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

 

FORM 10-Q

 

 

Commission File Number: 001-35228

 

EXELIS INC.

(Exact name of registrant as specified in its charter)

 

 

1650 Tysons Boulevard, Suite 1700, McLean, Virginia 22102
(Address of principal executive offices)

 

(703) 790-6300
(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes o No x

 

Indicate by check mark whether the registrant has submitted electronically and posted on its web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

 

As of November 15, 2011, there were 184,578,157 shares of common stock ($0.01 par value per share) issued and outstanding.

 

 

TABLE OF CONTENTS

 

 

 

THE DEFENSE AND INFORMATION SOLUTIONS SEGMENT OF ITT CORPORATION

 

 

The accompanying notes are an integral part of the Condensed Combined Financial Statements.

 

 

 

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THE DEFENSE AND INFORMATION SOLUTIONS SEGMENT OF ITT CORPORATION

 

 

 

The accompanying notes are an integral part of the Condensed Combined Financial Statements.

 

 

 

 

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THE DEFENSE AND INFORMATION SOLUTIONS SEGMENT OF ITT CORPORATION

 

 

The accompanying notes are an integral part of the Condensed Combined Financial Statements.

 

 

 

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THE DEFENSE AND INFORMATION SOLUTIONS SEGMENT OF ITT CORPORATION

 

 

The accompanying notes are an integral part of the Condensed Combined Financial Statements.

 

 

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THE DEFENSE AND INFORMATION SOLUTIONS SEGMENT OF ITT CORPORATION

 

NOTES TO CONDENSED COMBINED FINANCIAL STATEMENTS (UNAUDITED)

(DOLLARS IN MILLIONS, UNLESS OTHERWISE STATED)

 

NOTE 1

 

 

Background

Exelis Inc. (“Exelis” or the “Company”) is a leader in Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (C4ISR) related products and systems and information and technical services, which it supplies to military, government and commercial customers in the United States and globally. Exelis provides mission-critical systems in the areas of integrated electronic warfare, sensing and surveillance, air traffic management, information and cyber-security, and networked communications. Exelis also has growing positions in composite aerostructures, logistics and technical services. The Company’s customers include the U.S. Army, Navy, Marines and Air Force, NASA, various U.S. civil, intelligence and security agencies, the Federal Aviation Administration, allied militaries and governments, and various commercial customers. Exelis Inc. (f/k/a ITT DCO, Inc.) was incorporated in Indiana on May 4, 2011. The name of the Company was changed from ITT DCO, Inc. to Exelis Inc. on July 14, 2011.

 

On October 31, 2011, ITT Corporation (“ITT”) completed the previously announced spin-off (the “Spin-off”) of Exelis, formerly ITT’s Defense & Information Solutions segment. Effective as of 12:01 a.m., Eastern time on October 31, 2011 (the “Distribution Date”), the common stock of Exelis was distributed, on a pro rata basis, to ITT’s shareholders of record as of the close of business on October 17, 2011 (the “Record Date”). On the Distribution Date, each of the shareholders of ITT received one share of Exelis common stock for every one share of common stock of ITT held on the Record Date. The Spin-off was completed pursuant to the Distribution Agreement, dated as of October 25, 2011, among ITT, Exelis and Xylem Inc. After the Distribution Date, ITT does not beneficially own any shares of Exelis common stock.

 

Our Registration Statement on Form 10 was declared effective by the U.S. Securities and Exchange Commission (SEC) on October 6, 2011. Our common stock began trading “regular-way” under the symbol “XLS” on the New York Stock Exchange on November 1, 2011.

 

In connection with the Spin-off, the Company issued senior notes and borrowed under a credit facility to fund an $884 dividend to ITT (“ITT Dividend”). Specifically, on September 20, 2011, we issued an aggregate principal amount of $650 senior notes (See Note 9, Debt) and on October 28, 2011 we borrowed $240 under a revolving credit facility (See Note 15, Subsequent Events). The net proceeds from the issuance of the senior notes and borrowings under the credit facility were paid to ITT to fund the ITT Dividend. Following the Spin-off on October 31, 2011, we will have cash and cash equivalents balance of at least $200.

 

Unless the context otherwise requires, references in these notes to “Exelis”, “we,” “us,” “our,” “the Company” and “our company” refer to Exelis Inc. References in these notes to “ITT” or “parent” refers to ITT Corporation, an Indiana corporation, and its consolidated subsidiaries (other than Exelis), unless the context otherwise requires.

 

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Basis of Presentation

The unaudited Condensed Combined Financial Statements have been prepared pursuant to the rules and regulations of the SEC and, in the opinion of management, reflect all adjustments (which include normal recurring adjustments) necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented. Certain information and note disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) have been condensed or omitted pursuant to such SEC rules. We believe that the disclosures made are adequate to make the information presented not misleading. We consistently applied the accounting policies described in the information statement filed as an exhibit to our Registration Statement on Form 10 as amended and filed with the SEC on October 5, 2011 (“Information Statement”), in preparing these financial statements. These financial statements should be read in conjunction with the financial statements and notes thereto included in our Information Statement.

 

All significant intra-company transactions between our businesses have been eliminated. All significant intercompany transactions between us and ITT have been included in these financial statements and are considered to be effectively settled for cash in these financial statements at the time the transaction is recorded. The total net effect of the settlement of these transactions is reflected in the Condensed Combined Statements of Cash Flows as a financing activity and in the Condensed Combined Balance Sheets as “parent company investment.”

 

The unaudited Condensed Combined Financial Statements have been prepared on a stand-alone basis and are derived from the consolidated financial statements and accounting records of ITT and may not be indicative of Exelis’s future performance and periods prior to the Spin-off do not necessarily reflect what the results of operations, financial position, and cash flows would have been had Exelis operated as a stand-alone company.

