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EX-31.1 - EX-31.1 - CUBIC CORP /DE/cub-20160331ex3114c8a06.htm
EX-32.1 - EX-32.1 - CUBIC CORP /DE/cub-20160331ex321185f79.htm
EX-32.2 - EX-32.2 - CUBIC CORP /DE/cub-20160331ex3225b07e8.htm
EX-10.1 - EX-10.1 - CUBIC CORP /DE/cub-20160331ex1019e6c11.htm
EX-31.2 - EX-31.2 - CUBIC CORP /DE/cub-20160331ex31211ec97.htm
EX-3.2 - EX-3.2 - CUBIC CORP /DE/cub-20160331ex328d2a0a1.htm

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT

Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the Quarter Ended March 31, 2016

 

001-08931

Commission File Number

 

CUBIC CORPORATION

Exact Name of Registrant as Specified in its Charter

 

 

 

 

Delaware

 

95-1678055

State of Incorporation

 

IRS Employer Identification No.

 

9333 Balboa Avenue
San Diego, California 92123
Telephone (858) 277-6780

 

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  No  

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company (as defined in Rule 12b-2 of the Exchange Act).

 

 

 

 

Large accelerated filer

 

Accelerated filer

 

 

 

Non-accelerated filer

 

Small Reporting Company

 

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

 

As of April 20, 2016, registrant had only one class of common stock of which there were 26,976,698 shares outstanding (after deducting 8,945,300 shares held as treasury stock).

 

 

 

 


 

CUBIC CORPORATION

QUARTERLY REPORT ON FORM 10-Q

For the Quarter Ended March 31, 2016

 

TABLE OF CONTENTS

 

 

 

 

 

 

 

    

    

Page

 

 

 

 

 

 

 

PART I - FINANCIAL INFORMATION

 

 

 

 

 

 

 

 

Item 1. 

Financial Statements (Unaudited)

 

3

 

 

Condensed Consolidated Statements of Income (Loss)

 

3

 

 

Condensed Consolidated Statements of Comprehensive Loss

 

4

 

 

Condensed Consolidated Balance Sheets

 

5

 

 

Condensed Consolidated Statements of Cash Flows

 

6

 

 

Notes to Condensed Consolidated Financial Statements

 

7

 

Item 2. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

28

 

Item 3. 

Quantitative and Qualitative Disclosures about Market Risk

 

37

 

Item 4. 

Controls and Procedures

 

37

 

 

 

 

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

 

 

 

 

Item 1. 

Legal Proceedings

 

38

 

Item 1A. 

Risk Factors

 

38

 

Item 6. 

Exhibits

 

38

 

 

 

 

2


 

PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

 

CUBIC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS) (UNAUDITED)

(amounts in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

Three Months Ended

 

 

 

March 31,

 

March 31,

 

 

 

2016

    

2015

    

2016

    

2015

 

Net sales:

 

 

 

 

 

 

 

 

 

 

 

 

 

Products

 

$

280,763

 

$

259,122

 

$

155,794

 

$

130,510

 

Services

 

 

399,074

 

 

398,200

 

 

210,230

 

 

208,324

 

 

 

 

679,837

 

 

657,322

 

 

366,024

 

 

338,834

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Products

 

 

219,637

 

 

194,545

 

 

120,445

 

 

90,121

 

Services

 

 

314,594

 

 

305,337

 

 

159,938

 

 

156,045

 

Selling, general and administrative expenses

 

 

138,265

 

 

100,476

 

 

79,774

 

 

52,922

 

Research and development

 

 

9,625

 

 

6,892

 

 

6,143

 

 

2,640

 

Amortization of purchased intangibles

 

 

14,954

 

 

14,429

 

 

8,499

 

 

8,494

 

Restructuring costs

 

 

(75)

 

 

5,258

 

 

311

 

 

5,406

 

 

 

 

697,000

 

 

626,937

 

 

375,110

 

 

315,628

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

 

(17,163)

 

 

30,385

 

 

(9,086)

 

 

23,206

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (expenses):

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest and dividend income

 

 

737

 

 

903

 

 

339

 

 

438

 

Interest expense

 

 

(3,917)

 

 

(1,933)

 

 

(2,579)

 

 

(1,062)

 

Other income (expense), net

 

 

398

 

 

(900)

 

 

223

 

 

16

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before income taxes

 

 

(19,945)

 

 

28,455

 

 

(11,103)

 

 

22,598

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income tax expense (benefit)

 

 

(24,675)

 

 

34,304

 

 

(21,247)

 

 

33,609

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

 

4,730

 

 

(5,849)

 

 

10,144

 

 

(11,011)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Less noncontrolling interest in income of VIE

 

 

 —

 

 

23

 

 

 —

 

 

13

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to Cubic

 

$

4,730

 

$

(5,872)

 

$

10,144

 

$

(11,024)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)  per share attributable to Cubic:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.18

 

$

(0.22)

 

$

0.38

 

$

(0.41)

 

Diluted

 

$

0.18

 

$

(0.22)

 

$

0.38

 

$

(0.41)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends per common share

 

$

0.14

 

$

0.14

 

$

0.14

 

$

0.14

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in per share calculations:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

26,968

 

 

26,861

 

 

26,973

 

 

26,862

 

Diluted

 

 

26,986

 

 

26,861

 

 

26,995

 

 

26,862

 

 

See accompanying notes.

