal 2020, GAAP operating income, as a percentage of the consolidated net sales, is still expected to approximate 7.0%. Excluding such expenses, operating income, as a percentage of fiscal 2020 consolidated net sales, is expected to approximate 7.7%. |
• | There is no change to our expected interest expense rate (including amortization of deferred financing costs) of approximately 4.6% or total interest expense of approximately $7.5 million. Our current and fiscal 2020 expected cash borrowing rate is approximately 4.0%. |
• | Our effective income tax rate (excluding discrete tax items) for each of the remaining quarters of fiscal 2020 is expected to approximate 23.0%. |
• | Consistent with Comtech's business cycle for the past several years, our financial performance in the second half of fiscal 2020 is anticipated to be higher than the first half. Based on anticipated product mix and timing assumptions, we expect our second quarter consolidated net sales to range from $168.0 million to $170.0 million, with Adjusted EBITDA ranging from $19.0 million to approximately $21.0 million. Our fourth quarter of fiscal 2020 is still expected to be the peak quarter - by far - for our consolidated net sales, GAAP operating income, GAAP net income and Adjusted EBITDA. |
Our fiscal 2020 targets reflect several items, the timing of which could shift and impact our expected quarterly financial performance. In addition, the aforementioned fiscal 2020 financial targets do not include the impact of the pending acquisition of UHP or the impact of any other expense we may incur in order to achieve our strategic objectives. If we achieve all of our fiscal 2020 business goals, it is possible that financial results could be higher than our targeted amounts.
Our Business Outlook for Fiscal 2020 depends, in large part, on timely deliveries and the receipt of, and performance on, orders from our customers and could be adversely impacted if orders and/or deliveries are delayed, business conditions deteriorate, or our current or prospective customers materially postpone, reduce or even forgo purchases of our products and services. Additionally, we continue to evaluate cost reduction initiatives in our business, including in connection with the repositioning of our location technology solutions offerings. Our updated fiscal 2020 financial targets do not consider the financial impact of any additional future actions we may take in this regard.
On December 4, 2019, our Board of Directors declared a dividend of $0.10 per common share, payable on February 14, 2020 to stockholders of record at the close of business on January 15, 2020. Future dividends remain subject to compliance with financial covenants under our Credit Facility, as amended, as well as Board approval.
Additional information related to our Business Outlook for Fiscal 2020 and a definition and explanation of Adjusted EBITDA is included in the below section "Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of the Results of Operations for the Three Months Ended October 31, 2019 and 2018."
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COMPARISON OF THE RESULTS OF OPERATIONS FOR THREE MONTHS ENDED OCTOBER 31, 2019 AND 2018
Net Sales. Consolidated net sales were $170.3 million and $160.8 million for the three months ended October 31, 2019 and 2018, respectively, representing an increase of $9.5 million, or 5.9%. The period-over-period increase in net sales reflects significantly higher net sales in our Commercial Solutions segment, offset in part by a decrease in our Government Solutions segment. Net sales by operating segment are discussed below.
Commercial Solutions
Net sales in our Commercial Solutions segment were $94.3 million for the three months ended October 31, 2019, as compared to $78.0 million for the three months ended October 31, 2018, a significant increase of $16.3 million, or 20.9%. Our Commercial Solutions segment represented 55.4% of consolidated net sales for the three months ended October 31, 2019 as compared to 48.5% for the three months ended October 31, 2018. As further discussed below, demand for our products appears strong and looking forward, we believe this segment will grow in fiscal 2020.
Bookings in our Commercial Solutions segment during our first quarter of fiscal 2020 were comparable to our first quarter of fiscal 2019 and significantly higher than the bookings we achieved in our fourth quarter of fiscal 2019. Our book-to-bill ratio (a measure defined as bookings divided by net sales) for this segment was 0.80. Period-to-period fluctuations in bookings is normal for this segment.
Net sales of our satellite ground station technologies during the three months ended October 31, 2019 were slightly higher than the three months ended October 31, 2018. Growth in the first quarter of fiscal 2020 was driven by higher net sales to both U.S. government and international customers. This strength was offset, in part, by lower sales for inflight communication amplifiers sold primarily to a U.S. domestic customer. Our HeightsTM solutions continue to gain traction and related bookings during the first quarter of fiscal 2020 remained strong. For example, our HeightsTM networking platform was recently selected by Telefonica, one of the largest telecommunications companies in the world by number of customers, for a multi-year program to upgrade Vivo Brazil and Telefonica Argentina mobile networks in support of 2G, 3G and LTE backhaul. Based on the anticipated increase in the number of high-throughput satellites and low earth orbit and medium earth orbit satellites expected to be launched, and the migration of networks from 3G to 4G and ultimately 5G technologies in emerging countries, we believe that we are in the early stages of a multi-year period of growing demand for satellite ground station technologies which are used to backhaul cellular traffic. Sales to U.S. government customers for fiscal 2020 are expected to remain strong with a small amount of year-to-year growth anticipated. As a result, we expect fiscal 2020 to be a year of net sales growth for our satellite earth station product line.
Net sales in the three months ended October 31, 2019 of our public safety and location technology solutions were significantly higher as compared to the net sales we achieved in the three months ended October 31, 2018. During the first quarter of fiscal 2020, we benefited from incremental sales to key wireless customers for 911 call routing and incremental sales to state and local agencies for our next-generation 911 products. Sales during our most recent quarter reflect the benefit of our fiscal 2019 acquisitions of Solacom and the GD NG-911 business. Sales of our location technology solutions during the first quarter of fiscal 2020 were comparable to the first quarter of fiscal 2019. Our public safety and location technology solutions have long sales cycles and are subject to difficult-to-predict changes in the overall procurement strategies of wireless carrier customers, but we believe we are positioned well. For instance, we recently announced a $4.4 million contract award from a key customer, which renewed the licensing of our GPS-enabled navigation platform. We also recently announced that this same customer awarded us a two-year renewal agreement worth $6.4 million for various location-based services ("LBS") in the telecommunications industry. Overall market conditions remain favorable; as such, we expect fiscal 2020 to be another year of growth for our public safety and location technology solutions.
Bookings, sales and profitability in our Commercial Solutions segment can fluctuate from period-to-period due to many factors, including changes in the general business environment. As such, period-to-period comparisons of our results may not be indicative of a trend or future performance.
Government Solutions
Net sales in our Government Solutions segment were $76.0 million for the three months ended October 31, 2019 as compared to $82.9 million for the three months ended October 31, 2018, a decrease of $6.9 million, or 8.3%. Our Government Solutions segment represented 44.6% of consolidated net sales for the three months ended October 31, 2019, as compared to 51.5% for the three months ended October 31, 2018. As further discussed below, our business remains strong and demand for our solutions still appears robust. Looking forward, we believe that sales in our Government Solutions segment will be similar or slightly higher than the level we achieved in fiscal 2019, with the ultimate level largely determined by the timing of orders and sales.
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Bookings in our Government Solutions segment during our first quarter of fiscal 2020 were lower than our first quarter of fiscal 2019 but significantly higher than the bookings we achieved in our fourth quarter of fiscal 2019. Our book-to-bill ratio (a measure defined as bookings divided by net sales) in this segment for the first quarter of fiscal 2020 was 0.80. Period-to-period fluctuations in bookings is normal for this segment; and as discussed further below, bookings this quarter do not reflect the full amount of orders expected from a large U.S. Army global field support contract that we won or any amount from a forthcoming multi-million dollar contract to provide troposcatter equipment for use by the U.S. Marine Corps.