 

Our unaudited Condensed Combined Financial Statements include expenses of ITT allocated to us for certain functions provided by ITT, including, but not limited to, general corporate expenses related to finance, legal, information technology, human resources, communications, ethics and compliance, shared services, employee benefits and incentives, insurance and stock-based compensation. These expenses have been allocated to us on the basis of direct usage when identifiable, with the remainder allocated on the basis of revenue, headcount or other measures. Both we and ITT consider the basis on which the expenses have been allocated to be a reasonable reflection of the utilization of services provided to, or the benefit received by, us during the periods presented. The allocations may not, however, reflect the expense we would have incurred as an independent, publicly-traded company for the periods presented. Actual costs that may have been incurred if we had been a stand-alone company would depend on a number of factors, including the chosen organizational structure, what functions were outsourced or performed by employees and strategic decisions made in areas such as information technology and infrastructure. Following our separation from ITT, we will perform these functions using our own resources or purchased services. For an interim period, however, some of these functions will continue to be provided by ITT under transition services agreements, which are planned to extend for a period of 3 to 24 months in most circumstances. In addition to the transition services agreements, we will enter into a number of commercial agreements with ITT in connection with the separation, many of which are expected to have terms longer than one year.

 

ITT uses a centralized approach to cash management and financing of its operations, excluding debt where we are the legal obligor. Prior to the Spin-off, the majority of our cash was transferred to ITT daily and ITT funded our operating and investing activities as needed. Cash transfers to and from ITT’s cash management accounts are reflected in the Condensed Combined Balance Sheets as “Parent company investment.”

 

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The unaudited Condensed Combined Financial Statements include certain assets and liabilities that have historically been held at the ITT corporate level but are specifically identifiable or otherwise allocable to us. The cash and cash equivalents held by ITT at the corporate level are not specifically identifiable to Exelis and therefore were not allocated to us for any of the periods presented. Cash and cash equivalents in our balance sheets primarily represent cash held locally by entities included in these financial statements. ITT third-party debt, and the related interest expense has not been allocated to us for any of the periods presented as we were not the legal obligor of the debt and the ITT borrowings were not directly attributable to our business.

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting periods. Estimates are revised as additional information becomes available. Estimates and assumptions are used for, but not limited to, revenue recognition, income tax contingency accruals and valuation allowances, fair value measurements, impairment of goodwill and other intangibles, postretirement obligations and certain contingent liabilities. Actual results could differ from these estimates.

 

Exelis combines companies in which it has a controlling financial interest or when Exelis is considered the primary beneficiary of a variable interest entity. We account for investments in companies over which we have the ability to exercise significant influence, but do not hold a controlling interest under the equity method, and we record our proportionate share of income or losses in the Condensed Combined Statements of Operations. The results of companies acquired or disposed of during the fiscal year are included in the Condensed Combined Statements of Operations from the effective date of acquisition or up to the date of disposal.

 

Our quarterly financial periods end on the Saturday closest to the last day of the calendar quarter, except for the last quarterly period of the fiscal year, which ends on December 31^st. For ease of presentation, the quarterly unaudited Condensed Combined Financial Statements are described as ending on the last day of the calendar quarter.

 

NOTE 2

 

 

Recently Adopted Pronouncements

In December 2010, the Financial Accounting Standards Board (FASB) issued additional guidance applicable to the testing of goodwill for potential impairment. Specifically, for reporting units with zero or negative carrying amounts, an entity is required to perform the second step of the goodwill impairment test (a comparison between the carrying amount of a reporting unit’s goodwill to its implied fair value) if it is more likely than not that a goodwill impairment exists, considering any adverse qualitative factors. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2010. As of the date of our most recent goodwill impairment test, none of our reporting units would have been affected by the application of this guidance as each reporting unit had a carrying amount that exceeded zero.

 

In April 2010, the FASB issued authoritative guidance permitting use of the milestone method of revenue recognition for research or development arrangements that contain payment provisions or consideration contingent on the achievement of specified events. On January 1, 2011, we adopted the new guidance on a prospective basis. The adoption of this guidance did not have a material impact on our financial condition, results of operations or cash flows.

 

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In October 2009, the FASB issued amended guidance on the accounting for revenue arrangements that contain multiple elements by eliminating the criteria that objective and reliable evidence of fair value for undelivered products or services needs to exist in order to be able to account separately for deliverables and eliminating the use of the residual method of allocating arrangement consideration. The amendments establish a hierarchy for determining the selling price of a deliverable and will allow for the separation of products and services in more instances than previously permitted. On January 1, 2011, we adopted the new guidance on a prospective basis. The adoption of this guidance did not have a material impact on our financial condition, results of operations or cash flows.

 

Pronouncements Not Yet Adopted

In September 2011, the FASB provided companies with the option to make an initial qualitative evaluation, based on the entity’s events and circumstances, to determine the likelihood of goodwill impairment. The results of this qualitative assessment determine whether it is necessary to perform the currently required two-step impairment test. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, a company would be required to perform the two-step impairment test. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011, with early adoption permitted. We will adopt this guidance on January 1, 2012; however, the requirements are not expected to have a material effect on the Company’s Unaudited Condensed Combined Financial Statements.

 

In May 2011, the FASB issued guidance intended to achieve common fair value measurements and related disclosures between U.S. GAAP and international accounting standards. The amendments primarily clarify existing fair value guidance and are not intended to change the application of existing fair value measurement guidance. However, the amendments include certain instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This guidance is effective for the periods beginning after December 15, 2011, and early application is prohibited. We will adopt these amendments on January 1, 2012; however, the requirements are not expected to have a material effect on the Company’s Unaudited Condensed Combined Financial Statements.

 

NOTE 3

 

ACQUISITIONS & DIVESTITURES

 

Acquisitions

We did not engage in any significant acquisitions during the first nine months of 2011 and 2010.