3


 

CUBIC CORPORATION

CONDENSED CONSOLIDATED

STATEMENTS OF COMPREHENSIVE INCOME (LOSS) (UNAUDITED)

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

Three Months Ended

 

 

 

March 31,

 

March 31,

 

 

    

2016

    

2015

 

2016

    

2015

 

Net income (loss)

 

$

4,730

 

$

(5,849)

 

$

10,144

 

$

(11,011)

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation

 

 

(17,621)

 

 

(33,057)

 

 

(9,118)

 

 

(19,094)

 

Change in unrealized gains/losses from cash flow hedges:

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in fair value of cash flow hedges, net of tax

 

 

(347)

 

 

967

 

 

(375)

 

 

300

 

Adjustment for net gains/losses realized and included in net income, net of tax

 

 

(574)

 

 

(868)

 

 

395

 

 

(392)

 

Total change in unrealized gains/losses realized from cash flow hedges, net of tax

 

 

(921)

 

 

99

 

 

20

 

 

(92)

 

Total other comprehensive loss

 

 

(18,542)

 

 

(32,958)

 

 

(9,098)

 

 

(19,186)

 

Total comprehensive income (loss)

 

$

(13,812)

 

$

(38,807)

 

$

1,046

 

$

(30,197)

 

 

 

 

 

4


 

 

CUBIC CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

March 31,

 

September 30,

 

 

    

2016

    

2015

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

158,808

 

$

218,476

 

Restricted cash

 

 

72,759

 

 

69,245

 

Marketable securities

 

 

14,380

 

 

30,533

 

Accounts receivable - net

 

 

347,617

 

 

358,925

 

Recoverable income taxes

 

 

16,678

 

 

753

 

Inventories - net

 

 

78,512

 

 

63,700

 

Deferred income taxes and other current assets

 

 

41,744

 

 

33,670

 

Total current assets

 

 

730,498

 

 

775,302

 

 

 

 

 

 

 

 

 

Long-term contract receivables

 

 

46,106

 

 

36,809

 

Long-term capitalized contract costs

 

 

69,837

 

 

73,017

 

Property, plant and equipment, net

 

 

93,910

 

 

74,690

 

Deferred income taxes

 

 

1,555

 

 

11,443

 

Goodwill

 

 

409,442

 

 

237,899

 

Purchased intangibles, net

 

 

143,833

 

 

72,936

 

Other assets

 

 

5,906

 

 

18,180

 

 

 

$

1,501,087

 

$

1,300,276

 

 

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Short-term borrowings

 

$

240,000

 

$

60,000

 

Trade accounts payable

 

 

62,853

 

 

47,170

 

Customer advances

 

 

60,160

 

 

77,083

 

Accrued compensation and other current liabilities

 

 

126,799

 

 

143,919

 

Income taxes payable

 

 

1,509

 

 

4,675

 

Deferred income taxes

 

 

 —

 

 

13,404

 

Current portion of long-term debt

 

 

498

 

 

525

 

Total current liabilities

 

 

491,819

 

 

346,776

 

 

 

 

 

 

 

 

 

Long-term debt

 

 

200,872

 

 

126,180

 

Other long-term liabilities

 

 

67,000

 

 

71,032

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

Common stock

 

 

28,178

 

 

25,560

 

Retained earnings

 

 

819,674

 

 

818,642

 

Accumulated other comprehensive loss

 

 

(70,378)

 

 

(51,836)

 

Treasury stock at cost

 

 

(36,078)

 

 

(36,078)

 

Total shareholders’ equity

 

 

741,396

 

 

756,288

 

 

 

$

1,501,087

 

$

1,300,276

 

 

See accompanying notes.

 

 

5


 

CUBIC CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

Three Months Ended

 

 

    

2016

    

2015

 

2016

    

2015

 

Operating Activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

4,730

 

$

(5,849)

 

$

10,144

 

$

(11,011)

 

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

18,977

 

 

20,064

 

 

10,029

 

 

11,117

 

Share-based compensation expense

 

 

4,088

 

 

5,291

 

 

1,970

 

 

4,238

 

Changes in operating assets and liabilities, net of effects from acquisitions

 

 

(65,490)

 

 

41,592

 

 

(10,251)

 

 

48,473

 

NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES

 

 

(37,695)

 

 

61,098

 

 

11,892

 

 

52,817

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investing Activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Acquisition of businesses, net of cash acquired

 

 

(243,483)

 

 

(89,460)

 

 

(213,765)

 

 

(6,037)

 

Purchases of property, plant and equipment

 

 

(21,375)

 

 

(2,580)

 

 

(11,015)

 

 

(1,704)

 

Purchases of marketable securities

 

 

(14,686)

 

 

(4,590)

 

 

(7,145)

 

 

(4,590)

 

Proceeds from sales or maturities of marketable securities

 

 

29,870

 

 

1,196

 

 

15,694

 

 

1,196

 

Purchases of other assets

 

 

 —

 

 

(2,993)

 

 

 —

 

 

(641)

 

NET CASH USED IN INVESTING ACTIVITIES

 

 

(249,674)

 

 

(98,427)

 

 

(216,231)

 

 

(11,776)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financing Activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Proceeds from short-term borrowings

 

 

253,300

 

 

70,000

 

 

180,700

 

 

10,000

 

Principal payments on short-term borrowings

 

 

(73,300)

 

 

(15,000)

 

 

(50,700)

 

 

(15,000)

 

Proceeds from long-term borrowings

 

 

75,000

 

 

 —

 

 

75,000

 

 

 —

 

Principal payments on long-term debt

 

 

(254)

 

 

(269)

 

 

(123)

 

 

(131)

 

Purchase of common stock

 

 

(1,658)

 

 

(1,723)

 

 

 —

 

 

(141)

 

Dividends paid

 

 

(3,641)

 

 

(3,627)

 

 

(3,641)

 

 

(3,627)

 

Net change in restricted cash

 

 

(3,514)

 

 

(101)

 

 

(1,102)

 

 

(42)

 

Contingent consideration payments related to acquisitions of businesses

 

 

(1,679)

 

 

 —

 

 

 —

 

 

 —

 

NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES

 

 

244,254

 

 

49,280

 

 

200,134

 

 

(8,941)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of exchange rates on cash

 

 

(16,553)

 

 

(19,696)

 