In October 2019, we announced that the U.S Army awarded us a contract with a $98.6 million ceiling to provide global field support services for military satellite communication ("SATCOM") terminals around the world. These SATCOM terminals provide inter and intra-theater network communications with worldwide reach back capability. The field support contract covers diverse engineering and technical skills to support these SATCOM terminals, including logistics, help desk, network engineering, security engineering, RF and satellite system engineering and support. To date, the contract has been funded at $24.4 million with additional funding expected to occur across the twelve-month performance period plus a possible six-month extension period. Additionally, in November 2019, the U.S. government announced that our teaming partner on a U.S. Marine Corps troposcatter opportunity was awarded a 10-year $325.0 million "IDIQ" contract to provide 172 next-generation troposcatter systems and related services. The teaming partner announced that it intends to subcontract the manufacture and delivery of these troposcatter systems to Comtech, including the test support, logistics and training documentation, training execution, fielding support and sustainment. We are currently negotiating contract terms with our teaming partner and expect our initial order soon. We believe this multi-year opportunity validates Comtech’s market leading troposcatter technologies and expertise.
Net sales of our mission-critical technologies during the three months ended October 31, 2019 were significantly lower as compared to the three months ended October 31, 2018, due primarily to deliveries of our next generation MT-2025 mobile satellite transceivers in the comparable period of the prior fiscal year.
Net sales of our high-performance transmission technologies during the three months ended October 31, 2019 were higher than the three months ended October 31, 2018, driven by increased sales of our solid-state, high-power amplifiers and related switching technologies, as well as increased sales of our troposcatter technologies (including our Modular Transportable Transmission System ("MTTS") troposcatter terminals to an Asia Pacific military service).
Bookings, sales and profitability in our Government Solutions segment can fluctuate dramatically from period-to-period due to many factors, including unpredictable funding, deployment and technology decisions by our U.S. and international government customers. As such, period-to-period comparisons of our results may not be indicative of a trend or future performance.
Geography and Customer Type
Sales by geography and customer type, as a percentage of related sales, for the three months ended October 31, 2019 and 2018 are as follows:
Three months ended October 31, | ||||||||||||||||||
2019 | 2018 | 2019 | 2018 | 2019 | 2018 | |||||||||||||
Commercial Solutions | Government Solutions | Consolidated | ||||||||||||||||
U.S. government | 17.7 | % | 18.2 | % | 69.5 | % | 68.6 | % | 40.8 | % | 44.2 | % | ||||||
Domestic | 56.6 | % | 54.2 | % | 10.6 | % | 10.0 | % | 36.1 | % | 31.4 | % | ||||||
Total U.S. | 74.3 | % | 72.4 | % | 80.1 | % | 78.6 | % | 76.9 | % | 75.6 | % | ||||||
International | 25.7 | % | 27.6 | % | 19.9 | % | 21.4 | % | 23.1 | % | 24.4 | % | ||||||
Total | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % | ||||||
Sales to U.S. government customers include sales to the U.S. Department of Defense ("DoD"), intelligence and civilian agencies, as well as sales directly to or through prime contractors.
Domestic sales include sales to commercial customers, as well as to U.S. state and local governments. Except for the U.S. government, there were no customers that represented more than 10.0% of consolidated net sales during the three months ended October 31, 2019 and 2018.
International sales for the three months ended October 31, 2019 and 2018 (which include sales to U.S. domestic companies for inclusion in products that are sold to international customers) were $39.4 million and $39.3 million, respectively. Except for the U.S., no individual country (including sales to U.S. domestic companies for inclusion in products that are sold to a foreign country) represented more than 10.0% of consolidated net sales for the three months ended October 31, 2019 and 2018.
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Gross Profit. Gross profit was $63.6 million and $57.8 million for the three months ended October 31, 2019 and 2018, respectively. The increase of $5.8 million reflects significantly higher net sales in our Commercial Solutions segment, offset in part by a decrease in sales in our Government Solutions segment, as discussed above.
Gross profit, as a percentage of consolidated net sales, for the three months ended October 31, 2019 was 37.3% as compared to 35.9% for the three months ended October 31, 2018. This increase was almost entirely driven by product mix changes as a result of the significant period-over-period increase in net sales in our Commercial Solutions segment. This segment historically achieves higher gross margins than our Government Solutions segment. Gross profit, as a percentage of related segment net sales, is further discussed below.
Our Commercial Solutions segment's gross profit, as a percentage of related segment net sales, for the three months ended October 31, 2019 decreased slightly in comparison to the three months ended October 31, 2018. The decrease in gross profit percentage in the three months ended October 31, 2019 primarily reflects changes in products and services mix, including significantly higher net sales of our public safety and location technologies. Our gross profit percentage in this segment during the most recent fiscal quarter also includes net sales of our HeightsTM solutions, which currently have lower gross margins than our traditional satellite ground station technologies. Looking forward, we expect our gross profit as a percentage of this segment's net sales in fiscal 2020 to be slightly lower than the percentage achieved in fiscal 2019, primarily due to anticipated mix changes, including higher net sales of our HeightsTM solutions and the cessation of sales to AT&T for 911 wireless call routing which is expected to occur in the second half of fiscal 2020.
Our Government Solutions segment's gross profit, as a percentage of related segment net sales, for the three months ended October 31, 2019 increased slightly in comparison to the three months ended October 31, 2018. Based on the mix and anticipated timing of shipments and performance related to orders currently in our backlog and the mix and timing of expected new orders and related net sales, gross profit for this segment, as a percentage of related segment net sales, for fiscal 2020 is expected to be similar or slightly lower than the level achieved in fiscal 2019.
Included in consolidated cost of sales for the three months ended October 31, 2019 and 2018 are provisions for excess and obsolete inventory of $0.4 million and $0.7 million, respectively. As discussed in "Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies - Provisions for Excess and Obsolete Inventory," we regularly review our inventory and record a provision for excess and obsolete inventory based on historical and projected usage trends.
Because our consolidated gross profit, as a percentage of consolidated net sales, depends on the volume of sales, sales mix and related gross profit for each individual segment, it is inherently difficult to forecast. Nevertheless, based on expected bookings, expected timing of our performance on orders and the anticipated mix of net sales between our Commercial Solutions and Government Solutions segments, we currently expect our consolidated gross profit, as a percentage of consolidated net sales, for fiscal 2020 to be the same or slightly lower than the percentage we achieved in fiscal 2019.
Selling, General and Administrative Expenses. Selling, general and administrative expenses were $31.9 million and $31.8 million for the three months ended October 31, 2019 and 2018, respectively, representing an increase of $0.1 million, or 0.3%. As a percentage of consolidated net sales, selling, general and administrative expenses were 18.7% and 19.8% for the three months ended October 31, 2019 and 2018, respectively. The decrease, as a percentage of consolidated net sales, is primarily attributable to the increase in our consolidated net sales.
During the three months ended October 31, 2018, we incurred $1.4 million of facility exit costs in our Government Solutions segment. Excluding such costs, our selling, general and administrative expenses would have been $30.4 million, or 18.9% of consolidated net sales for the three months ended October 31, 2018.