 

Divestitures

We did not engage in any divestitures during the first nine months of 2011. On September 8, 2010, we completed the sale of CAS, Inc. (CAS), a component of our Information and Technical Services segment engaged in systems engineering and technical assistance (SETA) for the U.S. Government. Proceeds from the sale were $237, net of applicable direct transaction costs. The sale resulted in a $130 after tax gain reported as a component of income from discontinued operations. The transaction resulted in a tax benefit of $4 primarily due to the difference in book and tax bases of CAS. Subsequent to this divestiture, we do not have any significant continuing involvement in the operations of CAS, nor do we expect significant continuing cash flows from CAS. Accordingly, the financial position, results of operations and cash flows from CAS are reported as a discontinued operation for the periods presented. During the three and nine months ended September 30, 2010, CAS provided third-party revenue of $46 and $160, respectively, and operating income of $4 and $13, respectively, included within discontinued operations.

 

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NOTE 4

 

RESTRUCTURING CHARGES, NET

 

During the three and nine months ended September 30, 2011, we recognized restructuring charges of $1 and $11, respectively, representing additional employee severance costs associated with restructuring actions initiated primarily by our C4ISR Electronics and Systems segment. We do not expect to incur significant future charges related to these actions.

 

During the three and nine months ended September 30, 2010, we recognized restructuring charges of $5 and $32, respectively, primarily related to an action to realign our company to enable better product portfolio integration, encouraging a more coordinated market approach and reduced operational redundancies. The initiative was substantially completed during 2010 and resulted in a total charge of $26 primarily related to employee severance, and to a lesser extent, lease cancellation and other costs associated with three facilities that were substantially closed during 2010. There was no remaining liability related to the realignment activities as of September 30, 2011. The realignment resulted in headcount reductions of 642, which included 162 factory workers, 457 office workers and 23 management employees.

 

The table provided below summarizes the presentation of restructuring charges, net, within our Condensed Combined Statements of Operations for the three and nine month periods ended September 30, 2011 and 2010.

 

 

NOTE 5

 

 

Effective Tax Rate

Our income taxes as presented are calculated on a separate tax return basis, and may not be reflective of the results that would have occurred on a stand-alone basis. Our operations have historically been included in ITT’s U.S. federal and state tax returns or non-U.S. jurisdictions tax returns.

 

With the exception of certain dedicated foreign entities, we are deemed to settle the current tax balances annually at year-end or at spin-off with the legal tax-paying entities in the respective jurisdictions. The annual year-end settlements are reflected as changes in parent company investment in the Condensed Combined Balance Sheets. The quarterly taxes payable balance is recorded in other accrued liabilities in our Condensed Combined Balance Sheet.

 

Our quarterly income tax expense is measured using an estimated annual effective tax rate, adjusted for discrete items within the period. The comparison of effective tax rates between periods is significantly affected by discrete items recognized during the periods, the level and mix of earnings by tax jurisdiction and permanent differences. The estimated annual effective tax rate for 2011 and 2010 was comparable before the impact of discrete items.

 

For the three months ended September 30, 2011, the Company recorded an income tax provision of $53 or 34.4% of income from continuing operations before income tax expense compared to $61 or 36.1% during the same prior year period. For 2011 and 2010, the effective tax rate varies from the

 

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federal statutory rate of 35% due to favorable impacts from the U.S. manufacturing deduction and research and development credits substantially offset by the unfavorable impact of state taxes.

 

For the nine months ended September 30, 2011, the Company recorded an income tax provision of $142 or 35.1% of income from continuing operations before income tax expense compared to $169 or 35.4% during the same prior year period. For 2011 and 2010, the effective tax rate was slightly higher than the federal statutory rate of 35% due to favorable impacts from the U.S. manufacturing deduction and research and development credits substantially offset by the unfavorable impact of state taxes.

 

Uncertain Tax Positions

We recognize a tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. As of September 30, 2011 and December 31, 2010, we had $34 and $38, respectively, of total unrecognized tax benefits. The amount of unrecognized tax benefits that would affect the effective tax rate was $21 and $18, as of September 30, 2011 and December 31, 2010, respectively. Uncertain tax positions are related to tax years that remain subject to examination by the relevant taxing authorities. We believe it is reasonably possible that the total amount of unrecognized tax benefits at September 30, 2011 could decrease by $8 within the next 12 months.

 

We classify interest relating to tax matters as a component of interest expense and tax penalties as a component of income tax expense in our Condensed Combined Statement of Operations. We had $4 and $3 of interest accrued as of September 30, 2011 and December 31, 2010, respectively.

 

NOTE 6

 

 

 

Unbilled contract receivables represent revenue recognized on long-term contracts in excess of amounts billed as of the balance sheet date. We expect to bill and collect substantially all of the September 30, 2011 unbilled contract receivables during the next twelve months as scheduled performance milestones are completed or units are delivered.

 

Total billed receivables due from the U.S. Government, either directly or as subcontractor with the Government were $455 and $489 at September 30, 2011 and December 31, 2010, respectively.

 

NOTE 7

 

 

 

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Deferred production costs incurred on in-process and delivered units in excess of the aggregate estimated average cost of those units were $39 and $29 as of September 30, 2011 and December 31, 2010, respectively.

 

NOTE 8

 

 

Goodwill

During the second quarter of 2011, the Company finalized its valuation of the purchase price and acquired intangible assets for SRA AOS which was acquired during the fourth quarter of 2010, resulting in a $2 increase in other intangible assets and a corresponding decrease in goodwill. The following table provides a roll-forward of the carrying amount of goodwill by segment during the nine months ended September 30, 2011:

 

 

Other Intangible Assets, Net

 

 

We amortize other intangible assets on a straight-line basis unless the pattern of usage of the benefits indicates an alternate method is more representative of the usage of the asset. Amortization expense related to other intangible assets for the three and nine month periods ended September 30, 2011 were $12 and $36, respectively, and $15 and $46 for the three and nine month periods ended September 30, 2010, respectively. Estimated amortization expense for the remaining three months of 2011 and each of the five succeeding years is as follows:

 

 

 

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NOTE 9

 

 

The following table provides the components of long-term debt at September 30, 2011 and December 31, 2010:

 

 

The following table provides a summary of outstanding Notes with associated maturity dates and interest rates at September 30, 2011 and December 31, 2010. The estimated fair value was determined using quoted prices in active markets (Level 1 inputs) for identical securities obtained from an external pricing service.