 

(8,350)

 

 

(11,259)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

 

(59,668)

 

 

(7,745)

 

 

(12,555)

 

 

20,841

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents at the beginning of the period

 

 

218,476

 

 

215,849

 

 

171,363

 

 

187,263

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

CASH AND CASH EQUIVALENTS AT THE END OF THE PERIOD

 

$

158,808

 

$

208,104

 

$

158,808

 

$

208,104

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental disclosure of non-cash investing and financing activities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Liability incurred to acquire GATR, net

 

$

7,651

 

$

 —

 

$

7,651

 

$

 —

 

Liability incurred to acquire TeraLogics, net

 

$

4,998

 

$

 —

 

$

 —

 

$

 —

 

Liability incurred to acquire H4 Global, net

 

$

952

 

$

 —

 

$

 —

 

$

 —

 

Liability incurred to acquire DTECH, net

 

$

 —

 

$

8,854

 

$

 —

 

$

 —

 

Liability incurred to acquire internal use software

 

$

 —

 

$

10,800

 

$

 —

 

$

10,800

 

 

See accompanying notes.

 

 

6


 

CUBIC CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

March 31, 2016

 

Note 1 — Basis for Presentation

 

Cubic Corporation (“we”, “us”, and “Cubic”) has prepared the accompanying unaudited condensed consolidated financial statements in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.

 

In our opinion, the accompanying financial statements reflect all adjustments, consisting of normal recurring adjustments, considered necessary for a fair presentation of the results for the interim periods presented. Operating results for the three- and six-month periods ended March 31, 2016 are not necessarily indicative of the results that may be expected for the year ending September 30, 2016. For further information, refer to the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended September 30, 2015.

 

The preparation of the financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Significant Accounting Policies

 

There have been no material changes to our significant accounting policies as compared with the significant accounting policies described in our Annual Report on Form 10-K for the year ended September 30, 2015.

 

Recent Accounting Pronouncements

 

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. ASU 2014-09 outlines a comprehensive revenue recognition model and supersedes most current revenue recognition guidance and will require revenue to be recognized when promised goods or services are transferred to customers in amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services. Adoption of the new rules could affect the timing of revenue recognition for certain transactions. ASU 2014-09 will be effective for us starting in the first quarter of fiscal 2019 or we may adopt ASU 2014-09 early, in the first quarter of 2018. ASU 2014-09 allows for two methods of adoption: (a) “full retrospective” adoption, meaning the standard is applied to all periods presented, or (b) “modified retrospective” adoption, meaning the cumulative effect of applying ASU 2014-09 is recognized as an adjustment to the opening retained earnings balance in the year of adoption. We do not intend to adopt the standard early and we have not yet determined which method of adoption we will select. As the new standard will supersede substantially all existing revenue guidance affecting us under GAAP, it could impact revenue and cost recognition on a significant number of contracts across our business segments, in addition to our business processes and our information technology systems. As a result, our evaluation of the effect of the new standard will likely extend over several future periods.

 

In August 2014, the FASB issued ASU 2014-15, Presentation of Financial Statements - Going Concern, which requires management to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and provide related footnote disclosures. ASU 2014-15 will be effective for us for the year ended September 30, 2017 and for interim reporting periods thereafter. Early adoption is permitted for financial statements that have not been previously issued, but we have not yet adopted this standard. This adoption is not expected to have a significant impact on our financial statements.

 

In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis. The new standard modifies current guidance on consolidation under the variable interest model and the voting model. We adopted ASU 2015-02 on October 1, 2015 with no significant impact on our consolidated financial statements.

7


 

 

In April 2015, the FASB issued ASU 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. ASU 2015-05 provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, then the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. ASU 2015-05 will be effective for the Company beginning on October 1, 2016, with early adoption permitted. We are currently assessing the impact that adopting this new accounting guidance will have on our consolidated financial statements.

 

In April 2015, the FASB issued ASU 2015-03, Simplifying the Presentation of Debt Issuance Costs which requires that all costs incurred to issue debt be presented in the balance sheet as a direct reduction from the carrying value of the debt, similar to the presentation of debt discounts. ASU 2015-03 is effective for us on October 1, 2016 with early adoption permitted. We do not expect that the adoption of this new accounting guidance will have a material impact on our consolidated financial statements.

 

In September 2015, the FASB issued ASU 2015-16, Simplifying the Accounting for Measurement-Period Adjustments in business combinations. This standard eliminates the need for an acquirer in a business combination to recognize measurement-period adjustments retrospectively, but instead measurement-period adjustments are to be recorded during the period in which the amount of the adjustment is determined, including the effect on earnings of any amount that would have been recorded in a previous period had the amount been recorded at the acquisition date. We adopted ASU 2015-16 on January 1, 2016 with no significant impact on our consolidated financial statements.

 

In November 2015, the FASB issued ASU 2015-17, Balance Sheet Classification of Deferred Taxes which removes the requirement to separate deferred tax liabilities and assets into current and noncurrent amounts and instead requires all such amounts be classified as noncurrent on the balance sheet. We adopted ASU 2015-17 prospectively on October 1, 2015 and reclassified the current portion of our net deferred tax assets and liabilities to net noncurrent deferred tax assets and liabilities. No prior periods were retrospectively adjusted.

 

In January 2016, the FASB issued Accounting Standards Update ASU 2016-01, Financial Instruments – Overall (Subtopic 825-10) which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for us beginning October 1, 2018 and early adoption is not permitted. We are currently evaluating the impact this guidance will have on our financial statements and related disclosures.

 

In February 2016, the FASB issued ASU No. 2016-02, Leases. Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the commencement date: (a) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and (b) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. The ASU will be effective for us beginning October 1, 2019 with early adoption permitted. We are currently evaluating the impact of the application of this accounting standard update on our consolidated financial statements.