Amortization of stock-based compensation expense recorded as selling, general and administrative expenses was $0.7 million in the three months ended October 31, 2019 as compared to $0.9 million in the three months ended October 31, 2018. Amortization of stock-based compensation is not allocated to our two reportable operating segments.
Based on our current spending plans, we expect total fiscal 2020 selling, general and administrative expenses, in dollars, to be higher and, as a percentage of consolidated net sales, to be slightly lower than the 19.1% recorded in fiscal 2019.
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Research and Development Expenses. Research and development expenses were $14.9 million and $13.2 million for the three months ended October 31, 2019 and 2018, respectively, representing an increase of $1.7 million, or 12.9%. As a percentage of consolidated net sales, research and development expenses were 8.7% and 8.2% for the three months ended October 31, 2019 and 2018, respectively.
For the three months ended October 31, 2019 and 2018, research and development expenses of $12.9 million and $11.4 million, respectively, related to our Commercial Solutions segment, and $1.9 million and $1.7 million, respectively, related to our Government Solutions segment. The remaining research and development expenses of $0.1 million for both the three months ended October 31, 2019 and 2018, respectively, related to the amortization of stock-based compensation expense.
Whenever possible, we seek customer funding for research and development to adapt our products to specialized customer requirements. During the three months ended October 31, 2019 and 2018, customers reimbursed us $2.7 million and $5.0 million, respectively, which is not reflected in the reported research and development expenses but is included in net sales with the related costs included in cost of sales.
We continue to invest in enhancements to existing products as well as in new products across almost all of our product lines. Based on our current spending plans, we expect fiscal 2020 research and development expenses, in dollars, to be higher and, as a percentage of consolidated net sales, to be slightly lower than the 8.4% achieved in fiscal 2019.
Amortization of Intangibles. Amortization relating to intangible assets with finite lives was $5.2 million (of which $4.4 million was for the Commercial Solutions segment and $0.8 million was for the Government Solutions segment) for the three months ended October 31, 2019 and $4.3 million (of which $3.5 million was for the Commercial Solutions segment and $0.8 million was for the Government Solutions segment) for the three months ended October 31, 2018. The increase of $0.9 million was due to our fiscal 2019 acquisitions of Solacom and the GD NG-911 business.
Our Business Outlook for Fiscal 2020 assumes total annual amortization of intangible assets of approximately $21.0 million which reflects a full year of amortization of intangibles related to our fiscal 2019 acquisitions of Solacom and the GD NG-911 business. Such amount, however, does not include the impact of any pending or future acquisitions.
Acquisition Plan Expenses. During the three months ended October 31, 2019, we incurred acquisition plan expenses of $2.4 million, including expenses related to our pending acquisition of UHP, as discussed above. During the three months ended October 31, 2018, we incurred acquisition plan expenses of $1.1 million, which primarily related to our fiscal 2019 acquisition of Solacom. These expenses are recorded in our Unallocated segment.
In order to position ourselves to take advantage of additional growth opportunities and meet our strategic objectives, during the second quarter of fiscal 2020, we expect to incur approximately $2.4 million of acquisition plan expenses for companies whose solution offerings are complementary to our business. There is no certainty that our acquisition plan efforts will be successful and total acquisition plan expenses in the second quarter of fiscal 2020 may ultimately be higher.
Operating Income. Operating income for the three months ended October 31, 2019 was $9.3 million as compared to $7.3 million for the three months ended October 31, 2018. Operating income by reportable segment is shown in the table below:
Three months ended October 31, | ||||||||||||||||||||||||||
2019 | 2018 | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||
($ in millions) | Commercial Solutions | Government Solutions | Unallocated | Consolidated | ||||||||||||||||||||||
Operating income (loss) | $ | 9.8 | 7.1 | 7.1 | 6.7 | (7.7 | ) | (6.4 | ) | $ | 9.3 | 7.3 | ||||||||||||||
Percentage of related net sales | 10.4 | % | 9.1 | % | 9.3 | % | 8.1 | % | NA | NA | 5.5 | % | 4.5 | % | ||||||||||||
The increase in our Commercial Solutions segment’s operating income for the three months ended October 31, 2019, both in dollars and as a percentage of related segment net sales, was due primarily to the significant increase in this segment’s net sales offset, in part, by a slight decrease in this segment’s gross profit percentage, higher research and development expenses and increased amortization of intangibles, as discussed above. Looking forward, given expected sales and product mix assumptions, as discussed above, we expect fiscal 2020 operating income, both in dollars and as a percentage of related segment net sales, to be higher than the 10.1% achieved in fiscal 2019.
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The increase in our Government Solutions segment’s operating income for the three months ended October 31, 2019, both in dollars and as a percentage of related segment net sales, was due primarily to the $1.4 million of facility exit costs that we incurred during the three months ended October 31, 2018, as discussed above. Excluding such facility exit costs, operating income in our Government Solutions segment for the three months ended October 31, 2018 would have been $8.0 million, or 9.7% of related segment sales. The decrease, both in dollars and as a percentage of related segment net sales, in the three months ended October 31, 2019 was due primarily to the decrease in net sales, as discussed above. Looking forward, given expected sales and product mix assumptions, as discussed above, we expect fiscal 2020 operating income, in dollars, to be comparable to the amount achieved in fiscal 2019, and as a percentage of related segment net sales, to be slightly lower than the 9.2% achieved in fiscal 2019.
The increase in unallocated expenses for the three months ended October 31, 2019 as compared to the three months ended October 31, 2018 is primarily due to increased business and sales activity, as well as higher acquisition plan expenses during the most recent fiscal quarter, as discussed above. Amortization of stock-based compensation was $0.9 million and $1.0 million, respectively, for the three months ended October 31, 2019 and 2018.
Excluding the $2.4 million of acquisition plan expenses and $0.2 million of estimated contract settlement costs, consolidated operating income for the three months ended October 31, 2019 would have been $11.9 million, or 7.0% of consolidated net sales. Excluding the $1.1 million of acquisition plan expenses and $1.4 million of facility exit costs in the three months ended October 31, 2018, consolidated operating income would have been $9.8 million, or 6.1% of consolidated net sales. The increase from 6.1% to 7.0% reflects the benefit of incremental sales growth and changes in overall spending, as discussed above.
Our Business Outlook for Fiscal 2020 assumes, similar to the prior three fiscal years, that we will continue to pay certain annual non-equity incentive awards in the form of fully-vested share units. Amortization of stock-based compensation can fluctuate from period-to-period based on the type and timing of stock-based awards, estimated forfeitures and the achievement of applicable performance goals. If we do not achieve our fiscal 2020 business goals, amortization of stock-based compensation expense would be lower than our current expected fiscal 2020 range.
Looking forward, unallocated operating expenses in fiscal 2020 are expected to be higher than the $23.6 million incurred in fiscal 2019. The increase in unallocated expenses is expected to be driven by: (i) increased amortization of stock-based compensation (which is not allocated to our two reportable segments) which, in fiscal 2020, is expected to range from $12.0 million to $14.0 million; (ii) increased compensation costs, including incremental costs for additional personnel to support our anticipated growth; (iii) the absence of a $3.2 million benefit in fiscal 2020 resulting from the favorable ruling in the prior fiscal year related to a legacy TCS intellectual property matter; (iv) incremental acquisition plan expenses; and (iv) other increased spending as a result of increased business activity assumed in fiscal 2020.