 

 

Senior Notes

In connection with the Spin-off, on September 20, 2011, the Company and ITT entered into an indenture with Union Bank, N.A., as trustee (the “Indenture”), related to the issuance by the Company of $250 aggregate principal amount of 4.25% senior notes due October 1, 2016 (the “2016 Notes”) and $400 aggregate principal amount of 5.55% senior notes due October 1, 2021 (the “2021 Notes” and together with the 2016 Notes, the “Notes”) in a private placement arrangement to qualified institutional buyers pursuant to Rule 144A under the U.S. Securities Act of 1933, as amended (the “Securities Act”). The public offering prices of the 2016 Notes and the 2021 Notes were 99.824% and 99.762%, respectively, of their principal amounts. Interest on the 2016 Notes and the 2021 Notes accrue from September 20, 2011 and is payable on April 1 and October 1 of each year, commencing on April 1, 2012. The Notes were initially guaranteed on a senior unsecured basis by ITT, which guarantee was automatically and unconditionally terminated on October 31, 2011, in connection with the Spin-off. The Company paid the net proceeds from the issuance of the Notes to ITT as part of the ITT Dividend, which is included in transfer to parent, net, in our Condensed Combined Statements of Cash Flows.

 

In connection with the issuance of the Notes, we capitalized debt issuance costs of approximately $2 and $4 for the 2016 Notes and 2021 Notes, respectively, which are included in other non-current assets. The original debt discount of $0.4 and $1 for the 2016 and 2021 Notes, respectively, are included as a reduction to long-term debt. Both the debt issuance costs and the debt discount will be amortized over the life of the Notes. Accrued interest payable, included in other accrued liabilities was $1 at September 30, 2011.

 

The Indenture includes covenants that restrict our ability to, subject to exceptions, incur indebtedness secured by liens or engage in sale and leaseback transactions. The Indenture also provides for customary events of default (subject, in certain cases, to receipt of notice of default and/or customary grace and cure periods), including but not limited to, (i) failure to pay interest for 30 days, (ii) failure to pay principal when due, (iii) failure to perform any other covenant in the

 

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Indenture for 90 days after receipt of notice from the trustee or from holders of 25% of the outstanding principal amount and (iv) certain events of bankruptcy, insolvency or reorganization of the Company.

 

We may redeem each series of the Notes, in whole or in part, at any time at a redemption price equal to the principal amount of the Notes to be redeemed. The Notes shall be redeemable as a whole or in part, at the Company’s option at any time and from time to time, at a redemption price equal to the greater of (i) 100% of the principal amount of such Notes and (ii) the sum of the present values of the remaining scheduled payments of principal and interest thereon (exclusive of interest accrued to the date of redemption) discounted to the redemption date on a semiannual basis at the Treasury Rate plus 50 basis points, plus in each case accrued and unpaid interest to the date of redemption. If a change of control triggering event occurs, as defined in the Indenture, we will be required to make an offer to purchase the Notes at a price equal to 101% of their principal amount plus accrued and unpaid interest to the date of repurchase.

 

On September 20, 2011, the Company entered into a registration rights agreement with the initial purchasers of the Notes (the “Exelis Registration Rights Agreement”). The Company agreed under the Exelis Registration Rights Agreement, to (i) file a registration statement on an appropriate registration form with respect to a registered offer to exchange the Notes, as applicable, for new notes, with terms substantially identical in all material respects to the Notes, as applicable, and (ii) cause the registration statement to be declared effective under the Securities Act. If the exchange offer is not completed within 365 days after the issue date of the Notes or, if required, the Company will use its reasonable best efforts to file and to have declared effective a shelf registration statement relating to the resale of the Notes. If the Company fails to satisfy this obligation (a “registration default”) under the Exelis Registration Rights Agreement, the annual interest rate on the Notes will increase by 0.25%. The annual interest rate on the Notes will increase by an additional 0.25% for each subsequent 90-day period during which the registration default continues, up to a maximum additional interest rate of 1.00% per year. If the registration default is corrected, the applicable interest rate on such Notes will revert to the original level. If the Company must pay additional interest, the Company will pay it to the holders of the Notes in cash on the same dates that it makes other interest payments until the registration default is corrected.

 

NOTE 10

 

 

The following tables provide the components of net periodic benefit costs for pension plans, and other employee-related benefit plans for the three and nine months ended September 30, 2011 and 2010:

 

 

 

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We contributed approximately $33 and $4 to our various plans during the nine months ended September 30, 2011 and 2010, respectively. We expect to make additional contributions of $8 during the remainder of 2011. Certain Company employees participate in defined benefit pension and other postretirement benefit plans sponsored by ITT, which include participants of other ITT subsidiaries. We recorded approximately $27 and $67 of expense related to such multiemployer plans during the three and nine months ended September 30, 2011, respectively, and $16 and $48 for the three and nine months ended September 30, 2010, respectively.

 

Accumulated Other Comprehensive Loss

The following table provides the components of accumulated other comprehensive loss:

 

 

The changes in the unamortized defined benefit plan costs, net of tax, were $4 and $3 for the nine months ended September 30, 2011 and 2010, respectively, and are included in other comprehensive income in the Condensed Combined Statements of Comprehensive Income.

 

Unamortized defined benefit plan costs consist primarily of net after-tax actuarial loss amounts totaling $60 and $62 as of September 30, 2011, and December 31, 2010, respectively. Net actuarial gains or losses principally arise from gains or losses on plan assets due to variations in the fair market value of the underlying assets and changes in the benefit obligation due to changes in actuarial assumptions.

 

NOTE 11

 

 

ITT maintains several plans for the benefit of certain of its officers, directors and employees. The following disclosures represent our portion of the plans maintained by ITT in which our employees participated. All awards granted under the plans consist of ITT common shares. Accordingly, the amounts presented are not necessarily indicative of future performance and do not necessarily reflect the results that we would have experienced as an independent, publicly-traded company for the periods presented. ITT’s long-term incentive awards program comprises three components: non-qualified stock options (NQOs), restricted stock or restricted stock units (RS) and a target cash award (TSR). We account for NQOs and RS as equity-based compensation awards. TSR awards are cash settled and accounted for as liability-based compensation.