 

In March 2016, the FASB issued ASU No. 2016-09, Compensation-Stock Compensation. The new guidance simplifies several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. The amendments in this standard are effective for our annual year and first fiscal quarter beginning on October 1, 2017 with early adoption is permitted. We are currently evaluating the impact of the application of this accounting standard update on our consolidated financial statements.

 

 

 

 

Note 2 — Acquisitions

 

Each of the following acquisitions has been treated as a business combination for accounting purposes. The results of operations of each acquired business has been included in our consolidated financial statements since the respective date of each acquisition.

 

8


 

GATR

 

On February 2, 2016 we acquired all of the outstanding capital stock of GATR Technologies, LLC (GATR), a defense systems business based in Huntsville, Alabama which manufactures deployable satellite communication terminal solutions. GATR expands our satellite communications and networking applications technologies for our Cubic Global Defense Systems (CGD Systems) segment and expands our customer base.

 

GATR’s sales have totaled $9.3 million since the acquisition date. GATR’s operating income for the quarter ended March 31, 2016 was significantly impacted by the GAAP accounting requirements regarding business combinations. Prior to our acquisition of GATR, GATR had a number of share-based payment awards in place to its employees. Due to the structure of certain of these share-based payment awards and the acceleration of vesting of certain of these awards in connection with our acquisition of GATR, we were required to recognize compensation expense, rather than purchase consideration, for the portion of our purchase price that we paid to the seller that was distributed to the recipients of these awards. Consequently, we recognized $18.5 million of compensation expense within general and administrative expenses during the quarter ended March 31, 2016 related to this matter. Of this $18.5 million amount, $15.4 million is not expected to be deductible for tax purposes. In addition during the quarter ended March 31, 2016, GATR incurred charges of $2.4 million for the amortization of intangibles and acquisition costs of $0.4 million. As a result of the charges above, the GATR net loss after taxes for the three and six-month periods ended March 31, 2016 totaled $18.3 million.

 

The estimated fair value of consideration is $221.2 million, which is comprised of cash paid of $231.3 million plus the estimated fair value of contingent consideration of $2.5 million, plus additional held back consideration to be paid in the future estimated at $5.2 million, less $17.7 million of cash paid to the seller related to the $18.5 million recorded as expense described above. Under the purchase agreement, we will pay the sellers up to $7.5 million of contingent consideration if GATR meets certain gross profit goals for the 12 month periods ended February 28, 2017 and 2018. The contingent consideration liability will be re-measured to fair value at each reporting date until the contingencies are resolved and any changes in fair value are recognized in earnings.

 

The acquisition of GATR is being paid for predominantly with the proceeds of the borrowings described below. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition date (in millions):

 

 

 

 

 

 

Customer relationships

    

$

51.7

 

Backlog

 

 

3.4

 

Technology

 

 

10.7

 

Non-compete agreements

 

 

1.2

 

Trade name

 

 

4.7

 

Accounts receivable

 

 

10.6

 

Inventory

 

 

3.4

 

Income tax receivable

 

 

5.5

 

Accounts payable and accrued expenses

 

 

(2.4)

 

Deferred tax liabilities

 

 

(22.2)

 

Other net assets acquired (liabilities assumed)

 

 

(0.1)

 

Net identifiable assets acquired

 

 

66.5

 

Goodwill

 

 

154.7

 

Net assets acquired

 

$

221.2

 

 

The estimated fair values of assets acquired and liabilities assumed, including deferred tax assets and liabilities, purchased intangibles and deferred revenue, as well as the estimated fair value of contingent consideration and the amount of expense recognized in connection with the modification of the share-based payment awards described above are preliminary estimates pending the finalization of our valuation analyses. The fair values of purchased intangibles were determined using the valuation methodology deemed to be the most appropriate for each type of asset being valued. The customer relationships and backlog valuation used the excess earnings approach, the non-compete agreements used the with-and-without approach, and the technology and trade name asset valuations used the relief from royalty approach.

 

The intangible assets are being amortized using a combination of straight-line and accelerated methods based on the expected cash flows from the assets, over a weighted average useful life of nine years from the date of acquisition.

9


 

 

The goodwill resulting from the acquisition consists primarily of the synergies expected from combining the operations of GATR with our existing CGD Systems business, including the synergies expected from combining its satellite communications and networking applications technologies with our CGD Systems product portfolio. The goodwill also includes the value of the assembled workforce that became our employees following the close of the acquisition. The amount recorded as goodwill is allocated to our CGD Systems segment and is generally not expected to be deductible for tax purposes.

 

The estimated amortization expense related to the intangible assets recorded in connection with our acquisition of GATR for fiscal years 2016 through 2020 and thereafter is as follows (in millions):

 

 

 

 

 

 

Year Ended

 

 

 

 

September 30,

    

 

 

 

2016

 

$

9.7

 

2017

 

 

12.7

 

2018

 

 

11.1

 

2019

 

 

9.8

 

2020

 

 

8.3

 

Thereafter

 

 

20.1

 

 

TeraLogics

 

On December 21, 2015 we acquired all of the assets of TeraLogics, LLC, an Ashburn, Virginia-based provider of real-time full motion video processing, exploitation and dissemination (PED) for the Department of Defense, the intelligence community and commercial customers. TeraLogics’ ability to develop real-time video analysis and delivery software for full motion video complements the existing tactical communications portfolio of our CGD Systems segment and expands our customer base. For the quarter ended March 31, 2016, TeraLogics had sales of $3.8 million, but had no significant sales between the acquisition date and December 31, 2015. TeraLogics net loss after taxes was $0.2 million, and $1.2 million for three and six months ended March 31, 2016, respectively, including the impact of charges related to the acquisition. For the quarter and six months ended March 31, 2016 we incurred $0.5 million and $0.9 million, respectively, of transaction and acquisition expenses. In addition, during the quarter ended December 31, 2015 we incurred a $1.3 million charge for compensation expense incurred related to amounts paid to TeraLogics employees upon the close of the acquisition.