Despite the incurrence of $2.4 million of acquisition plan expenses and $0.2 million of estimated contract settlement costs in the first quarter of fiscal 2020 as well as an additional $2.4 million of such costs expected during the second quarter of fiscal 2020, our fiscal 2020 GAAP consolidated operating income (in dollars) is anticipated to be higher than the $41.4 million we achieved in fiscal 2019, and as a percentage of consolidated net sales, to approximate 7.0% as compared to the 6.2% we achieved in fiscal 2019.
Interest Expense and Other. Interest expense was $1.8 million and $2.7 million for the three months ended October 31, 2019 and 2018, respectively. The amount for the three months ended October 31, 2019 primarily relates to our new Credit Facility. The amount for the three months ended October 31, 2018 primarily relates to our Prior Credit Facility. Our effective interest rate (including amortization of deferred financing costs) in the three months ended October 31, 2019 was approximately 4.7%.
Looking forward, we expect our fiscal 2020 interest expense rate to approximate 4.6% and total interest expense to approximate $7.5 million. Our current and expected fiscal 2020 cash borrowing rate (which excludes the amortization of deferred financing costs) is approximately 4.0%.
Write-off of Deferred Financing Costs. In connection with the establishment of our new Credit Facility in the three months ended October 31, 2018, we wrote-off $3.2 million of deferred financing costs which primarily related to the term loan portion of our Prior Credit Facility. See "Notes to Condensed Consolidated Financial Statements - Note (11) - Credit Facility" for further information. There was no comparable charge in the three months ended October 31, 2019.
Interest (Income) and Other. Interest (income) and other for both the three months ended October 31, 2019 and 2018 was nominal. All of our available cash and cash equivalents are currently invested in bank deposits and money market deposit accounts which, at this time, are currently yielding an immaterial interest rate.
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Provision for (Benefit from) Income Taxes. The provision for income taxes during the three months ended October 31, 2019 was $1.1 million as compared to a benefit from income taxes of $2.1 million for the three months ended October 31, 2018. Our effective tax rate (excluding discrete tax items) for the three months ended October 31, 2019 was 23.0% as compared to 22.75% for the three months ended October 31, 2018. The increase from 22.75% to 23.0% is primarily due to expected product and geographical mix changes reflected in our Business Outlook for Fiscal 2020.
During the three months ended October 31, 2019, we recorded a net discrete tax benefit of $0.6 million, primarily related to discrete tax benefits for stock-based awards that were settled during the quarter. During the three months ended October 31, 2018, we recorded a net discrete tax benefit of $2.4 million, primarily related to (i) the favorable resolution of the IRS audit of our fiscal 2016 federal income tax return, and (ii) discrete tax benefits for stock-based awards that were settled during the quarter.
Our federal income tax returns for fiscal 2017 and 2018 are subject to potential future IRS audit. None of our state income tax returns prior to fiscal 2015 are subject to audit. TCS's federal income tax return for the tax period from January 1, 2016 to February 23, 2016, the date we acquired TCS, is subject to potential future IRS audit. None of TCS's state income tax returns prior to calendar year 2015 are subject to audit. Future tax assessments or settlements could have a material adverse effect on our consolidated results of operations and financial condition.
Net Income. During the three months ended October 31, 2019, consolidated net income was $6.4 million as compared to $3.5 million during the three months ended October 31, 2018.
Adjusted EBITDA. Adjusted EBITDA (both in dollars and as a percentage of related net sales) for both the three months ended October 31, 2019 and 2018 are shown in the table below (numbers in the table may not foot due to rounding):
Three months ended October 31, | ||||||||||||||||||||||||||
2019 | 2018 | 2019 | 2018 | 2019 | 2018 | 2019 | 2018 | |||||||||||||||||||
($ in millions) | Commercial Solutions | Government Solutions | Unallocated | Consolidated | ||||||||||||||||||||||
Net income (loss) | $ | 9.9 | 7.0 | 7.1 | 6.6 | (10.6 | ) | (10.1 | ) | $ | 6.4 | 3.5 | ||||||||||||||
Provision for (benefit from) income taxes | — | — | — | — | 1.1 | (2.1 | ) | 1.1 | (2.1 | ) | ||||||||||||||||
Interest (income) and other | (0.1 | ) | 0.1 | — | — | — | — | (0.1 | ) | 0.1 | ||||||||||||||||
Write-off of deferred financing costs | — | — | — | — | — | 3.2 | — | 3.2 | ||||||||||||||||||
Interest expense | — | — | — | — | 1.8 | 2.6 | 1.8 | 2.7 | ||||||||||||||||||
Amortization of stock-based compensation | — | — | — | — | 0.9 | 1.0 | 0.9 | 1.0 | ||||||||||||||||||
Amortization of intangibles | 4.4 | 3.4 | 0.8 | 0.8 | — | — | 5.2 | 4.3 | ||||||||||||||||||
Depreciation | 2.2 | 2.2 | 0.3 | 0.4 | 0.1 | 0.2 | 2.7 | 2.9 | ||||||||||||||||||
Estimated contract settlement costs | 0.2 | — | — | — | — | — | 0.2 | — | ||||||||||||||||||
Acquisition plan expenses | — | — | — | — | 2.4 | 1.1 | 2.4 | 1.1 | ||||||||||||||||||
Facility exit costs | — | — | — | 1.4 | — | — | — | 1.4 | ||||||||||||||||||
Adjusted EBITDA | $ | 16.6 | 12.7 | 8.2 | 9.2 | (4.3 | ) | (4.0 | ) | $ | 20.6 | 18.0 | ||||||||||||||
Percentage of related net sales | 17.6 | % | 16.3 | % | 10.8 | % | 11.1 | % | NA | NA | 12.1 | % | 11.2 | % | ||||||||||||
The increase in consolidated Adjusted EBITDA, both in dollars and as a percentage of consolidated net sales, during the three months ended October 31, 2019 as compared to the three months ended October 31, 2018 is primarily attributable to higher consolidated net sales and operating income, as discussed above.
The increase in our Commercial Solutions segment's Adjusted EBITDA, both in dollars and as a percentage of related segment net sales, was primarily driven by significantly higher net sales, as discussed above.
The decrease in our Government Solutions segment's Adjusted EBITDA, both in dollars and as a percentage of related segment net sales, was primarily driven by lower net sales, as discussed above.
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Because our consolidated Adjusted EBITDA, as a percentage of consolidated net sales, depends on the volume of sales, sales mix and related gross profit for each individual segment as well as unallocated spending, it is inherently difficult to forecast. In addition, our Business Outlook for Fiscal 2020 includes several items, the timing of which can still shift and impact our expected quarterly financial performance.
Looking forward, based on the mix and anticipated timing of shipments and performance related to orders currently in our backlog and the mix and timing of expected new orders and related sales, we are targeting consolidated Adjusted EBITDA (in dollars) to be higher in fiscal 2020 as compared to the $93.5 million we achieved in fiscal 2019. As a percentage of consolidated net sales, Adjusted EBITDA is expected to approximate 14.0% in fiscal 2020. If order flow remains strong and we are able to achieve all of our fiscal 2020 business goals, it is possible that our fiscal 2020 Adjusted EBITDA could be higher than our targeted amount.