 

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Long-term incentive employee compensation costs for grants to Exelis employees are primarily recorded within selling, general and administrative (SG&A) expenses, and are reduced by an estimated forfeiture rate. The following table provides the impact of these costs in our Condensed Combined Statements of Operations for the three and nine months ended September 30, 2011 and 2010:

 

 

At September 30, 2011, there was $17 of total unrecognized compensation cost related to non-vested NQOs and RS held by Exelis employees. This cost is expected to be recognized ratably over a weighted-average period of 1.9 years.

 

On March 3, 2011, ITT granted long-term incentive awards to Exelis employees consisting of 0.2 NQOs, 0.2 RS and 2.8 TSR’s with respective grant date fair values (in whole dollars) of $14.31, $57.68 and $1.00. The NQOs vest either on the completion of a three-year service period or annually in three equal installments, as determined by employee level, and have a ten-year expiration period. RS and TSR units vest on the completion of a three-year service period.

 

ITT did not grant any awards to Exelis employees during the second or third quarter of 2011.

 

The fair value of RS is determined based on the closing price of ITT common stock on the date of grant. The fair value of each NQO grant was estimated on the date of grant using the binomial lattice pricing model incorporating multiple and variable assumptions over time, including assumptions such as employee exercise patterns, stock price volatility and changes in dividends. The following table details the assumptions utilized.

 

 

Expected volatilities are based on ITT’s historical stock price volatility, and implied volatility derived from traded options on ITT’s stock. ITT uses historical data to estimate employee option exercise and employee termination behavior within the valuation model. Employee groups and option characteristics are considered separately for valuation purposes. The expected life represents an estimate of the period of time options are expected to remain outstanding. The expected life provided above represents the weighted average of expected behavior for certain groups of employees who have historically exhibited different behavior. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of option grant.

 

NOTE 12

 

 

Related Party Sales and Cost of Revenue

Our unaudited Condensed Combined Financial Statements have been prepared on a stand-alone basis and are derived from the consolidated financial statements and accounting records of ITT.

 

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During the three and nine months ended September 30, 2011 and 2010, we sold inventory to other ITT businesses, which were included in total revenue and cost of product and service revenue, respectively, in our Condensed Combined Statements of Operations. These amounts were not significant. The aggregate inventory on hand from other ITT businesses as of September 30, 2011 and December 30, 2010 was not significant.

 

Allocation of General Corporate Expenses

 

The unaudited Condensed Combined Financial Statements include expense allocations for certain functions provided by ITT as well as other ITT employees not solely dedicated to Exelis, including, but not limited to, general corporate expenses related to finance, legal, information technology, human resources, communications, ethics and compliance, shared services, employee benefits and incentives, and stock-based compensation. These expenses have been allocated to us on the basis of direct usage when identifiable, with the remainder allocated on the basis of revenue, headcount or other measure. During the three and nine month periods ended September 30, 2011, we were allocated $31 and $90, respectively, and $33 and $82 for the three and nine month periods ended September 30, 2010, respectively, of general corporate expenses incurred by ITT which is included within SG&A expenses in our Condensed Combined Statements of Operations.

 

The expense allocations have been determined on a basis that we consider to be a reasonable reflection of the utilization of services provided or the benefit received by us during the periods presented. The allocations may not, however, reflect the expense we would have incurred as an independent, publicly-traded company for the periods presented. Actual costs that may have been incurred if we had been a stand-alone company would depend on a number of factors, including the chosen organizational structure, functions outsourced or performed by employees and strategic decisions made in areas such as information technology and infrastructure.

 

Parent Company Equity

Parent company investment in the Condensed Combined Balance Sheets represents ITT’s historical investment in our accumulated net earnings after taxes and the net effect of the transactions with and allocations from ITT described above.

 

NOTE 13

 

COMMITMENTS AND CONTINGENCIES

 

General

From time to time, we are involved in legal proceedings that are incidental to the operation of our businesses. Some of these proceedings seek remedies relating to environmental matters, product liability, personal injury claims, employment and pension matters, and commercial or contractual disputes, sometimes related to acquisitions or divestitures. We will continue to defend vigorously against all claims.

 

Although the ultimate outcome of any legal matter cannot be predicted with certainty, based on present information, including our assessment of the merits of the particular claim, we do not expect that any asserted or unasserted legal claims or proceedings, individually or in the aggregate, will have a material adverse effect on our cash flow, results of operations, or financial condition.

 

Environmental

In the ordinary course of business, we are subject to federal, state, local, and foreign environmental laws and regulations. We are responsible, or are alleged to be responsible, for ongoing environmental

 

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investigation and remediation of multiple sites. These sites are in various stages of investigation and/or remediation and in many of these proceedings our liability is considered de minimis. We have received notification from the U.S. Environmental Protection Agency, and from similar other environmental agencies, that a number of sites formerly or currently owned and/or operated by Exelis, and other properties or water supplies that may be or have been impacted from those operations, contain disposed or recycled materials or wastes and require environmental investigation and/or remediation. These sites include instances where we have been identified as a potentially responsible party under federal and state environmental laws and regulations.

 

Accruals for environmental matters are recorded on a site by site basis when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, based on current law and existing technologies. Our accrued liabilities for these environmental matters represent the best estimates related to the investigation and remediation of environmental media such as water, soil, soil vapor, air and structures, as well as related legal fees. These estimates, and related accruals, are reviewed quarterly and updated for progress of investigation and remediation efforts and changes in facts and legal circumstances. Liabilities for these environmental expenditures are recorded on an undiscounted basis.

 

It is difficult to estimate the final costs of investigation and remediation due to various factors, including incomplete information regarding particular sites and other potentially responsible parties, uncertainty regarding the extent of investigation or remediation and our share, if any, of liability for such conditions, the selection of alternative remedial approaches, and changes in environmental standards and regulatory requirements. We have estimated and accrued $27 and $22 as of September 30, 2011 and December 31, 2010, respectively, for environmental matters. In our opinion, the total amount accrued is appropriate based on existing facts and circumstances.