 

The estimated fair value of consideration is $33.9 million, which is comprised of cash paid of $28.9 million plus the estimated acquisition-date fair value of contingent consideration of $5.0 million. Under the purchase agreement, we will pay the sellers up to $9.0 million of contingent consideration. Of this amount, up to $6.0 million will be paid if TeraLogics meets certain revenue thresholds in fiscal years 2016, 2017 and 2018; and up to $3.0 million will be paid if specific contract extensions are exercised by TeraLogics customers through fiscal 2018. The contingent consideration liability will be re-measured to fair value at each reporting date until the contingencies are resolved and any changes in fair value are recognized in earnings. There has been no significant change in the fair value of contingent consideration since the date of the acquisition.

 

10


 

The acquisition of TeraLogics is being paid for with a combination of funds from our existing cash resources and borrowings on our revolving credit facility. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition date (in millions):

 

 

 

 

 

 

Customer relationships

    

$

6.7

 

Backlog

 

 

5.6

 

Software

 

 

2.5

 

Non compete agreements

 

 

0.1

 

Accounts receivable

 

 

1.4

 

Accounts payable and accrued expenses

 

 

(0.5)

 

Other net assets acquired (liabilities assumed)

 

 

(0.1)

 

Net identifiable assets acquired

 

 

15.7

 

Goodwill

 

 

18.2

 

Net assets acquired

 

$

33.9

 

 

The estimated fair values of purchased intangibles and deferred revenue, as well as the estimated fair value of contingent consideration are preliminary estimates pending the finalization of our valuation analyses. The fair values of purchased intangibles were determined using the valuation methodology deemed to be the most appropriate for each type of asset being valued. The customer relationships and backlog valuation used the excess earnings approach, the non-compete agreements used the with-and-without approach, and the software used the replacement cost new less cost decrements for obsolescence approach.

 

The intangible assets are being amortized using a combination of straight-line and accelerated methods based on the expected cash flows from the assets, over a weighted average useful life of seven years from the date of acquisition.

 

The goodwill resulting from the acquisition consists primarily of the synergies expected from combining the operations of TeraLogics with our existing CGD Systems business, including the synergies expected from combining TeraLogics real-time video capabilities with our existing tactical communications product portfolio. The goodwill also includes the value of the assembled workforce who became our employees following the close of the acquisition. The amount recorded as goodwill is allocated to our CGD Systems segment and is expected to be deductible for tax purposes.

 

The estimated amortization expense amounts related to the intangible assets recorded in connection with our acquisition of TeraLogics for fiscal years 2016 through 2020 and thereafter is as follows (in millions):

 

 

 

 

 

 

Year Ended

 

 

 

 

September 30,

    

 

 

 

2016

 

$

3.0

 

2017

 

 

3.5

 

2018

 

 

2.8

 

2019

 

 

2.1

 

2020

 

 

1.4

 

Thereafter

 

 

2.1

 

 

H4 Global

 

On November 4, 2015 we acquired all of the assets of H4 Global, a U.K.-based provider of simulation-based training solutions which complements our CGD Systems segment portfolio. For the quarter ended March 31, 2016, the amounts of H4 Global’s sales and net income after taxes included in our Consolidated Statement of Income (Loss) were $0.6 million and $0.1 million, respectively. In the short time period between our acquisition of H4 Global and December 31, 2015, H4 Global did not have significant sales or net income. During the quarter ended December 31, 2015 we incurred $0.1 million of transaction costs to acquire H4 Global.

 

The estimated fair value of consideration is $1.9 million, which is comprised of cash paid of $0.9 million plus the estimated fair value of contingent consideration of $1.0 million. Under the purchase agreement, we will pay the sellers up to $4.1 million of contingent consideration, based upon the value of contracts entered over the five-year period beginning on the acquisition date. The contingent consideration liability will be re-measured to fair value at each

11


 

reporting date until the contingencies are resolved and any changes in fair value will be recognized in earnings. There has been no significant change in the fair value of contingent consideration since the date of the acquisition.

 

The fair value of the net assets acquired and liabilities assumed was not material. Consequently, virtually the entire purchase price of $1.9 million was recorded as goodwill, which is comprised of expected synergies and assembled workforce. The amount recorded as goodwill is allocated to our CGD Systems segment and is not expected to be deductible for tax purposes. The estimated fair values of purchased intangibles and the estimated fair value of contingent consideration are preliminary estimates pending the finalization of our valuation analyses.

 

DTECH

 

On December 16, 2014 we acquired all of the outstanding capital stock of DTECH LABs, Inc. (DTECH). Based in Sterling, VA, DTECH is a provider of modular networking and baseband communications equipment that adds networking capability to our secure communications business. This acquisition expands the portfolio of product offerings and the customer base of our CGD Systems segment.

 

For the three months ended March 31, 2016, the amounts of DTECH’s sales and net loss after taxes included in our Consolidated Statement of Income (Loss) were $1.4 million and $2.3 million, respectively, compared to $10.8 million and $1.0 million, respectively for the three months ended March 31, 2015. For the six months ended March 31, 2016, the amount of DTECH’s sales and net loss after tax were $9.2 million and $3.6 million, respectively, compared to $11.8 million and $1.8 million, respectively for the six months ended March 31, 2015. The DTECH operating results for the quarter and six months ended March 31, 2016 include charges of $1.1 million and $1.9 million, respectively for the increase in the fair value of contingent consideration. There was no significant change in the fair value of contingent consideration in the quarter or six months ended March 31, 2015. For the six months ended March 31, 2015, DTECH’s operations also included $0.8 million of transaction and acquisition related costs before related income taxes.