A reconciliation of our fiscal 2019 GAAP Net Income to Adjusted EBITDA of $93.5 million is shown in the table below (numbers in the table may not foot due to rounding):
($ in millions) | Fiscal Year 2019 | ||
Reconciliation of GAAP Net Income to Adjusted EBITDA: | |||
Net income | $ | 25.0 | |
Provision for income taxes | 3.9 | ||
Interest income and other | — | ||
Write-off of deferred financing costs | 3.2 | ||
Interest expense | 9.2 | ||
Amortization of stock-based compensation | 11.4 | ||
Amortization of intangibles | 18.3 | ||
Depreciation | 11.9 | ||
Estimated contract settlement costs | 6.4 | ||
Settlement of intellectual property litigation | (3.2 | ) | |
Acquisition plan expenses | 5.9 | ||
Facility exit costs | 1.4 | ||
Adjusted EBITDA | $ | 93.5 | |
In addition, a reconciliation of our GAAP consolidated operating income, net income and net income per diluted share during the three months ended October 31, 2019 and 2018 to the corresponding non-GAAP measures are shown in the tables below (numbers and per share amounts in the table may not foot due to rounding):
Three months ended October 31, 2019 | ||||||||||||
($ in millions, except for per share amount) | Operating Income | Net Income | Net Income per Diluted Share | |||||||||
Reconciliation of GAAP to Non-GAAP Earnings: | ||||||||||||
GAAP measures, as reported | $ | 9.3 | $ | 6.4 | $ | 0.26 | ||||||
Acquisition plan expenses | 2.4 | 1.8 | 0.07 | |||||||||
Estimated contract settlement costs | 0.2 | 0.2 | 0.01 | |||||||||
Net discrete tax benefit | — | (0.6 | ) | (0.02 | ) | |||||||
Non-GAAP measures | $ | 11.9 | $ | 7.8 | $ | 0.32 | ||||||
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Three months ended October 31, 2018 | ||||||||||||
($ in millions, except for per share amount) | Operating Income | Net Income | Net Income per Diluted Share | |||||||||
Reconciliation of GAAP to Non-GAAP Earnings: | ||||||||||||
GAAP measures, as reported | $ | 7.3 | $ | 3.5 | $ | 0.14 | ||||||
Facility exit costs | 1.4 | 1.1 | 0.04 | |||||||||
Acquisition plan expenses | 1.1 | 0.9 | 0.04 | |||||||||
Write-off of deferred financing costs | — | 2.5 | 0.10 | |||||||||
Net discrete tax benefit | — | (2.4 | ) | (0.10 | ) | |||||||
Non-GAAP measures | $ | 9.8 | $ | 5.5 | $ | 0.22 | ||||||
Our Adjusted EBITDA is a Non-GAAP measure that represents earnings (loss) before income taxes, interest (income) and other, write-off of deferred financing costs, interest expense, amortization of stock-based compensation, amortization of intangibles, depreciation expense, estimated contract settlement costs, settlement of intellectual property litigation, acquisition plan expenses, facility exit costs and strategic alternatives analysis expenses and other. Our definition of Adjusted EBITDA may differ from the definition of EBITDA or Adjusted EBITDA used by other companies and therefore may not be comparable to similarly titled measures used by other companies. Adjusted EBITDA is also a measure frequently requested by our investors and analysts. We believe that investors and analysts may use Adjusted EBITDA, along with other information contained in our SEC filings, in assessing our performance and comparability of our results with other companies. Our Non-GAAP measures for consolidated operating income, net income and net income per diluted share reflect the GAAP measures as reported, adjusted for certain items as described. These Non-GAAP financial measures have limitations as an analytical tool as they exclude the financial impact of transactions necessary to conduct our business, such as the granting of equity compensation awards, and are not intended to be an alternative to financial measures prepared in accordance with GAAP. These measures are adjusted as described in the reconciliation of GAAP to Non-GAAP in the above tables, but these adjustments should not be construed as an inference that all of these adjustments or costs are unusual, infrequent or non-recurring. Non-GAAP financial measures should be considered in addition to, and not as a substitute for or superior to, financial measures determined in accordance with GAAP. Investors are advised to carefully review the GAAP financial results that are disclosed in our SEC filings. We have not quantitatively reconciled our fiscal 2020 Adjusted EBITDA target to the most directly comparable GAAP measure because items such as stock-based compensation, adjustments to the provision for income taxes, amortization of intangibles and interest expense, which are specific items that impact these measures, have not yet occurred, are out of our control, or cannot be predicted. For example, quantification of stock-based compensation expense requires inputs such as the number of shares granted and market price that are not currently ascertainable. Accordingly, reconciliations to the Non-GAAP forward looking metrics are not available without unreasonable effort and such unavailable reconciling items could significantly impact our financial results.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents increased $1.3 million from $45.6 million at July 31, 2019 to $46.9 million at October 31, 2019. The increase in cash and cash equivalents during the three months ended October 31, 2019 was driven by the following:
• | Net cash provided by operating activities was $5.4 million for the three months ended October 31, 2019 as compared to net cash used in operating activities of $14.1 million for the three months ended October 31, 2018. The period-over-period increase in cash flow from operating activities reflects overall changes in net working capital requirements, principally the timing of shipments, billings and payments. |
• | Net cash used in investing activities for the three months ended October 31, 2019 was $1.3 million as compared to $1.6 million for the three months ended October 31, 2018. Both of these amounts primarily represented expenditures relating to ongoing equipment upgrades and enhancements. |
• | Net cash used in financing activities was $2.9 million for the three months ended October 31, 2019 as compared to net cash provided by financing activities of $15.2 million for the three months ended October 31, 2018. During the three months ended October 31, 2018, we entered into a new Credit Facility and repaid in full the outstanding borrowings under our Prior Credit Facility. During the three months ended October 31, 2019, we had net borrowings under our Credit Facility of $4.0 million. During the three months ended October 31, 2019 and 2018, we paid $2.7 million and $2.6 million, respectively, in cash dividends to our stockholders. We also made $4.6 million and $5.0 million of payments to remit employees' statutory tax withholding requirements related to the net settlement of stock-based awards during the three months ended October 31, 2019 and 2018, respectively. |
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The Credit Facility is discussed below and in "Notes to Condensed Consolidated Financial Statements - Note (11) - Credit Facility."
Our investment policy relating to our cash and cash equivalents is intended to minimize principal loss while at the same time maximize the income we receive without significantly increasing risk. To minimize risk, we generally invest our cash and cash equivalents in money market mutual funds (both government and commercial), certificates of deposit, bank deposits, and U.S. Treasury securities. Many of our money market mutual funds invest in direct obligations of the U.S. government, bank securities guaranteed by the Federal Deposit Insurance Corporation, certificates of deposit and commercial paper and other securities issued by other companies. While we cannot predict future market conditions or market liquidity, we believe our investment policies are appropriate in the current environment. Ultimately, the availability of our cash and cash equivalents is dependent on a well-functioning liquid market.