 

The following table illustrates the range of estimated loss and number of active sites for these environmental matters:

 

 

U.S. Government Contracts, Investigations and Claims

The company has U.S. Government contracts that are funded incrementally on a year-to-year basis. Changes in government policies, priorities or funding levels through agency or program budget reductions by the U.S. Congress or executive agencies could materially adversely affect the company’s financial condition or results of operations. Furthermore, contracts with the U.S. Government may be terminated or suspended by the U.S. Government at any time, with or without cause. Such contract suspensions or terminations could result in unreimbursable expenses or charges or otherwise adversely affect the company’s financial condition and/or results of operations.

 

Departments and agencies of the U.S. Government have the authority to investigate various transactions and operations of the company, and the results of such investigations may lead to administrative, civil or criminal proceedings, the ultimate outcome of which could be fines, penalties, repayments or compensatory or treble damages. U.S. Government regulations provide that certain findings against a contractor may lead to suspension or debarment from future U.S. Government contracts or the loss of export privileges for a company or an operating division or subdivision. Suspension or debarment could have a material adverse effect on the company because of its reliance on government contracts.

 

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U.S. Government agencies, including the Defense Contract Audit Agency (DCAA) and others, routinely audit and review a contractor’s performance on government contracts, indirect rates and pricing practices, and compliance with applicable contracting and procurement laws, regulations and standards. Accordingly, costs billed or billable to the U.S. Government customers are subject to potential adjustment upon audit by such agencies. They also review the adequacy of the contractor’s compliance with government standards for its accounting and management internal control systems, including: control environment and overall accounting system, general information technology system, budget and planning system, purchasing system, material management and accounting system, compensation system, labor system, indirect and other direct costs system, billing system and estimating system. Audits currently underway include the Company’s control environment and overall accounting, billing, and indirect and other direct cost systems, as well as reviews of the Company’s compliance with certain U.S. Government Cost Accounting Standards.

 

From time to time, customers advise the company of claims and penalties concerning certain potential disallowed costs. When such findings are presented, Exelis and the U.S. Government representatives engage in discussions to enable Exelis Inc. to evaluate the merits of these claims as well as to assess the amounts being claimed. Where appropriate, provisions are made to reflect the expected exposure to the matters raised by the U.S. Government representatives and such provisions are reviewed on a quarterly basis for sufficiency based on the most recent information available.

 

On March 27, 2007, ITT Corporation reached a settlement relating to an investigation of our Night Vision Division’s compliance with the International Traffic in Arms Regulations (ITAR) pursuant to which ITT pled guilty to two violations, based on the export of defense articles without a license and the omission of material facts in required export reports. ITT was assessed a total of $50 in fines, forfeitures and penalties. ITT also entered into a Deferred Prosecution Agreement with the U.S. Government which deferred action regarding a third count of violations related to ITAR pending implementation of a remedial action plan, including the appointment of an independent monitor. ITT was also assessed a deferred prosecution monetary penalty of $50 which is being reduced for monies spent, during the five-year period following the date of the Plea Agreement, to accelerate and further the development and fielding of advanced night vision technology. On April 12, 2011, the Department of Justice dismissed the deferred third count of the Deferred Prosecution Agreement. This dismissal terminates any further obligation of ITT and the Company under the Deferred Prosecution Agreement with the exception of the obligation to fulfill the $50 deferred prosecution monetary penalty as identified above. Management believes that this matter will not have a material adverse effect on our combined financial position, results of operations or cash flows.

 

Indemnifications

As part of the Spin-off, Exelis, ITT and Xylem Inc. will indemnify one another with respect to such parties’ assumed or retained liabilities under the Distribution Agreement and breaches of the Distribution Agreement or related Spin-off agreements. ITT’s indemnification obligations include asserted and unasserted asbestos and silica liability claims that relate to the presence or alleged presence of asbestos or silica in products manufactured, repaired or sold prior to the Distribution Date, subject to limited exceptions with respect to certain employee claims, or in the structure or material of any building or facility, subject to exceptions with respect to employee claims relating to Exelis or Xylem Inc. buildings or facilities. The indemnifications are absolute and indefinite. The indemnification associated with pending and future asbestos claims does not expire. Exelis expects ITT and Xylem Inc. to fully perform under the terms of the Distribution Agreement and therefore we have not recorded a liability for matters for which we will be indemnified. In addition, we are not aware of any claims or other circumstances that would give rise to material payments to ITT or Xylem Inc. under the indemnity that we will provide.

 

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NOTE 14

 

 

The Company’s segments are reported on the same basis used internally for evaluating performance and for allocating resources. We operate in two segments: C4ISR Electronics and Systems, and Information and Technical Services. Assets of the business segments exclude general corporate assets, which principally consist of cash, deferred tax assets, certain plant, property, and equipment, and certain other assets.

 

C4ISR Electronics and Systems

This segment provides communications, sensing and surveillance, space and advanced engineering solutions for government and commercial customers around the world.

 

Information and Technical Services

This segment provides a broad range of systems integration, operations, sustainment, advanced engineering, logistics, space launch and range-support solutions for a wide variety of U.S. military and government agency customers.

 

 

 

 

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NOTE 15

 

 

Separation from ITT Corporation

On October 31, 2011, Exelis completed its Spin-off from ITT Corporation and became an independent publicly owned company. On October 31, 2011, each ITT stockholder received a dividend of one share of Exelis common stock and one share of Xylem Inc. common stock for every one share of ITT common stock held on the Record Date. The shares of common stock of Exelis began “regular-way” trading on the New York Stock Exchange on November 1, 2011, under the ticker symbol “XLS.”

 

Pursuant to the terms of the Distribution Agreement, (i) Exelis and ITT effected certain transfers of assets and assumed certain liabilities so that Exelis and ITT retained both the assets of and liabilities associated with their respective businesses, (ii) subject to certain exceptions, all agreements, arrangements, commitments and undertakings, including all intercompany accounts payable or accounts receivable, including intercompany indebtedness were terminated, novated or otherwise satisfied, effective no later than the Distribution Date, and (iii) Exelis and ITT effected a pro rata distribution of our common stock to ITT shareholders.