 

The purchase agreement states that the cost of the acquisition is approximately $99.5 million, adjusted by the difference between the net working capital acquired and the targeted working capital amounts and adjusted for other acquisition related payments made upon closing, plus a contingent amount of up to $15.0 million based upon DTECH’s achievement of revenue and gross profit targets in the future. The acquisition date fair value of the consideration was $99.4 million. The total acquisition date fair value of consideration includes the acquisition fair value of holdback consideration and contingent consideration described below.

 

Approximately $4.7 million of cash consideration (Holdback Consideration) will be paid to the seller over time when certain events occur in the future. At March 31, 2016, the fair value of the Holdback Consideration is estimated to approximate $4.4 million using a discounted cash flow model, based upon the expected timing of the payment of the Holdback Consideration. In addition to the Holdback Consideration, we will pay the seller up to $15.0 million of contingent cash consideration based upon DTECH’s achievement of revenue and gross profit targets. The purchase agreement specifies independent revenue and gross profit targets for the period from our acquisition of DTECH through September 30, 2015, and separately for each of fiscal 2016 and fiscal 2017. At the acquisition date, the total fair value of the contingent consideration was estimated at $3.9 million using a real options approach (see Note 5 for further discussion of fair value measurements). During the measurement period ended September 30, 2015, DTECH met both the revenue and gross profit targets. As a result, $5.0 million was paid to the seller in December 2015. The remaining contingent consideration liability will be re-measured to fair value at each reporting date until the contingencies are resolved and any changes in fair value are recognized in earnings. At March 31, 2016 the fair value of the contingent consideration was $4.4 million.

 

Through March 31, 2016 we have paid $96.3 million to the seller. At March 31, 2016 we have recorded a liability of $8.8 million as an estimate of the additional cash consideration that will be due to the seller in the future, including the Holdback Consideration and contingent consideration.

 

12


 

The acquisition of DTECH is being paid for with a combination of funds from our existing cash resources and borrowings on our revolving credit facility. The following table summarizes the fair values of the assets acquired and liabilities assumed at the acquisition date (in millions):

 

 

 

 

 

 

 

Customer relationships

    

$

35.1

 

Non-compete agreements

 

 

0.7

 

Backlog

 

 

2.1

 

Cash

 

 

0.9

 

Accounts receivable

 

 

5.4

 

Inventory

 

 

4.2

 

Warranty obligation

 

 

(0.4)

 

Tax liabilities

 

 

(3.3)

 

Accounts payable and accrued expenses

 

 

(3.4)

 

Other net assets acquired

 

 

0.2

 

Net identifiable assets acquired

 

 

41.5

 

Goodwill

 

 

57.9

 

Net assets acquired

 

$

99.4

 

 

The fair values of purchased intangibles were determined using the valuation methodology deemed to be the most appropriate for each type of asset being valued. The customer relationships and backlog valuation used the excess earnings approach and the non-compete agreements used the with-and-without approach.

 

The intangible assets are being amortized using a combination of straight-line and accelerated methods based on the expected cash flows from the assets, over a weighted average useful life of seven years from the date of acquisition and the amortization is expected to be deductible for tax purposes.

 

The goodwill resulting from the acquisition consists primarily of the synergies expected from combining the operations of DTECH with our existing CGD Systems business, including the synergies expected from combining the networking and secure communications technologies of DTECH, and complementary products that will enhance our overall product and service portfolio. The goodwill also consists of the value of the assembled workforce that became our employees following the close of the acquisition. The amount recorded as goodwill is allocated to our CGD Systems segment and is expected to be deductible for tax purposes.

 

13


 

The estimated amortization expense amounts related to the intangible assets recorded in connection with our acquisition of DTECH for fiscal years 2016 through 2020 and thereafter is as follows (in millions):

 

 

 

 

 

 

 

Year Ended September 30,

    

 

 

 

2016

 

$

8.0

 

2017

 

 

6.8

 

2018

 

 

5.5

 

2019

 

 

4.1

 

2020

 

 

2.8

 

Thereafter

 

 

1.5

 

 

Changes in goodwill for the six months ended March 31, 2016 were as follows (in millions):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

    

 

 

    

Cubic Global

    

Cubic Global

    

 

 

 

 

 

Transportation

 

Defense

 

Defense

 

 

 

 

 

 

Systems

 

Systems

 

Services

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balances at September 30, 2015

 

$

56.0

 

$

87.5

 

$

94.4

 

$

237.9

 

Acquisitions

 

 

 —

 

 

173.6

 

 

 —

 

 

173.6

 

Foreign currency exchange rate changes

 

 

(2.3)

 

 

0.2

 

 

 —

 

 

(2.1)

 

Balances at March 31, 2016

 

$

53.7

 

$

261.3

 

$

94.4

 

$

409.4

 

 

Pro forma information

 

The following unaudited pro forma information presents our consolidated results of operations as if GATR, TeraLogics, H4 Global and DTECH had been included in our consolidated results since October 1, 2014 (in millions):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

Three Months Ended

 

 

 

March 31,

 

March 31,

 

 

 

2016

    

2015

 

2016

    

2015

 

Net sales

 

$

699.9

 

$

694.7

 

$

367.3

 

$

352.1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income attributable to Cubic

 

$

3.8

 

$

(6.3)

 

$

9.5

 

$

(12.4)

 

 

The pro forma information includes adjustments to give effect to pro forma events that are directly attributable to the acquisitions and have a continuing impact on operations including the amortization of purchased intangibles and the elimination of interest expense for the repayment of debt. No adjustments were made for transaction expenses, other adjustments that do not reflect ongoing operations or for operating efficiencies or synergies. The pro forma financial information is not necessarily indicative of what the consolidated financial results of our operations would have been had the acquisitions been completed on October 1, 2014, and it does not purport to project our future operating results.

 

 

Note 3 — Net Income (Loss) Per Share

 

Basic net income (loss) per share (EPS) is computed by dividing the net income (loss) for the period by the weighted average number of common shares outstanding during the period, including vested restricted stock units (RSUs).