As of October 31, 2019, our material short-term cash requirements primarily consist of: (i) interest payments under our Credit Facility; (ii) payments related to lease commitments; (iii) our ongoing working capital needs, including income tax payments; and (iv) payment of accrued quarterly dividends. Also, in November 2019, we entered into an agreement to acquire UHP and its sister company (together, "UHP") for a purchase price of approximately $40.0 million, of which we anticipate $5.0 million to be paid in Comtech common stock with the remaining balance payable in cash. The purchase agreement also provides an earn-out up to an additional $10.0 million payable, at our election, in cash and or shares of Comtech common stock, if certain agreed upon sales milestones are reached in the twelve-month period following the completion of the acquisition. We expect to use existing cash and cash equivalents and increased borrowings under our Credit Facility to complete the UHP acquisition.
In December 2018, we filed a $400.0 million shelf registration statement with the SEC for the sale of various types of securities, including debt. The shelf registration statement was declared effective by the SEC as of December 14, 2018.
As of October 31, 2019 and December 4, 2019, we were authorized to repurchase up to an additional $8.7 million of our common stock, pursuant to our current $100.0 million stock repurchase program. Our stock repurchase program has no time restrictions and repurchases may be made in open-market or privately negotiated transactions and may be made pursuant to SEC Rule 10b5-1 trading plans. There were no repurchases of our common stock during the three months ended October 31, 2019 and 2018.
On September 24, 2019, our Board of Directors declared a dividend of $0.10 per common share, which was paid on November 15, 2019. On December 4, 2019, our Board of Directors declared a dividend of $0.10 per common share, payable on February 14, 2020 to stockholders of record at the close of business on January 15, 2020. Future dividends remain subject to compliance with financial covenants under our Credit Facility, as amended, as well as Board approval.
Our material long-term cash requirements primarily consist of mandatory interest payments pursuant to our Credit Facility and lease commitments.
We have historically met both our short-term and long-term cash requirements with funds provided by a combination of cash and cash equivalent balances, cash generated from operating activities and cash generated from financing transactions. Based on our anticipated level of future sales and operating income, we believe that our existing cash and cash equivalent balances, our cash generated from operating activities and amounts potentially available under our Credit Facility will be sufficient to meet both our currently anticipated short-term and long-term operating cash requirements.
Although it is difficult in the current economic and credit environment to predict the terms and conditions of financing that may be available in the future, should our short-term or long-term cash requirements increase beyond our current expectations, we believe that we would have sufficient access to credit from financial institutions and/or financing from public and private debt and equity markets.
Credit Facility
On October 31, 2018, we entered into a First Amended and Restated Credit Agreement (the "Credit Facility") with a syndicate of lenders, replacing our prior Credit Agreement dated as of February 23, 2016 (as amended by that certain First Amendment, dated as of June 6, 2017 (the "Prior Credit Facility")).
The Credit Facility provides a senior secured loan facility of up to $550.0 million consisting of: (i) a revolving loan facility ("Revolving Loan Facility") with a borrowing limit of $300.0 million; (ii) an accordion feature allowing us to borrow up to an additional $250.0 million; (iii) a $35.0 million letter of credit sublimit; and (iv) a swingline loan credit sublimit of $25.0 million.
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The Credit Facility matures on October 31, 2023 (the "Revolving Maturity Date"). If we issue new unsecured debt in excess of $5.0 million with a maturity date that is less than 91 days from October 31, 2023, the Revolving Maturity Date would automatically accelerate so that it would be 91 days earlier than the maturity date of the new unsecured debt.
The proceeds of the Credit Facility were used, in part, to repay in full the outstanding borrowings under the Prior Credit Facility, and additional proceeds of the Credit Facility are expected to be used by us for working capital and other general corporate purposes. As of October 31, 2019, the amount outstanding under our Credit Facility was $169.0 million, which is reflected in the non-current portion of long-term debt on our Condensed Consolidated Balance Sheet. At October 31, 2019, we had $2.6 million of standby letters of credit outstanding under our Credit Facility related to our guarantees of future performance on certain customer contracts and no outstanding commercial letters of credit. During the three months ended October 31, 2019, we had outstanding balances under the Credit Facility ranging from $142.0 million to $169.0 million.
Borrowings under the Credit Facility shall be either: (i) Alternate Base Rate borrowings, which bear interest from the applicable borrowing date at a rate per annum equal to (x) the greatest of (a) the Prime Rate (as defined) in effect on such day, (b) the Federal Funds Effective Rate (as defined) in effect on such day plus 1/2 of 1.00% per annum and (c) the Adjusted LIBO Rate (as defined) on such day (or, if such day is not a business day, the immediately preceding business day) plus 1.00% per annum, plus (y) the Applicable Rate (as defined), or (ii) Eurodollar borrowings, which bear interest from the applicable borrowing date at a rate per annum equal to (x) the Adjusted LIBO Rate for such interest period plus (y) the Applicable Rate. Determination of the Applicable Rate is based on a pricing grid that is dependent upon our Secured Leverage Ratio (as defined) as of the end of each fiscal quarter for which consolidated financial statements have been most recently delivered.
The Credit Facility contains customary representations, warranties and affirmative covenants. The Credit Facility also contains customary negative covenants, subject to negotiated exceptions, including but not limited to: (i) liens, (ii) investments, (iii) indebtedness, (iv) significant corporate changes, including mergers and acquisitions, (v) dispositions, (vi) restricted payments, including stockholder dividends, and (vii) certain other restrictive agreements. The Credit Facility also contains certain financial covenants and customary events of default (subject to grace periods, as appropriate), such as payment defaults, cross-defaults to other material indebtedness, bankruptcy and insolvency, the occurrence of a defined change in control and the failure to observe the negative covenants and other covenants related to the operation of our business. In addition, under certain circumstances, we may be required to enter into amendments to the Credit Facility in connection with any further syndication of the Credit Facility.
The Credit Facility provides for, among other things: (i) no scheduled payments of principal until maturity; (ii) a maximum Secured Leverage Ratio of 3.75x trailing twelve months ("TTM") Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA") and a Maximum Total Leverage Ratio of 4.50x TTM Adjusted EBITDA, each with no step downs; and (iii) a Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA.
As of October 31, 2019, our Secured Leverage Ratio was 1.75x TTM Adjusted EBITDA compared to the maximum allowable Secured Leverage Ratio of 3.75x TTM Adjusted EBITDA. Our Interest Expense Coverage Ratio as of October 31, 2019 was 13.07x TTM Adjusted EBITDA compared to the Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA. Given our expected future business performance, we anticipate maintaining compliance with the terms and financial covenants in our Credit Facility for the foreseeable future.
The obligations under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the "Guarantors"). As collateral security under the Credit Facility and the guarantees thereof, we and the Guarantors have granted to the administrative agent, for the benefit of the lenders, a lien on, and first priority security interest in, substantially all of our tangible and intangible assets.
On December 6, 2018, we entered into the first amendment to the Credit Facility. The purpose of the amendment is to provide for a mechanism to replace the LIBO Rate for Eurodollar borrowings with an alternative benchmark interest rate, should the LIBO Rate generally become unavailable in the future on an other-than-temporary basis.
Capitalized terms used but not defined herein have the meanings set forth for such terms in the Credit Facility and the Prior Credit Facility, which have been documented and filed with the SEC.
OFF-BALANCE SHEET ARRANGEMENTS
As of October 31, 2019, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K.
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COMMITMENTS
In the normal course of business, other than as discussed below, we routinely enter into binding and non-binding purchase obligations primarily covering anticipated purchases of inventory and equipment. We do not expect that these commitments, as of October 31, 2019, will materially adversely affect our liquidity.