 

Following the Spin-off, Exelis and ITT began operating independently of each other, and neither has any ownership interest in the other. In order to govern certain ongoing relationships between Exelis and ITT following the Spin-off and to provide mechanisms for an orderly transition, on October 25, 2011, Exelis, ITT, and Xylem Inc. executed various agreements that will govern the ongoing relationships between and among the three companies after the Spin-off and provide for the allocation of employee benefits, income taxes, and certain other liabilities and obligations attributable to periods prior to the Spin-off. The executed agreements include the Distribution Agreement, Benefits and Compensation Matters Agreement, Tax Matters Agreement, Master Transition Services Agreement and a number of on-going commercial relationships. The Distribution Agreement also provides for certain indemnifications and cross-indemnifications among Exelis, ITT and Xylem Inc. The indemnifications address a variety of subjects, including indemnification by ITT of Exelis in respect of certain asserted and unasserted asbestos or silica liability claims relating to the presence or alleged presence of asbestos or silica in products sold prior to the Distribution Date or in the structure or material of any building or facility, subject to limited exceptions. The indemnifications are absolute and indefinite. The indemnification associated with pending and future asbestos and silica claims does not expire. Effective upon the Distribution, we intend for certain intercompany work orders and/or informal intercompany commercial arrangements to be converted into third-party contracts based on ITT’s standard terms and conditions.

 

New Credit Facility

 

On October 25, 2011, we entered into a competitive advance and revolving credit facility agreement (Credit Facility) with a consortium of lenders including JP Morgan Chase Bank, N.A., as administrative agent, and Citibank, N.A. as syndication agent. The Credit Facility will be used for working capital, capital

 

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expenditures and other general corporate purposes. The Credit Facility provides for a four year maturity with a one year extension option upon satisfaction of certain conditions, and comprises an aggregate principal amount of up to $600 million of (i) revolving extensions of credit (the “revolving loans”) outstanding at any time, (ii) competitive advance borrowing option which will be provided on an uncommitted competitive advance basis through an auction mechanism (the “competitive advances”), and (iii) letters of credit in a face amount up to $100 million at any time outstanding. Subject to certain conditions, we will be permitted to terminate permanently the total commitments and reduce commitments in minimum amounts of $10 million. We will also be permitted, subject to certain conditions, to request that lenders increase the commitments under the facility by up to $200 million for a maximum aggregate principal amount of $800 million. Voluntary prepayments will be permitted in minimum amounts of $50 million.

 

At our election, the interest rate per annum applicable to the competitive advances will be based on either (i) a Eurodollar rate determined by reference to LIBOR, plus an applicable margin offered by the lender making such loans and accepted by us or (ii) a fixed percentage rate per annum specified by the lender making such loans. At our election, interest rate per annum applicable to the revolving loans will be based on either (i) a Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, plus an applicable margin or (ii) a fluctuating rate of interest determined by reference to the greatest of (a) the prime rate of JPMorgan Chase Bank, N.A., (b) the federal funds effective rate plus one-half of 1% or (c) the Eurodollar rate determined by reference to LIBOR, adjusted for statutory reserve requirements, in each case, plus an applicable margin.

 

We will pay certain customary and recurring fees with respect to the Credit Facility, including (i) fees on the commitments of the lenders under the revolving facility, (ii) administration fees and (iii) letter of credit participation fees on the aggregate face amounts of outstanding letters of credit, plus a customary fronting fee to the issuing bank.

 

The credit facility contains customary affirmative and negative covenants that, among other things, limits or restricts our ability to: incur additional debt or issue guarantees; create liens; enter into certain sale and lease-back transactions; merge or consolidate with another person; sell, transfer, lease or otherwise dispose of assets; liquidate or dissolve; and enter into restrictive covenants. Additionally, the credit facility agreement requires us not to permit the ratio of combined total indebtedness to combined EBITDA (leverage ratio) to exceed 3.50 to 1.00 at any time.

 

On October 28, 2011, we borrowed $240 under the Credit Facility to fund the remaining balance of the ITT Dividend.

 

ITT Transfer of Pension Liability to Exelis

 

In connection with the Spin-off, on October 31, 2011, ITT transferred to the Company certain defined benefit pension and other postretirement benefit plans (Transferred Plans), most significantly the ITT Salaried Retirement Plan (U.S. SRP). As a result of this action, we assumed all liabilities and assets associated with the Transferred Plans and became the plans’ sponsor. The net liabilities associated with the Transferred Plans were approximately $2,150, excluding net deferred tax assets of $800.

 

The funded status of the plans and future required contributions will depend primarily on the return on assets and the discount rate used to measure the benefit obligation at the end of the year. Depending on these factors, and the resulting funded status of our pension plans, the level of future statutory minimum contributions could be material.

 

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Rabbi Trust

 

On November 2, 2011, the Company established a grantor trust (“Rabbi Trust”) for the purpose of assisting the Company with the payment of certain nonqualified deferred compensation obligations in the event of a change in control of the Company. The Company will make a nominal contribution to establish the Rabbi Trust and, under the terms of the trust agreement, the Company is obligated to contribute an amount equal to 110 percent of the Company’s obligations under eight nonqualified deferred compensation plans at the time of an “Acceleration Event,” as defined in such plans and the Rabbi Trust.

 

Dividends

 

On November 2, 2011, the Board of Directors declared a cash dividend of $0.1033 per share, payable on January 1, 2012 to shareholders of record on November 16, 2011.

 

(In millions, unless otherwise stated)

 

You should read the following discussion of our results of operations and financial condition together with the unaudited Condensed Combined Financial Statements included in this Form 10-Q, as well as the audited historical Combined financial statements and the notes thereto included in the information statement filed as an exhibit to our Registration Statement on Form 10 as amended and filed with the SEC on October 5, 2011 (Information Statement), which provides additional information regarding our products and services, industry outlook and forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward looking statements.