 

In periods with a net income, diluted EPS is computed by dividing the net income for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares consist of dilutive restricted stock units. Dilutive restricted stock units are calculated based on the average share price for each fiscal period using the treasury stock method. For RSUs with performance-based vesting, no common equivalent shares are included in the computation of diluted EPS until the related performance criteria have been met. In periods with a net loss, common equivalent shares are not included in the computation of diluted EPS, because to do so would be anti-dilutive. There were no anti-dilutive securities for the three and six months ended March 31, 2016. For the three and six months ended March 31, 2015, the effect of 0.8 million shares of restricted stock were excluded from diluted loss per share that would have been included if we had been in a net income position.

 

14


 

Basic and diluted EPS are computed as follows (amounts in thousands, except per share data).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Six Months Ended

 

Three Months Ended

 

 

 

 

March 31,

 

March 31,

 

 

 

    

2016

    

2015

    

2016

    

2015

    

 

Net income (loss) attributable to Cubic

 

$

4,730

 

$

(5,872)

 

$

10,144

 

$

(11,024)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares - basic

 

 

26,968

 

 

26,861

 

 

26,973

 

 

26,862

 

 

Effect of dilutive securities

 

 

18

 

 

 —

 

 

22

 

 

 —

 

 

Weighted average shares - diluted

 

 

26,986

 

 

26,861

 

 

26,995

 

 

26,862

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share attributable to Cubic, basic

 

$

0.18

 

$

(0.22)

 

$

0.38

 

$

(0.41)

 

 

Effect of dilutive securities

 

 

 —

 

 

 —

 

 

 —

 

 

 —

 

 

Net income (loss) per share attributable to Cubic, diluted

 

$

0.18

 

$

(0.22)

 

$

0.38

 

$

(0.41)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Anti-dilutive employee share-based awards

 

 

 —

 

 

762

 

 

 —

 

 

762

 

 

 

 

 

 

Note 4 — Balance Sheet Details

 

Marketable Securities

 

Marketable securities consist of fixed time deposits with short-term maturities. Marketable securities are classified and accounted for as available-for-sale. These investments are recorded at fair value in the accompanying Condensed Consolidated Balance Sheets and the change in fair value is recorded, net of taxes, as a component of other comprehensive loss. There have been no significant realized or unrealized gains or losses on these marketable securities to date. Marketable securities have been classified as current assets in the accompanying Condensed Consolidated Balance Sheets based upon the nature of the securities and availability for use in current operations.

 

Accounts Receivable

 

The components of accounts receivable are as follows (in thousands):

 

 

 

 

 

 

 

 

 

 

 

March 31,

 

September 30,

 

    

2016

    

2015

 

 

 

 

 

 

 

Trade and other receivables

 

$

10,581

 

$

12,812

Long-term contracts:

 

 

 

 

 

 

Billed

 

 

135,019

 

 

127,462

Unbilled

 

 

248,302

 

 

255,639

Allowance for doubtful accounts

 

 

(179)

 

 

(179)

Total accounts receivable

 

 

393,723

 

 

395,734

Less estimated amounts not currently due

 

 

(46,106)

 

 

(36,809)

Current accounts receivable

 

$

347,617

 

$

358,925

 

The amount classified as not currently due is an estimate of the amount of long-term contract accounts receivable that will not be collected within one year from March 31, 2016 under transportation systems contracts in the U.S. and Australia, and under a CGD Systems contract in Italy based upon the payment terms in the contracts. The non-current balance at September 30, 2015 represented non-current amounts due from these same customers.

 

15


 

Inventories

 

Inventories consist of the following (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

March 31,

 

September 30,

 

 

    

2016

    

2015

 

 

 

 

 

 

 

 

 

Finished products

 

$

650

 

$

644

 

Work in process and inventoried costs under long-term contracts

 

 

80,537

 

 

66,293

 

Materials and purchased parts

 

 

2,272

 

 

2,733

 

Customer advances

 

 

(4,947)

 

 

(5,970)

 

Net inventories

 

$

78,512

 

$

63,700

 

 

Pursuant to contract provisions, agencies of the U.S. government and certain other customers have title to, or security interest in, inventories related to such contracts as a result of advances, performance-based payments, and progress payments. Contract advances, performance-based payments and progress payments received are recorded as an offset against the related inventory balances for contracts that are accounted for on a percentage-of-completion basis using units-of-delivery as the basis to measure progress toward completing the contract. This determination is performed on a contract by contract basis. Any amount of payments received in excess of the cumulative amount of accounts receivable and inventoried costs for a contract is classified as customer advances, which is classified as a liability on the balance sheet.

 

At March 31, 2016, work in process and inventoried costs under long-term contracts includes approximately $4.9 million in costs incurred outside the scope of work or in advance of a contract award compared to $1.9 million at September 30, 2015. We believe it is probable that we will recover the costs inventoried at March 31, 2016, plus a profit margin, under contract change orders or awards within the next year.

 

Long-term Capitalized Costs

 

Long-term capitalized contract costs include costs incurred on contracts to develop and manufacture transportation systems for customers for which revenue recognition does not begin until the customers begin operating the systems. These capitalized costs are being recognized in cost of sales based upon the ratio of revenue recorded during a period compared to the revenue expected to be recognized over the term of the contracts. Long-term capitalized costs that were recognized as cost of sales totaled $2.1 million and $4.3 million for the quarter and six-month periods ended March 31, 2016, respectively, and $2.1 million and $3.9 million for the quarter and six-month periods ended March 31, 2015, respectively.

 

Capitalized Software

 

We capitalize certain costs associated with the development or purchase of internal-use software. The amounts capitalized are included in property, plant and equipment in our Condensed Consolidated Balance Sheets and are amortized on a straight-line basis over the estimated useful life of the software, which ranges from three to seven years. No amortization expense is recorded until the software is ready for its intended use.

 

As a part of our efforts to upgrade our current information systems, early in fiscal 2015 we purchased new enterprise resource planning (ERP) software and began the process of designing and configuring this software and other software applications to manage our operations. Capitalized software development costs related to these systems totaled $30.7 million at March 31, 2016 and $16.0 million at September 30, 2015. Such costs are classified as construction and internal-use software development in process at March 31, 2016 and September 30, 2015 are not yet ready for their intended use.

 

In addition to software costs that were capitalized in fiscal 2016, during the quarter and six-month periods ended March 31, 2016 we recognized expense related to the development of our ERP system of $6.9 million and $12.2 million, and $0.3 million and $1.9 million during the quarter and six-month periods ended March 31, 2015, respectively, for costs that did not meet the requirements for capitalization. Amounts that were expensed in connection with the development of these systems are classified within selling, general and administrative expenses in the Consolidated Statements of Income (Loss).

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Deferred Compensation Plan

 

We have a non-qualified deferred compensation plan offered to a select group of highly compensated employees. The plan provides participants with the opportunity to defer a portion of their compensation in a given plan year. The liabilities associated with the non-qualified deferred compensation plan are included in other long-term liabilities in our Condensed Consolidated Balance Sheets and totaled $10.3 million and $9.9 million at March 31, 2016 and September 30, 2015, respectively.

 

In the first quarter of fiscal 2015, we began making contributions to a rabbi trust to provide a source of funds for satisfying a portion of these deferred compensation liabilities. The total carrying value of the assets set aside to fund deferred compensation liabilities as of March 31, 2016 was $3.0 million, which included life insurance contracts with a carrying value of $2.4 million and marketable securities with a carrying value of $0.6 million. At September 30, 2015, the total carrying value of the assets set aside to fund deferred compensation liabilities was $2.9 million, which included life insurance contracts with a carrying value of $1.9 million and marketable securities with a carrying value of $1.0 million. The carrying value of the life insurance contracts is based on the cash surrender value of the policies. The marketable securities in the rabbi trust are carried at fair value, which is based upon quoted market prices for identical securities. Changes in the carrying value of the deferred compensation liability, and changes in the carrying value of the assets held in the rabbi trust are reflected in our Condensed Consolidated Statements of Income (Loss).

 

Note 5 — Fair Value of Financial Instruments

 

The valuation techniques required to determine fair value are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect internal market assumptions. The two types of inputs create the following fair value hierarchy:

 

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Level 1 - Quoted prices for identical instruments in active markets.

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Level 2 - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

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Level 3 - Significant inputs to the valuation model are unobservable.

 

The fair value of certain of our cash equivalents are based upon quoted prices for identical instruments in active markets. The fair value of our other cash equivalents and our available for sale marketable securities is based upon a discounted cash flow model and approximate cost. The marketable securities in the rabbi trust are carried at fair value, which is based upon quoted market prices for identical securities. Derivative financial instruments are measured at fair value, the material portions of which are based on active or inactive markets for identical or similar instruments or model-derived valuations whose inputs are observable. Where model-derived valuations are appropriate, we use the applicable credit spread as the discount rate. Credit risk related to derivative financial instruments is considered minimal and is managed by requiring high credit standards for counterparties and through periodic settlements of positions.

 

The fair value of our contingent consideration liabilities to the sellers of businesses that we have acquired are revalued to their fair value each period and any increase or decrease is recorded into selling, general and administrative expense. Any changes in the assumed timing and amount of the probability of payment scenarios could impact the fair value.

 

The fair value of contingent consideration liabilities that are based upon revenue targets or gross margin targets are based upon a real option approach. The contingent consideration liabilities that are valued using this real option approach include a portion of the TeraLogics contingent consideration, the DTECH contingent consideration, and the GATR contingent consideration. Under this real option approach, each payment was modeled using a long digital options written on the underlying revenue or gross margin metric. The strike price for each option is the respective revenue or gross margin as specified in the related agreement, and the spot price is calibrated to the revenue or gross margin forecast by calculating the present value of the corresponding projected revenues or gross margins using a risk-adjusted discount rate. The volatility for the underlying revenue metrics was based upon analysis of comparable guideline public companies and the volatility factor used in the March 31, 2016 valuations was 18% for TeraLogics, 22% for DTECH and 19% for GATR. The volatility factor used in the September 30, 2015 valuation for DTECH was 20%. The risk-free rate was selected based on the quoted yields for U.S. Treasury securities with terms matching the earn-out payment period.

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The fair value of the portion of the TeraLogics contingent consideration that is based on customer execution of contract extensions was estimated using a probability weighted approach. Subject to the terms and conditions of the TeraLogics Purchase Agreement, contingent consideration will be paid over a period commencing on the closing date and ending on December 21, 2018. The fair value of the contingent consideration was determined by applying probabilities of achieving the periodic payment to each period’s potential payment, and summing the present value of any future payments.

 

The fair value of the H4 Global contingent consideration was estimated using a probability weighted approach. Subject to the terms and conditions of the H4 Global Purchase Agreement, contingent consideration will be paid over a five year term that commenced on October 1, 2015 and ends on September 30, 2020. The payments will be calculated based on the award of certain contracts during the specified period. The fair value of the contingent consideration was determined by applying probabilities to different scenarios, and summing the present value of any future payments.

 

The inputs to each of the contingent consideration fair value models include significant unobservable inputs and therefore represent Level 3 measurements within the fair value hierarchy. Significant judgment is employed in determining the appropriateness of these assumptions as of the acquisition dates and each subsequent period. Accordingly, changes in the assumptions described above can materially impact the amount of contingent consideration expense we record in any period.

 

As of March 31, 2016, the following table summarizes the change in fair value of our Level 3 contingent consideration liability (in thousands):