At October 31, 2019, cash payments due under long-term obligations (including estimated interest expense on our Credit Facility), excluding purchase orders that we entered into in our normal course of business, are as follows:
Obligations Due by Fiscal Years or Maturity Date (in thousands) | |||||||||||||||
Total | Remainder of 2020 | 2021 and 2022 | 2023 and 2024 | After 2024 | |||||||||||
Credit Facility - principal payments | $ | 169,000 | — | — | 169,000 | — | |||||||||
Credit Facility - interest payments | 29,428 | 5,595 | 14,674 | 9,159 | — | ||||||||||
Operating lease liabilities | 40,800 | 8,192 | 16,006 | 10,047 | 6,555 | ||||||||||
Finance lease and other obligations | 588 | 588 | — | — | — | ||||||||||
Contractual cash obligations | $ | 239,816 | 14,375 | 30,680 | 188,206 | 6,555 | |||||||||
As discussed further in "Notes to Condensed Consolidated Financial Statements - Note (11) - Credit Facility," our Credit Facility provides a senior secured loan facility of up to $550.0 million consisting of: (i) a revolving loan facility ("Revolving Loan Facility") with a borrowing limit of $300.0 million; (ii) an accordion feature allowing us to borrow up to an additional $250.0 million; (iii) a $35.0 million letter of credit sublimit; and (iv) a swingline loan credit sublimit of $25.0 million. The Credit Facility matures on October 31, 2023 (the "Revolving Maturity Date"). In addition, if we issue new unsecured debt in excess of $5.0 million with a maturity date that is less than 91 days from October 31, 2023, the Revolving Maturity Date would automatically accelerate so that it would be 91 days earlier than the maturity date of the new unsecured debt.
As discussed further in "Notes to Condensed Consolidated Financial Statements - Note (18) - Stockholders’ Equity," on December 4, 2019, our Board of Directors declared a dividend of $0.10 per common share, payable on February 14, 2020 to stockholders of record at the close of business on January 15, 2020. Future dividends remain subject to compliance with financial covenants under our Credit Facility, as amended, as well as Board approval.
At October 31, 2019, we have approximately $2.6 million of standby letters of credit outstanding under our Credit Facility related to our guarantees of future performance on certain customer contracts. Such amounts are not included in the above table.
In fiscal 2018, we entered into a full and final warranty settlement with AT&T, the largest customer/distributor of a small product line that we refer to as the TCS 911 call handling software solution. As discussed in "Notes to Condensed Consolidated Financial Statements - Note (9) - Accrued Expenses and Other Current Liabilities," pursuant to the settlement agreement, we issued thirty-six credits to AT&T of $0.2 million which AT&T can apply on a monthly basis to purchases of solutions from us, beginning October 2017 through September 2020. As of October 31, 2019, the total present value of these monthly credits is $1.6 million, all of which is included in our current accrued warranty obligations on our Condensed Consolidated Balance Sheet. Such amount is not shown in the above commitment table.
As discussed further in "Notes to Condensed Consolidated Financial Statements - Note (2) - Acquisitions," in November 2019, we entered into an agreement to acquire UHP for a total purchase price payable at closing of approximately $40.0 million, of which we anticipate $5.0 million to be paid in Comtech common stock with the remaining balance payable in cash. The purchase agreement also provides an earn-out up to an additional $10.0 million payable, at our election, in cash and or shares of Comtech common stock, if certain agreed upon sales milestones are reached in the twelve-month period following closing. The transaction is subject to customary closing conditions and is expected to occur late in the second half of our fiscal 2020. We expect to fund a significant portion of the UHP purchase price in cash. Such amount is not shown in the above commitment table.
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In the ordinary course of business, we include indemnification provisions in certain of our customer contracts. Pursuant to these agreements, we have agreed to indemnify, hold harmless and reimburse the indemnified party for certain losses suffered or incurred by the indemnified party, including but not limited to losses related to third-party intellectual property claims. It is not possible to determine the maximum potential amount under these agreements due to a history of nominal claims in the Comtech legacy business and the unique facts and circumstances involved in each particular agreement. As discussed further in "Notes to Condensed Consolidated Financial Statements - Note (19) - Legal Proceedings and Other Matters," TCS is subject to a number of indemnification demands and we are incurring ongoing legal expenses in connection with these matters. Our insurance policies may not cover the cost of defending indemnification claims or providing indemnification. As a result, pending or future claims asserted against us by a party that we have agreed to indemnify could result in legal costs and damages that could have a material adverse effect on our consolidated results of operations and financial condition.
We have change in control agreements, severance agreements and indemnification agreements with certain of our executive officers and certain key employees. All of these agreements may require payments by us, in certain circumstances, including, but not limited to, a change in control of our Company or an involuntary termination of employment without cause.
Our Condensed Consolidated Balance Sheet as of October 31, 2019 includes total liabilities of $7.8 million for uncertain tax positions, including interest, any or all of which may result in a cash payment. The future payments related to uncertain tax positions have not been presented in the table above due to the uncertainty of the amounts and timing of any potential cash settlement with the taxing authorities.
RECENT ACCOUNTING PRONOUNCEMENTS
We are required to prepare our condensed consolidated financial statements in accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") which is the source for all authoritative U.S. generally accepted accounting principles, which is commonly referred to as "GAAP." The FASB ASC is subject to updates by the FASB, which are known as Accounting Standards Updates ("ASUs").
As further discussed in "Notes to Condensed Consolidated Financial Statements - Note (3) - Adoption of Accounting Standards and Updates," during the three months ended October 31, 2019, we adopted:
• | FASB ASU No. 2016-02 - Leases (Topic 842). See "Notes to Condensed Consolidated Financial Statements - Note (12) - Leases" for further information. |
• | FASB ASU No. 2017-11, which provides guidance on the accounting for certain financial instruments with embedded features that result in the strike price of the instrument or embedded conversion option being reduced on the basis of the pricing of future equity offerings (commonly referred to as "down round" features). On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we did not have any financial instruments with such "down round" features. |
• | FASB ASU No. 2017-12, which expands and refines hedge accounting for both non-financial and financial risk components and simplifies and aligns the recognition and presentation of the effects of the hedging instrument and the hedged item in the financial statements. On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we are not a party to any such hedging transactions. |
• | FASB ASU No. 2018-07, which expands the scope of Topic 718 to include certain share-based payment transactions for acquiring goods and services from nonemployees. On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we did not have any outstanding share-based awards with nonemployees that required remeasurement. |
• | FASB ASU No. 2018-16, which expands the list of eligible U.S. benchmark interest rates permitted in the application of hedge accounting due to broad concerns about the long-term sustainability of the LIBO Rate. This ASU adds the Overnight Index Swap ("OIS") rate, based on the Secured Overnight Financing Rate ("SOFR"), as an eligible U.S. benchmark interest rate. On August 1, 2019, we adopted this ASU. Our adoption did not have any impact on our condensed consolidated financial statements and disclosures, as we are not a party to any such hedging transactions. |
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In addition, the following FASB ASUs have been issued and incorporated into the FASB ASC and have not yet been adopted by us as of October 31, 2019:
• | FASB ASU No. 2016-13 issued in June 2016 and ASU No. 2018-19 issued in November 2018, which require the measurement of expected credit losses for financial assets held at the reporting date to be based on historical experience, current conditions and reasonable and supportable forecasts. In April 2019, FASB ASU No. 2019-04 was issued to provide clarification guidance in the following areas: (i) accrued interest; (ii) recoveries; (iii) projections of the interest rate environment; (iv) consideration of prepayments; and (v) other topics. In May 2019, FASB ASU No. 2019-05 was issued to provide entities with an option to irrevocably elect the fair value option applied on an instrument by instrument basis for eligible instruments. In November 2019, FASB ASU No. 2019-11 was issued to provide clarification guidance in the following areas: (i) expected recoveries for purchased financial assets with credit deterioration; (ii) transition relief for troubled debt restructurings; (iii) disclosures related to accrued interest receivables; (iv) financial assets secured by collateral maintenance provisions; and (v) conforming amendment to subtopic 805-20. These ASUs are effective for fiscal years beginning after December 15, 2019 (our fiscal year beginning on August 1, 2020), including interim periods within those fiscal years. All entities may adopt the amendments in this ASU earlier as of the fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Except for a prospective transition approach required for debt securities for which an other-than-temporary impairment had been recognized before the effective date, an entity will apply the amendments in this ASU through a cumulative effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective (that is, on a modified-retrospective approach). We are evaluating the impact of this ASU on our condensed consolidated financial statements and disclosures. |
• | FASB ASU No. 2018-13, issued in August 2018, which modifies the disclosure requirements for fair value measurements in Topic 820. This ASU is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (our fiscal year beginning on August 1, 2020). Upon the effective date, certain provisions are to be applied prospectively, while others are to be applied retrospectively to all periods presented. An entity is permitted to early adopt any removed or modified disclosures upon issuance of this ASU and delay adoption of the additional disclosures until their effective date. We are evaluating the impact of this ASU on our condensed consolidated financial statement disclosures. |
• | FASB ASU No. 2018-15, issued in August 2018, which aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal use software (and hosting arrangements that include an internal use software license). The accounting for the service element of a hosting arrangement that is a service contract is not affected by the amendments in this ASU. This ASU is effective for fiscal years beginning after December 15, 2019 (our fiscal year beginning on August 1, 2020), and interim periods within those fiscal years. Early adoption is permitted, including adoption in any interim period. This ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. We are evaluating the impact of this ASU on our condensed consolidated financial statements and disclosures. |
• | FASB ASU No. 2018-17, issued in October 2018, which requires entities to consider indirect interests held through related parties under common control on a proportional basis, rather than as the equivalent of a direct interest in its entirety when determining whether a decision-making fee is a variable interest. This ASU is effective for fiscal years beginning after December 15, 2019 (our fiscal year beginning on August 1, 2020) and for interim periods therein, with early adoption permitted. We are evaluating the impact of this ASU on our condensed consolidated financial statements and disclosures; however, we do not expect the adoption to have any effect given that we currently do not have any indirect interests held through related parties under common control. |
• | FASB ASU No. 2018-18, issued in November 2018, which clarifies when certain transactions between collaborative arrangement participants should be accounted for under ASC 606 and incorporates unit-of-account guidance consistent with ASC 606 to aid in this determination. The ASU also precludes entities from presenting consideration from transactions with a collaborator that is not a customer together with revenue recognized from contracts with customers. This ASU is effective for fiscal years beginning after December 15, 2019 (our fiscal year beginning on August 1, 2020) and for interim periods therein, with early adoption permitted. We are evaluating the impact of this ASU on our condensed consolidated financial statements and disclosures; however, we do not expect the adoption to have any effect given that we are currently not engaged in such collaborative arrangement transactions. |
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• | FASB ASU No. 2019-08, issued in November 2019, which requires that an entity measure and classify share based payment awards granted to a customer by applying the guidance in Topic 718. The amount recorded as a reduction of the transaction price is required to be measured on the basis of the grant-date fair value of the share based payment award. his ASU is effective for fiscal years beginning after December 15, 2019 (our fiscal year beginning on August 1, 2020) and interim periods therein. We are evaluating the impact of this ASU on our condensed consolidated financial statements and disclosures; however, we do not expect the adoption to have any effect given that we have not historically issued such share based awards to customers. |
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our earnings and cash flows are subject to fluctuations due to changes in interest rates primarily from borrowings under our Credit Facility. Based on the amount of outstanding debt under our Credit Facility, a hypothetical change in interest rates by 10% would change interest expense by approximately $0.6 million over a one-year period. Although we do not currently use interest rate derivative instruments to manage exposure to interest rate changes, we may choose to do so in the future in connection with our Credit Facility.
Our earnings and cash flows are also subject to fluctuations due to changes in interest rates on our investment of available cash balances. As of October 31, 2019, we had cash and cash equivalents of $46.9 million, which consisted of cash and highly-liquid money market deposit accounts. Many of these investments are subject to fluctuations in interest rates, which could impact our results. Based on our investment portfolio balance as of October 31, 2019, a hypothetical change in interest rates of 10% would have a nominal impact on interest income over a one-year period. Ultimately, the availability of our cash and cash equivalents is dependent on a well-functioning liquid market.
Item 4. Controls and Procedures
As of the end of the period covered by this Quarterly Report on Form 10-Q, an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934), was carried out by us under the supervision and with the participation of our management, including our President, Chief Executive Officer and Chairman and Chief Financial Officer. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by the report to provide reasonable assurance that the information required to be disclosed by us in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms and is accumulated and communicated to management, as appropriate, to allow timely decisions regarding required disclosure. A system of controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
There have been no changes in our internal controls over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
The certifications of our President, Chief Executive Officer and Chairman and Chief Financial Officer, that are Exhibits 31.1 and 31.2, respectively, should be read in conjunction with the foregoing information for a more complete understanding of the references in those Exhibits to disclosure controls and procedures and internal control over financial reporting.
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PART II
OTHER INFORMATION
Item 1. Legal Proceedings
See "Notes to Condensed Consolidated Financial Statements - Note (19) - Legal Proceedings and Other Matters," of this Form 10-Q for information regarding legal proceedings and other matters.
Item 1A. Risk Factors
There have been no material changes from the risk factors previously disclosed in our Form 10-K for the fiscal year ended July 31, 2019.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 4. Mine Safety Disclosures
Not applicable.
Item 6. Exhibits
Exhibit 101.INS - XBRL Instance Document
Exhibit 101.SCH - XBRL Taxonomy Extension Schema Document
Exhibit 101.CAL - XBRL Taxonomy Extension Calculation Linkbase Document
Exhibit 101.LAB - XBRL Taxonomy Extension Labels Linkbase Document
Exhibit 101.PRE - XBRL Taxonomy Extension Presentation Linkbase Document
Exhibit 101.DEF - XBRL Taxonomy Extension Definition Linkbase Document
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
COMTECH TELECOMMUNICATIONS CORP.
(Registrant)
Date: | December 4, 2019 | By: /s/ Fred Kornberg |
Fred Kornberg | ||
Chairman of the Board | ||
Chief Executive Officer and President | ||
(Principal Executive Officer) | ||
Date: | December 4, 2019 | By: /s/ Michael A. Bondi |
Michael A. Bondi | ||
Chief Financial Officer | ||
(Principal Financial and Accounting Officer) | ||
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