 

 

Exelis Inc. (“Exelis” or the “Company”) is a leader in Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (C4ISR) related products and systems and information and technical services, which it supplies to military, government and commercial customers in the United States and globally. Exelis provides mission-critical systems in the areas of integrated electronic warfare, sensing and surveillance, air traffic management, information and cyber-security, and networked communications. Exelis also has growing positions in composite aerostructures, logistics and technical services. The Company’s customers include the U.S. Army, Navy, Marines and Air Force, NASA, various U.S. civil, intelligence and security agencies, the Federal Aviation Administration, allied militaries and governments, and various commercial customers.

 

Our business is reported in two segments: C4ISR Electronics and Systems and Information and Technical Services. Our C4ISR Electronics and Systems segment provides engineered electronic systems and equipment, including force protection, electronic warfare systems, reconnaissance and surveillance systems, and integrated structures. Our Information and Technical Services segment is a provider of logistics, infrastructure, and sustainment support, while also providing a diverse set of technical services.

 

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On October 31, 2011, ITT Corporation (“ITT”) completed the previously announced spin-off (the “Spin-off”) of Exelis, formerly ITT’s Defense & Information Solutions segment. Effective as of 12:01 a.m., Eastern time on October 31, 2011 (the “Distribution Date”), the common stock of Exelis was distributed, on a pro rata basis, to ITT’s shareholders of record as of the close of business on October 17, 2011 (the “Record Date”). On the Distribution Date, each of the shareholders of ITT received one share of Exelis common stock for every one share of common stock of ITT held on the Record Date. The Spin-off was completed pursuant to the Distribution Agreement, dated as of October 25, 2011, among ITT, Exelis and Xylem Inc. After the Distribution Date, ITT does not beneficially own any shares of Exelis common stock.

 

Prior to the Spin-off, we were a subsidiary of ITT Corporation. The financial information included herein may not necessarily reflect our financial position, results of operations and cash flows in the future or what our financial position, result of operations and cash flows would have been had we been an independent, publicly traded company during the periods presented. We are incurring additional costs to be able to function as an independent, publicly traded company, including additional costs related to corporate finance, governance and public reporting.

 

Except as otherwise indicated or unless the context otherwise requires, the information included in this discussion and analysis assumes the completion of all the transactions referred to in this Form 10-Q in connection with the Spin-off and Distribution. Unless the context otherwise requires, references in this Form 10-Q to “Exelis”, “we,” “us,” “our” and “our company” refer to Exelis Inc. and its combined subsidiaries. References in this Form 10-Q to “ITT” or “parent” refers to ITT Corporation, an Indiana corporation, and its combined subsidiaries, unless the context otherwise requires. Amounts are in millions, unless stated otherwise.

 

Executive Summary

 

Exelis reported revenue of $1.5 billion for the quarter ended September 30, 2011, an increase of approximately 12% compared to the corresponding period in 2010. The increase in revenue was primarily driven by approximately 42% growth within our Information and Technical Services segment due primarily to new contract wins on our Middle Eastern Programs. The increase in revenue in our Information and Technical Services Segment was partially offset by lower demand for surge- related products in our C4ISR Electronics and Systems segment, including our Single Channel Ground and Airborne Radio Systems (SINCGARS). Operating income for the third quarter ended September 30, 2011, was $156, reflecting a decline of $5 or 3% compared to the corresponding prior period. Overall, operating margin declined year-over-year due to a shift in sales from higher margin products to lower margin services.

 

Additional Company highlights for the third quarter of 2011 included the following:

 

 

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Further details related to the quarter and year-to-date results are contained in the Discussion of Financial Results section.

 

Economic Opportunities, Challenges, and Risks

 

The following represents an update of trends and uncertainties from those included in our Information Statement, which could have a significant impact on our results of operations, financial position and/or cash flows:

 

The U.S. continues to face a complex and changing national security environment, and domestic economic challenges, such as unemployment, federal budget deficits and the growing national debt. Significant uncertainties exist due to the competing priorities to modernize and expand U.S. security capabilities and the efforts to reduce overall government spending. Although reductions to certain programs in which we participate or for which we expect to compete are always possible, we believe that spending on recapitalization, modernization and maintenance of defense and homeland security assets will continue to be a national priority. Based on the FY 2012 DoD budget, we believe that the U.S. Government will continue to place a high priority on the future challenges of modernization and transformation of forces and capabilities. Examples include intelligence, surveillance and reconnaissance, network communications, cyber warfare and security, unmanned aircraft and integrated logistics support. Our portfolio of defense solutions, which covers a broad range of air, sea and ground platforms and applications, aligns with the priorities outlined by the DoD. However, uncertainty related to potential changes in appropriations and priorities could materially impact our business.

 

The information provided above does not represent a complete list of known trends and uncertainties that could impact our business in either the near or long-term. It should, however, be considered along with the risk factors identified under the caption “Risk Factors” in our Information Statement and our disclosure under the caption “Forward-Looking Statements and Cautionary Statements” at the end of this section.

 

Key Performance Indicators and Non-GAAP Measures

Management reviews key performance indicators including revenue, segment operating income and margins, orders growth, and backlog, among others metrics on a regular basis. In addition, we consider certain additional measures to be useful to management and investors evaluating our operating performance for the periods presented, and provide a tool for evaluating our ongoing operations, liquidity and management of assets. This information can assist investors in assessing our financial performance and measures our ability to generate capital for deployment among competing strategic alternatives and initiatives, including, but not limited to, dividends, acquisitions, and debt repayment. These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (GAAP) and should not be considered a substitute for revenue, operating income, income from continuing operations, or net cash from continuing operations as determined in accordance with GAAP. We consider the following non-GAAP measures, which may not be comparable to similarly titled measures reported by other companies, to be key performance indicators:

 

 

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The following table provides a reconciliation of adjusted income from continuing operations for the three and nine months ended September 30, 2011 and 2010:

 

 

COMBINED OPERATING RESULTS

 

Selected financial highlights are presented in the table below: