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EX-32.2 - SECTION 1350 CERTIFICATION - COMTECH TELECOMMUNICATIONS CORP /DE/exhibit322q1fy19.htm
EX-32.1 - SECTION 1350 CERTIFICATION - COMTECH TELECOMMUNICATIONS CORP /DE/exhibit321q1fy19.htm
EX-31.2 - RULE 13A-14(A)/15D-14(A) CERTIFICATION - COMTECH TELECOMMUNICATIONS CORP /DE/exhibit312q1fy19.htm
EX-31.1 - RULE 13A-14(A)/15D-14(A) CERTIFICATION - COMTECH TELECOMMUNICATIONS CORP /DE/exhibit311q1fy19.htm

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
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Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended October 31, 2018
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Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

Commission File Number:    0-7928
form10-qa09.jpg
(Exact name of registrant as specified in its charter)
Delaware
 
11-2139466
(State or other jurisdiction of incorporation /organization)
 
(I.R.S. Employer Identification Number)
 
 
 
68 South Service Road, Suite 230,
Melville, NY
 
 
11747
(Address of principal executive offices)
 
(Zip Code)

(631) 962-7000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
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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).
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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
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Accelerated filer
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Emerging growth company
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Non-accelerated filer
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Smaller reporting company
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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. blankboxa11.jpg

Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
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APPLICABLE ONLY TO CORPORATE ISSUERS:
As of November 30, 2018, the number of outstanding shares of Common Stock, par value $0.10 per share, of the registrant was 23,905,893 shares.



COMTECH TELECOMMUNICATIONS CORP.
INDEX
 
 
 
Page
PART I. FINANCIAL INFORMATION
 
 
 
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 3.
 
 
 
 
 
Item 4.
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
Item 1.
 
 
 
 
 
Item 1A.
 
 
 
 
 
Item 2.
 
 
 
 
 
Item 4.
 
 
 
 
 
Item 6.
 
 
 
 
 
 



1


PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 
 
October 31, 2018
 
July 31, 2018
Assets
 
 
 
 
Current assets:
 
 
 
 
Cash and cash equivalents
 
$
42,943,000

 
43,484,000

Accounts receivable, net
 
159,255,000

 
147,439,000

Inventories, net
 
89,569,000

 
75,076,000

Prepaid expenses and other current assets
 
13,133,000

 
13,794,000

Total current assets
 
304,900,000

 
279,793,000

Property, plant and equipment, net
 
28,543,000

 
28,987,000

Goodwill
 
290,633,000

 
290,633,000

Intangibles with finite lives, net
 
236,507,000

 
240,796,000

Deferred financing costs, net
 
3,678,000

 
2,205,000

Other assets, net
 
2,679,000

 
2,743,000

Total assets
 
$
866,940,000

 
845,157,000

Liabilities and Stockholders’ Equity
 
 

 
 

Current liabilities:
 
 

 
 

Accounts payable
 
$
35,340,000

 
43,928,000

Accrued expenses and other current liabilities
 
68,809,000

 
65,034,000

Dividends payable
 
2,381,000

 
2,356,000

Contract liabilities
 
34,460,000

 
34,452,000

Current portion of long-term debt
 

 
17,211,000

Current portion of capital lease and other obligations
 
1,579,000

 
1,836,000

Interest payable
 
26,000

 
499,000

Total current liabilities
 
142,595,000

 
165,316,000

Non-current portion of long-term debt, net
 
193,400,000

 
148,087,000

Non-current portion of capital lease and other obligations
 
586,000

 
765,000

Income taxes payable
 
407,000

 
2,572,000

Deferred tax liability, net
 
13,200,000

 
10,927,000

Long-term contract liabilities
 
6,813,000

 
7,689,000

Other liabilities
 
3,843,000

 
4,117,000

Total liabilities
 
360,844,000

 
339,473,000

Commitments and contingencies (See Note 18)
 


 


Stockholders’ equity:
 
 

 
 

Preferred stock, par value $0.10 per share; shares authorized and unissued 2,000,000
 

 

Common stock, par value $0.10 per share; authorized 100,000,000 shares; issued 38,938,844 shares and 38,860,571 shares at October 31, 2018 and July 31, 2018, respectively
 
3,894,000

 
3,886,000

Additional paid-in capital
 
537,852,000

 
538,453,000

Retained earnings
 
406,199,000

 
405,194,000

 
 
947,945,000

 
947,533,000

Less:
 
 

 
 

Treasury stock, at cost (15,033,317 shares at October 31, 2018 and July 31, 2018)
 
(441,849,000
)
 
(441,849,000
)
Total stockholders’ equity
 
506,096,000

 
505,684,000

Total liabilities and stockholders’ equity
 
$
866,940,000

 
845,157,000


See accompanying notes to condensed consolidated financial statements.

2



COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

 
 
Three months ended October 31,
 
 
 
 
2018
 
2017
Net sales
 
$
160,844,000

 
121,569,000

Cost of sales
 
103,075,000

 
73,853,000

Gross profit
 
57,769,000

 
47,716,000

 
 
 
 
 
Expenses:
 
 

 
 

Selling, general and administrative
 
31,847,000

 
28,475,000

Research and development
 
13,210,000

 
13,750,000

Amortization of intangibles
 
4,289,000

 
5,269,000

Acquisition plan expenses
 
1,130,000

 

 
 
50,476,000

 
47,494,000

 
 
 
 
 
Operating income
 
7,293,000

 
222,000

 
 
 
 
 
Other expenses:
 
 

 
 

Interest expense
 
2,669,000

 
2,588,000

Write-off of deferred financing costs
 
3,217,000

 

Interest (income) and other
 
66,000

 
39,000

 
 
 
 
 
Income (loss) before benefit from income taxes
 
1,341,000

 
(2,405,000
)
Benefit from income taxes
 
(2,127,000
)
 
(745,000
)
 
 
 
 
 
Net income (loss)
 
$
3,468,000

 
(1,660,000
)
Net income (loss) per share (See Note 5):
 
 

 
 

Basic
 
$
0.14

 
(0.07
)
Diluted
 
$
0.14

 
(0.07
)
 
 
 
 
 
Weighted average number of common shares outstanding – basic
 
23,999,000

 
23,797,000

 
 
 
 
 
Weighted average number of common and common equivalent shares outstanding – diluted
 
24,375,000

 
23,797,000

 
See accompanying notes to condensed consolidated financial statements.

3



COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
THREE MONTHS ENDED OCTOBER 31, 2018 AND 2017
(Unaudited)
 
 
Common Stock
 
Additional
Paid-in
Capital
 
Retained Earnings
 
Treasury Stock
 
Stockholders'
Equity
 
 
Shares
 
Amount
 
 
 
Shares
 
Amount
 
Balance as of July 31, 2017
 
38,619,467

 
$
3,862,000

 
$
533,001,000

 
$
385,136,000

 
15,033,317

 
$
(441,849,000
)
 
$
480,150,000

Equity-classified stock award compensation
 

 

 
747,000

 

 

 

 
747,000

Proceeds from issuance of employee stock purchase plan shares
 
11,674

 
1,000

 
188,000

 

 

 

 
189,000

Forfeiture of restricted stock
 
(10,254
)
 
(1,000
)
 
1,000

 

 

 

 

Net settlement of stock-based awards
 
19,624

 
2,000

 
(997,000
)
 

 

 

 
(995,000
)
Cash dividends declared, net ($0.10 per share)
 

 

 

 
(2,351,000
)
 

 

 
(2,351,000
)
Accrual of dividend equivalents, net of reversal ($0.10 per share)
 

 

 

 
(61,000
)
 

 

 
(61,000
)
Net loss
 

 

 

 
(1,660,000
)
 

 

 
(1,660,000
)
Balance as of October 31, 2017
 
38,640,511

 
$
3,864,000

 
$
532,940,000

 
$
381,064,000

 
15,033,317

 
$
(441,849,000
)
 
$
476,019,000

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance as of July 31, 2018
 
38,860,571

 
$
3,886,000

 
$
538,453,000

 
$
405,194,000

 
15,033,317

 
$
(441,849,000
)
 
$
505,684,000

Equity-classified stock award compensation
 

 

 
1,046,000

 

 

 

 
1,046,000

Proceeds from exercises of stock options
 
6,100

 
1,000

 
173,000

 

 

 

 
174,000

Proceeds from issuance of employee stock purchase plan shares
 
8,861

 
1,000

 
240,000

 

 

 

 
241,000

Issuance of restricted stock
 
10,386

 
1,000

 
(1,000
)
 

 

 

 

Net settlement of stock-based awards
 
52,926

 
5,000

 
(2,059,000
)
 

 

 

 
(2,054,000
)
Cash dividends declared ($0.10 per share)
 

 

 

 
(2,381,000
)
 

 

 
(2,381,000
)
Accrual of dividend equivalents, net of reversal ($0.10 per share)
 

 

 

 
(82,000
)
 

 

 
(82,000
)
Net income
 

 

 

 
3,468,000

 

 

 
3,468,000

Balance as of October 31, 2018
 
38,938,844

 
$
3,894,000

 
$
537,852,000

 
$
406,199,000

 
15,033,317

 
$
(441,849,000
)
 
$
506,096,000


See accompanying notes to condensed consolidated financial statements.

4



COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
 
 
Three months ended October 31,
 
 
2018
 
2017
Cash flows from operating activities:
 
 
 
 
Net income (loss)
 
$
3,468,000

 
(1,660,000
)
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
 
 

 
 

Depreciation and amortization of property, plant and equipment
 
2,851,000

 
3,346,000

Amortization of intangible assets with finite lives
 
4,289,000

 
5,269,000

Amortization of stock-based compensation
 
1,046,000

 
747,000

Amortization of deferred financing costs
 
548,000

 
548,000

Write-off of deferred financing costs
 
3,217,000

 

Loss on disposal of property, plant and equipment
 
32,000

 
2,000

(Benefit from) provision for allowance for doubtful accounts
 
(7,000
)
 
147,000

Provision for excess and obsolete inventory
 
747,000

 
693,000

Deferred income tax expense
 
2,273,000

 
2,718,000

Changes in assets and liabilities:
 
 

 
 

Accounts receivable
 
(12,267,000
)
 
10,719,000

Inventories
 
(15,240,000
)
 
(10,281,000
)
Prepaid expenses and other current assets
 
3,054,000

 
1,714,000

Other assets
 
64,000

 
(200,000
)
Accounts payable
 
(9,180,000
)
 
610,000

Accrued expenses and other current liabilities
 
8,526,000

 
(2,379,000
)
Contract liabilities
 
(2,947,000
)
 
(1,635,000
)
Other liabilities, non-current
 
275,000

 
(313,000
)
Interest payable
 
(455,000
)
 
(213,000
)
Income taxes payable
 
(4,424,000
)
 
(3,346,000
)
Net cash (used in) provided by operating activities
 
(14,130,000
)
 
6,486,000

 
 
 
 
 
Cash flows from investing activities:
 
 

 
 

Purchases of property, plant and equipment
 
(1,645,000
)
 
(1,108,000
)
Net cash used in investing activities
 
(1,645,000
)
 
(1,108,000
)
 
 
 
 
 
Cash flows from financing activities:
 
 

 
 

Borrowings of long-term debt under Credit Facility
 
193,400,000

 

Net (payments) borrowings under Revolving Loan portion of Prior Credit Facility
 
(48,603,000
)
 
6,400,000

Repayment of debt under Term Loan portion of Prior Credit Facility
 
(120,121,000
)
 
(7,127,000
)
Remittance of employees' statutory tax withholdings for stock awards
 
(5,017,000
)
 
(995,000
)
Cash dividends paid
 
(2,615,000
)
 
(2,459,000
)
Payment of deferred financing costs
 
(1,771,000
)
 

Repayment of principal amounts under capital lease and other obligations
 
(454,000
)
 
(723,000
)
Proceeds from issuance of employee stock purchase plan shares
 
241,000

 
189,000

Proceeds from exercises of stock options
 
174,000

 

Net cash provided by (used in) financing activities
 
15,234,000

 
(4,715,000
)
 
 
 
 
 
Net (decrease) increase in cash and cash equivalents
 
(541,000
)
 
663,000

Cash and cash equivalents at beginning of period
 
43,484,000

 
41,844,000

Cash and cash equivalents at end of period
 
$
42,943,000

 
42,507,000

See accompanying notes to condensed consolidated financial statements. (Continued)

5



COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(Unaudited)

 
 
Three months ended October 31,
 
 
2018
 
2017
Supplemental cash flow disclosures:
 
 
 
 
Cash paid (received) during the period for:
 
 
 
 
Interest
 
$
2,470,000

 
2,164,000

Income taxes, net
 
$
25,000

 
(113,000
)
 
 
 
 
 
Non-cash investing and financing activities:
 
 
 
 
Cash dividends declared but unpaid (including dividend equivalents)
 
$
2,463,000

 
2,412,000

Accrued additions to property, plant and equipment
 
$
795,000

 
794,000

Accrued deferred financing costs
 
$
41,000

 

Issuance (forfeiture) of restricted stock
 
$
1,000

 
(1,000
)

See accompanying notes to condensed consolidated financial statements.


6


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


(1)    General

The accompanying condensed consolidated financial statements of Comtech Telecommunications Corp. and its subsidiaries ("Comtech," "we," "us," or "our") as of and for the three months ended October 31, 2018 and 2017 are unaudited. In the opinion of management, the information furnished reflects all material adjustments (which include normal recurring adjustments) necessary for a fair presentation of the results for the unaudited interim periods. Our results of operations for such periods are not necessarily indicative of the results of operations to be expected for the full fiscal year.

The preparation of our condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, and disclosure of contingent assets and liabilities, at the date of the condensed consolidated financial statements, and the reported amounts of net sales and expenses during the reported period. Actual results may differ from those estimates.

Our condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements, filed with the Securities and Exchange Commission ("SEC"), for the fiscal year ended July 31, 2018 and the notes thereto contained in our Annual Report on Form 10-K, and all of our other filings with the SEC.

As disclosed in more detail in Note (14) - "Segment Information," we manage our business in two reportable segments: Commercial Solutions and Government Solutions.

Certain reclassifications have been made to previously reported condensed consolidated financial statements to conform to the current fiscal period presentation.

(2)    Adoption of Accounting Standards and Updates

We are required to prepare our condensed consolidated financial statements in accordance with the Financial Accounting Standard Board ("FASB") Accounting Standards Codification ("ASC") which is the source for all authoritative U.S. generally accepted accounting principles, which are commonly referred to as "GAAP." The FASB ASC is subject to updates by the FASB, which are known as Accounting Standards Updates ("ASUs"). During the three months ended October 31, 2018, we adopted:

FASB ASU No. 2014-09 "Revenue from Contracts with Customers (Topic 606)." See Note (3) - "Revenue" for further information.

FASB ASU No. 2016-16 “Intra-Entity Transfers of Assets Other Than Inventory,” which eliminates a prior exception and now requires an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory (for example, intellectual property and property, plant and equipment) when the transfer occurs. We adopted this ASU on August 1, 2018. There was no material impact to our consolidated financial statements (including any cumulative-effect adjustment) and disclosures upon such adoption.


7


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


(3)    Revenue

On August 1, 2018, we adopted ASU No. 2014-09 "Revenue from Contracts with Customers (Topic 606)” or “ASC 606” applying the modified retrospective transition method. Except for new presentation or disclosure requirements, the impact of adoption, both as of August 1, 2018 and for the three months ended October 31, 2018, was not material to our business, results of operations or financial condition. As a practical expedient, we adopted the new standard only for existing contracts as of August 1, 2018. All periods prior to August 1, 2018 will continue to be reported under the accounting standards in effect in those periods. As a result of ASC 606, we made the following adjustments to our Condensed Consolidated Balance Sheet as of August 1, 2018:

 
As reported at
 
Adoption of
 
Balance at
 
July 31, 2018
 
ASC 606
 
August 1, 2018
Accrued expenses and other current liabilities(1)
$
65,034,000

 
$
(2,079,000
)
 
$
62,955,000

Contract liabilities, current and non-current(2)
42,141,000

 
2,079,000

 
44,220,000


(1) See Note (8) - "Accrued expenses and other current liabilities" for further discussion of reclassification.
(2) Formerly presented on the face of our Condensed Consolidated Balance Sheet as "Customer advances and deposits, current and non-current" prior to our adoption of ASC 606.

The core principle of ASC 606 is that revenue should be recorded in an amount that reflects the consideration to which we expect to be entitled in exchange for goods or services promised to customers. Under ASC 606, we follow a five-step model to (1) identify the contract with our customer; (2) identify our performance obligations in our contract; (3) determine the transaction price for our contract; (4) allocate the transaction price to our performance obligations; and (5) recognize revenue using one of the following two methods:

Over time - We recognize revenue using the over time method when there is a continuous transfer of control to the customer over the contractual period of performance. This generally occurs when we enter into a long-term contract relating to the design, development or manufacture of complex equipment or technology platforms to a buyer’s specification (or to provide services related to the performance of such contracts). Continuous transfer of control is typically supported by contract clauses which allow our customers to unilaterally terminate a contract for convenience, pay for costs incurred plus a reasonable profit and take control of work-in-process. Revenue recognized over time is generally based on the extent of progress toward completion of the related performance obligations. The selection of the method to measure progress requires judgment and is based on the nature of the products or services provided. In certain instances, typically for firm fixed-price contracts, we use the cost-to-cost measure because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion, including warranty costs. Revenues, including estimated fees or profits, are recorded proportionally as costs are incurred. Costs to fulfill generally include direct labor, materials, subcontractor costs, other direct costs and an allocation of indirect costs. When these contracts are modified, the additional goods or services are generally not distinct from those already provided. As a result, these modifications form part of an existing contract and we must update the transaction price and our measure of progress for the single performance obligation and recognize a cumulative catch-up to revenue and gross profits.

For over time contracts using a cost-to-cost measure of progress, we have an estimate at completion (“EAC”) process in which management reviews the progress and execution of our performance obligations. This EAC process requires management judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Since certain contracts extend over a long period of time, the impact of revisions in revenue and or cost estimates during the progress of work may impact current period earnings through a cumulative adjustment. Additionally, if the EAC process indicates a loss, a provision is made for the total anticipated loss in the period that it becomes evident. Contract revenue and cost estimates for significant contracts are generally reviewed and reassessed at least quarterly.


8


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


The cost-to-cost method is principally used to account for contracts in our command and control solutions and over-the-horizon microwave systems product lines and, to a lesser extent, certain location based and messaging infrastructure contracts in our enterprise technology solutions product line. For service-based contracts in both our enterprise technology solutions and safety and security technology solutions product lines, we recognize revenue over time. These services are typically recognized as a series of services performed over the contract term using the straight-line method, or based on our customers’ actual usage of the networks and platforms which we provide.

Point in time - When a performance obligation is not satisfied over time, we must record revenue using the point in time accounting method which generally results in revenue being recognized upon shipment or delivery of a promised good or service to a customer. This generally occurs when we enter into short term contracts or purchase orders where items are provided to customers with relatively quick turn-around times. Modifications to such contracts and or purchase orders, which typically provide for additional quantities or services, are accounted for as a new contract because the pricing for these additional quantities or services are based on standalone selling prices.

Point in time accounting is principally applied to contracts in our satellite earth station product line (which includes satellite modems, traveling wave tube amplifiers (“TWTAs”) and solid-state power amplifiers ("SSPAs")) and solid-state high-power narrow and broadband amplifiers. Point in time accounting is also applied to certain contracts in our command and control solutions product line. The contracts related to these product lines do not meet the requirements for over time revenue recognition because our customers cannot utilize the equipment for its intended purpose during any phase of our manufacturing process; customers do not simultaneously receive and or consume the benefits provided by our performance; customers do not control the asset (i.e., prior to delivery, customers cannot direct the use of the asset, sell or exchange the equipment, etc.); and, although many of our contracts have termination for convenience clauses and or an enforceable right to payment for performance completed to date, our performance creates an asset with an alternative use through the point of delivery.

In determining that our equipment has alternative use, we considered the underlying manufacturing process for our products. In the early phases of manufacturing, raw materials and work in process (including subassemblies) consist of common parts that are highly fungible among many different types of products and customer applications. Finished products are either configured to our standard configuration or based on our customers’ specifications. Finished products, whether built to our standard specification or to a customers’ specification, can be sold to a variety of customers and across many different end use applications with minimal rework, if needed, and without incurring a significant economic loss.

When identifying a contract with our customer, we consider when it has approval and commitment from both parties, if the rights of the parties are identified, if the payment terms are identified, if it has commercial substance and if collectability is probable.

When identifying performance obligations, we consider whether there are multiple promises and how to account for them. In our contracts, multiple promises are separated if they are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or comprise a series of distinct services performed over time, they are combined into a single performance obligation. In some cases, we may also provide the customer with an additional service-type warranty, which we recognize as a separate performance obligation. Service-type warranties do not represent a significant portion of our consolidated net sales. When service-type warranties represent a separate performance obligation, the revenue is deferred and recognized ratably over the extended warranty period. Our contracts, from time-to-time, may also include options for additional goods and services. To-date, these options have not represented material rights to the customer as the pricing for them reflects standalone selling prices. As a result, we do not consider options we offer to be performance obligations for which we must allocate a portion of the transaction price. In many cases, we provide assurance-type warranty coverage for some of our products for a period of at least one year from the date of delivery.


9


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


When identifying the transaction price, we typically utilize the contract's stated price as a starting point. The transaction price in certain arrangements may include estimated amounts of variable consideration, including award fees, incentive fees or other provisions that can either increase or decrease the transaction price. We estimate variable consideration as the amount to which we expect to be entitled, and we include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the estimation uncertainty is resolved. The estimation of this variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (e.g., historical, current and forecasted) that is reasonably available to us.

When allocating the contract’s transaction price, we consider each distinct performance obligation. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation using our best estimate of the standalone selling price of each distinct good or service in the contract. We determine standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as market conditions, including geographic or regional specific factors, competitive positioning, internal costs, profit objectives and internally approved pricing guidelines related to the performance obligations.

Almost all of our contracts with customers are denominated in U.S. dollars and typically either firm fixed-price or cost reimbursable type contracts (including fixed-fee, incentive-fee and time-and-material type contracts). In almost all of our contracts with customers, we are the principal in the arrangement and report revenue on a gross basis. Transaction prices for contracts with U.S. domestic and international customers are usually based on specific negotiations with each customer and in the case of the U.S. government, sometimes based on estimated or actual costs of providing the goods or services in accordance with applicable regulations. Sales by geography and customer type, as a percentage of consolidated net sales, are as follows:
 
 
Three months ended October 31,
 
 
2018
 
2017
United States
 
 
 
 
U.S. government
 
44.2
%
 
32.4
%
Domestic
 
31.4
%
 
44.3
%
Total United States
 
75.6
%
 
76.7
%
 
 
 
 
 
International
 
24.4
%
 
23.3
%
Total
 
100.0
%
 
100.0
%

Sales to U.S. government customers include sales to the U.S. Department of Defense ("DoD"), intelligence and civilian agencies, as well as sales directly to or through prime contractors. Domestic sales include sales to commercial customers, as well as to U.S. state and local governments. Included in domestic sales, are sales to Verizon Communications Inc. ("Verizon"). Sales to Verizon were 11.7% of consolidated net sales for the three months ended October 31, 2017. International sales for the three months ended October 31, 2018 and 2017 include sales to U.S. domestic companies for inclusion in products that are sold to international customers. Except for the U.S., no individual country (including sales to U.S. domestic companies for inclusion in products that are sold to a foreign country) represented more than 10% of consolidated net sales for the three months ended October 31, 2018 and 2017.





10


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


The following tables summarize our disaggregation of revenue consistent with information reviewed by our chief operating decision-maker ("CODM") for the three months ended October 31, 2018. We believe these categories best depict how the nature, amount, timing and uncertainty of revenue and cash flows are affected by economic factors which impact our business:

 
 
Three months ended October 31, 2018
 
 
Commercial Solutions
 
Government Solutions
 
Total
Geographical region and customer type
 
 
 
 
 
 
U.S. government
 
$
14,220,000

 
56,824,000

 
$
71,044,000

Domestic
 
42,237,000

 
8,274,000

 
50,511,000

Total United States
 
56,457,000

 
65,098,000

 
121,555,000

 
 
 
 
 
 
 
International
 
21,516,000

 
17,773,000

 
39,289,000

Total
 
$
77,973,000

 
82,871,000

 
$
160,844,000

Contract type
 
 
 
 
 
 
Firm fixed price
 
$
76,290,000

 
63,611,000

 
$
139,901,000

Cost reimbursable
 
1,683,000

 
19,260,000

 
20,943,000

Total
 
$
77,973,000

 
82,871,000

 
$
160,844,000

Transfer of control
 
 
 
 
 
 
Point in time
 
$
37,945,000

 
52,623,000

 
$
90,568,000

Over time
 
40,028,000

 
30,248,000

 
70,276,000

Total
 
$
77,973,000

 
82,871,000

 
$
160,844,000


The timing of revenue recognition, billings and collections results in receivables, unbilled receivables and contract liabilities on our Condensed Consolidated Balance Sheet. Under typical payment terms for our contracts accounted for over time, amounts are billed as work progresses in accordance with agreed-upon contractual terms, either at periodic intervals (e.g., monthly) or upon achievement of contractual milestones. For certain contracts with provisions that are intended to protect customers in the event we do not satisfy our performance obligations, billings occur subsequent to revenue recognition, resulting in what we have historically presented as unbilled receivables. Under ASC 606, unbilled receivables constitute contract assets. There were no material impairment losses recognized on contract assets during the three months ended October 31, 2018. On large long term contracts, and for contracts with international customers that do not do business with us regularly, payment terms typically require advanced payments and deposits. Under ASC 606, payments received from customers in excess of revenue recognized to-date results in a contract liability. These contract liabilities are not considered to represent a significant financing component of the contract because we believe these cash advances and deposits are generally used to meet working capital demands which can be higher in the earlier stages of a contract. Also, advanced payments and deposits provide us with some measure of assurance that the customer will perform on its obligations under the contract. Under the typical payment terms for our contracts accounted for at a point in time, costs are accumulated in inventory until the time of billing, which generally coincides with revenue recognition. Of the total contract liabilities at August 1, 2018, $23,127,000 was recognized as revenue during the three months ended October 31, 2018.

We recognize the incremental costs to obtain or fulfill a contract as expense when incurred if the amortization period of the asset is one year or less. Incremental costs to obtain or fulfill contracts with an amortization period greater than one year were not material. As commissions payable to our sales and marketing employees or contractors are contingent upon multiple factors, such commissions are not considered direct costs to obtain or fulfill a contract with a customer and are expensed as incurred in selling, general and administrative expenses on our Condensed Consolidated Statements of Operations. Commissions payable to our third party sales representatives related to large long-term contracts are included in total estimated costs at completion for such contracts and are expensed over time through cost of sales on our Condensed Consolidated Statements of Operations, as we consider these types of commissions direct and incremental costs to obtain and fulfill such contracts.

11


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)



Remaining performance obligations represent the transaction price of firm orders for which work has not been performed as of the end of a fiscal period. Remaining performance obligations, which we refer to as backlog, exclude unexercised contract options and potential orders under indefinite delivery / indefinite quantity ("IDIQ") contracts. As of October 31, 2018, the aggregate amount of the transaction price allocated to remaining performance obligations was $627,252,000. We expect that a significant portion of our remaining performance obligations at October 31, 2018 will be completed and recognized as revenue during the year. During the three months ended October 31, 2018, revenue recognized from performance obligations satisfied, or partially satisfied, in previous periods (for example due to changes in the transaction price) was not material.

(4)    Fair Value Measurements and Financial Instruments

Using the fair value hierarchy described in FASB ASC 820 "Fair Value Measurements and Disclosures," we valued our cash and cash equivalents using Level 1 inputs that were based on quoted market prices.

We believe that the carrying amounts of our other current financial assets (such as accounts receivable) and other current liabilities (including accounts payable, accrued expenses and the current portion of our favorable AT&T warranty settlement) approximate their fair values due to their short-term maturities.

The fair value of our Credit Facility that we entered into on October 31, 2018 approximates its carrying amount due to its variable interest rate and pricing grid that is dependent upon our leverage ratio as of the end of each fiscal quarter. We believe the fair value of our non-current portion of capital lease and other obligations, which currently has a blended interest rate of 7.1%, would not be materially different than its carrying value as of October 31, 2018.

The fair value of the non-current portion of our favorable AT&T warranty settlement would not be materially different than its carrying value as of as of October 31, 2018, given our belief that the present value of such liability reflects market participants' assumptions for a similar junior, unsecured debt instrument. See Note (8) - "Accrued Expenses and Other Current Liabilities" for further discussion of the favorable AT&T warranty settlement.

As of October 31, 2018 and July 31, 2018, other than the financial instruments discussed above, we had no other significant assets or liabilities included in our Condensed Consolidated Balance Sheets recorded at fair value, as such term is defined by FASB ASC 820.

(5)    Earnings Per Share

Our basic earnings per share ("EPS") is computed based on the weighted average number of common shares (including vested but unissued stock units, share units, performance shares and restricted stock units ("RSUs")), outstanding during each respective period. Our diluted EPS reflects the dilution from potential common stock issuable pursuant to the exercise of equity-classified stock-based awards, if dilutive, outstanding during each respective period. Pursuant to FASB ASC 260 "Earnings Per Share," equity-classified stock-based awards that are subject to performance conditions are not considered in our diluted EPS calculations until the respective performance conditions have been satisfied. When calculating our diluted earnings per share, we consider the amount an employee must pay upon assumed exercise of stock-based awards and the amount of stock-based compensation cost attributed to future services and not yet recognized.

There were no purchases of our common stock during the three months ended October 31, 2018 or 2017. See Note (17) - "Stockholders’ Equity" for more information.

Weighted average stock options, RSUs and restricted stock outstanding of 279,000 and 2,246,000 for the three months ended October 31, 2018 and 2017, respectively, were not included in our diluted EPS calculation because their effect would have been anti-dilutive.

Our EPS calculations exclude 236,000 and 252,000 weighted average performance shares outstanding for the three months ended October 31, 2018 and 2017, respectively, as the performance conditions have not yet been satisfied. However, the compensation expense related to these awards is included in net income (loss) (the numerator) for EPS calculations for each respective period.

12


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)



The following table reconciles the numerators and denominators used in the basic and diluted EPS calculations:
 
 
Three months ended October 31,
 
 
2018
 
2017
Numerator:
 
 
 
 
Net income (loss) for basic calculation
 
$
3,468,000

 
(1,660,000
)
Numerator for diluted calculation
 
$
3,468,000

 
(1,660,000
)
 
 
 
 
 
Denominator:
 
 
 
 
Denominator for basic calculation
 
23,999,000

 
23,797,000

Effect of dilutive securities:
 
 
 
 
Stock-based awards
 
376,000

 

Denominator for diluted calculation
 
24,375,000

 
23,797,000

    
(6)    Accounts Receivable

Accounts receivable consist of the following at:
 
 
October 31, 2018
 
July 31, 2018
Receivables from commercial and international customers
 
$
77,771,000

 
83,411,000

Unbilled receivables from commercial and international customers
 
19,549,000

 
19,731,000

Receivables from the U.S. government and its agencies
 
61,370,000

 
26,251,000

Unbilled receivables from the U.S. government and its agencies
 
2,217,000

 
19,807,000

Total accounts receivable
 
160,907,000

 
149,200,000

Less allowance for doubtful accounts
 
1,652,000

 
1,761,000

Accounts receivable, net
 
$
159,255,000

 
147,439,000


Unbilled receivables as of October 31, 2018 relate to contracts-in-progress for which revenue has been recognized, but for which we have not yet earned the right to bill the customer for work performed to-date. Under ASC 606, which we adopted on August 1, 2018 (see Note (3) - “Revenue”), unbilled receivables constitute contract assets. Management estimates that substantially all amounts not yet billed at October 31, 2018 will be billed and collected within one year.

Of the unbilled receivables from commercial and international customers at October 31, 2018 and July 31, 2018, approximately $1,592,000 and $1,558,000, respectively, relates to a large over-the-horizon microwave system contract with our large U.S. prime contractor customer (all of which related to our North African country end-customer).

As of October 31, 2018, except for the U.S. government (and its agencies), which represented 39.5% of total accounts receivable, there were no other customers which accounted for greater than 10.0% of total accounts receivable. As of July 31, 2018, the U.S. government (and its agencies) and Verizon represented 30.9% and 10.1%, respectively, of total accounts receivable.


13


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


(7)    Inventories

Inventories consist of the following at:
 
 
October 31, 2018
 
July 31, 2018
Raw materials and components
 
$
56,815,000

 
53,649,000

Work-in-process and finished goods
 
49,295,000

 
38,854,000

Total inventories
 
106,110,000

 
92,503,000

Less reserve for excess and obsolete inventories
 
16,541,000

 
17,427,000

Inventories, net
 
$
89,569,000

 
75,076,000


As of October 31, 2018 and July 31, 2018, the amount of inventory directly related to long-term contracts (including contracts-in-progress) was $1,235,000 and $1,249,000, respectively, and the amount of inventory related to contracts from third party commercial customers who outsource their manufacturing to us was $1,334,000 and $1,310,000, respectively.

(8)    Accrued Expenses and Other Current Liabilities

Accrued expenses and other current liabilities consist of the following at:
 
 
October 31, 2018
 
July 31, 2018
Accrued wages and benefits
 
$
22,506,000

 
23,936,000

Accrued contract costs
 
13,285,000

 
10,016,000

Accrued warranty obligations
 
9,982,000

 
11,738,000

Accrued legal costs
 
6,946,000

 
6,179,000

Accrued commissions and royalties
 
4,605,000

 
4,654,000

Other
 
11,485,000

 
8,511,000

Accrued expenses and other current liabilities
 
$
68,809,000

 
65,034,000


On August 1, 2018, in connection with our adoption of ASC 606, $2,079,000 of accrued expenses and other current liabilities were reclassified to contract liabilities on our Condensed Consolidated Balance Sheet. Of this total amount, $1,679,000 and $400,000, respectively, was reclassified from the “accrued warranty obligations” and “other” categories presented in the above table to contract liabilities as they represented deferred revenue related to service-type warranty performance obligations. See Note (3) - "Revenue" for further discussion of our adoption of ASC 606.

Other accrued expenses as of October 31, 2018 include $992,000 for the current portion of the facility exit costs related to the closure of a manufacturing facility, as discussed in more detail in Note (9) - "Cost Reduction Actions."

Accrued legal costs as of October 31, 2018 and July 31, 2018 include $3,314,000 and $3,372,000, respectively, related to estimated costs associated with certain TeleCommunication Systems, Inc. ("TCS") intellectual property matters. The accrued potential settlement costs do not reflect the final amounts we may actually pay. Ongoing legal costs associated with defending legacy TCS intellectual property matters and the ultimate resolution could vary and have a material adverse effect on our future consolidated results of operations, financial position or cash flows. TCS intellectual property matters are discussed in more detail in Note (18) - "Legal Proceedings and Other Matters."

Accrued contract costs represent direct and indirect costs on contracts as well as estimates of amounts owed for invoices not yet received from vendors or reflected in accounts payable.


14


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


Accrued warranty obligations as of October 31, 2018 relate to estimated liabilities for assurance-type warranty coverage that we provide to our customers. We generally provide warranty coverage for some of our products for a period of at least one year from the date of delivery. We record a liability for estimated warranty expense based on historical claims, product failure rates, a consideration of contractual obligations, future costs to resolve software issues and other factors. Some of our product warranties are provided under long-term contracts, the costs of which are incorporated into our estimates of total contract costs.

Changes in our accrued warranty obligations during the three months ended October 31, 2018 and 2017 were as follows:
 
 
Three months ended October 31,
 
 
2018
 
2017
Balance at beginning of period
 
$
11,738,000

 
17,617,000

Reclass to contract liabilities as of August 1, 2018
 
(1,679,000
)
 

Provision for warranty obligations
 
1,020,000

 
1,106,000

Charges incurred
 
(1,515,000
)
 
(1,830,000
)
Warranty settlement and reclass (see below)
 
418,000

 
(3,892,000
)
Balance at end of period
 
$
9,982,000

 
13,001,000


Our current accrued warranty obligations at October 31, 2018 and July 31, 2018 include $4,402,000 and $4,650,000, respectively, of warranty obligations for a small product line that we refer to as the TCS 911 call handling software solution. This solution was licensed to customers prior to our acquisition of TCS. During the three months ended October 31, 2017, we entered into a full and final warranty settlement with AT&T, the largest customer/distributor of this product line, pursuant to which we issued thirty-six credits to AT&T of $153,000 which AT&T can apply on a monthly basis to purchases of solutions from us, beginning October 2017 through September 2020. As of October 31, 2018, the total present value of these monthly credits is $3,232,000, of which $1,621,000 is included in our current accrued warranty obligations and $1,611,000 is reflected in other liabilities (non-current) on our Condensed Consolidated Balance Sheet. In connection with this favorable settlement, during the three months ended October 31, 2017, we recorded a benefit to cost of sales of $660,000.

(9)    Cost Reduction Actions

During the three months ended three months ended October 31, 2018, we took steps to improve our future operating results and we successfully consolidated our Government Solutions segment’s manufacturing facility located in Tampa, Florida with another facility that we maintain in Orlando, Florida; and in doing so, incurred $1,373,000 of facility exit costs, which are recorded in selling, general and administrative expenses on our Condensed Consolidated Statements of Operations. Of this amount, $992,000 and $381,000, respectively, was included in accrued expenses and other current liabilities and other liabilities (non-current) on our Condensed Consolidated Balance Sheet as of October 31, 2018. To-date, we have incurred an immaterial amount of severance and retention costs related to our shift in strategy.

(10)    Credit Facility

On October 31, 2018, we entered into a First Amended and Restated Credit Agreement (the “Credit Facility”) with a syndicate of lenders, replacing our prior Credit Agreement dated as of February 23, 2016 (as amended by that certain First Amendment, dated as of June 6, 2017 (the “Prior Credit Facility”)). In connection with the establishment of our new Credit Facility, we wrote-off $3,217,000 of deferred financing costs primarily related to the Term Loan Facility portion of our Prior Credit Facility and capitalized deferred financing costs of $1,812,000 related to the new Credit Facility.

The new Credit Facility provides a senior secured loan facility of up to $550,000,000 consisting of: (i) a revolving loan facility (“Revolving Loan Facility”) with a borrowing limit of $300,000,000; (ii) an accordion feature allowing us to borrow up to an additional $250,000,000; (iii) a $35,000,000 letter of credit sublimit; and (iv) a swingline loan credit sublimit of $25,000,000.


15


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


The Credit Facility matures on October 31, 2023 (the “Revolving Maturity Date”). If we issue new unsecured debt in excess of $5,000,000 with a maturity date that is less than 91 days from October 31, 2023, the Revolving Maturity Date would automatically accelerate so that it would be 91 days earlier than the maturity date of the new unsecured debt.
 
The proceeds of the new Credit Facility were used, in part, to repay in full the outstanding borrowings under the Prior Credit Facility, and additional proceeds of the Credit Facility are expected to be used by us for working capital and other general corporate purposes. As of October 31, 2018, the amount outstanding under our Credit Facility was $193,400,000, which is reflected in the non-current portion of long-term debt on our Condensed Consolidated Balance Sheet. At October 31, 2018, we had $2,705,000 of standby letters of credit outstanding under our Credit Facility related to guarantees of future performance on certain customer contracts and no outstanding commercial letters of credit.

As of October 31, 2018, total net deferred financing costs related to the Credit Facility were $3,678,000 and will be amortized over the term of our Credit Facility through October 31, 2023.

Interest expense, including amortization of deferred financing costs, recorded during the three months ended October 31, 2018 and 2017, was: (i) $2,542,000 and $2,465,000, respectively; (ii) principally related to the Prior Credit Facility; and (iii) reflects a blended interest rate of approximately 6.00% and 5.30%, respectively.

Borrowings under the Credit Facility shall be either: (i) Alternate Base Rate borrowings, which bear interest from the applicable borrowing date at a rate per annum equal to (x) the greatest of (a) the Prime Rate (as defined) in effect on such day, (b) the Federal Funds Effective Rate (as defined) in effect on such day plus 1/2 of 1.00% per annum and (c) the Adjusted LIBO Rate (as defined) on such day (or, if such day is not a business day, the immediately preceding business day) plus 1.00% per annum, plus (y) the Applicable Rate (as defined), or (ii) Eurodollar borrowings, which bear interest from the applicable borrowing date at a rate per annum equal to (x) the Adjusted LIBO Rate for such interest period plus (y) the Applicable Rate. Determination of the Applicable Rate is based on a pricing grid that is dependent upon our Secured Leverage Ratio (as defined) as of the end of each fiscal quarter for which consolidated financial statements have been most recently delivered.

The Credit Facility contains customary representations, warranties and affirmative covenants. The Credit Facility also contains customary negative covenants, subject to negotiated exceptions, including but not limited to: (i) liens, (ii) investments, (iii) indebtedness, (iv) significant corporate changes, including mergers and acquisitions, (v) dispositions, (vi) restricted payments, including stockholder dividends, and (vii) certain other restrictive agreements. The Credit Facility also contains certain financial covenants and customary events of default (subject to grace periods, as appropriate), such as payment defaults, cross-defaults to other material indebtedness, bankruptcy and insolvency, the occurrence of a defined change in control and the failure to observe the negative covenants and other covenants related to the operation of our business. In addition, under certain circumstances, we may be required to enter into amendments to the Credit Facility in connection with any further syndication of the Credit Facility.

The Credit Facility provides for, among other things: (i) a significant increase in our balance sheet flexibility; (ii) no scheduled payments of principal until maturity; (iii) a maximum Secured Leverage Ratio of 3.75x trailing twelve months ("TTM") Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA") and a Maximum Total Leverage Ratio of 4.50x TTM Adjusted EBITDA, each with no step downs; (iv) a Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA; (v) reduced interest rates of approximately 25 basis points as compared to the Prior Credit Facility (based on our Secured Leverage Ratio as of July 31, 2018); and (vi) the elimination or relaxation of many restrictive covenants in our Prior Credit Facility.

As of October 31, 2018, our Secured Leverage Ratio was 2.25x TTM Adjusted EBITDA compared to the maximum allowable Secured Leverage Ratio of 3.75x TTM Adjusted EBITDA. Our Interest Expense Coverage Ratio as of October 31, 2018 was 11.31x TTM Adjusted EBITDA compared to the Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA. Given our expected future business performance, we anticipate maintaining compliance with the terms and financial covenants in our Credit Facility for the foreseeable future.

The obligations under the Credit Facility are guaranteed by certain of our domestic subsidiaries (the “Guarantors”). As collateral security under the Credit Facility and the guarantees thereof, we and the Guarantors have granted to the administrative agent, for the benefit of the lenders, a lien on, and first priority security interest in, substantially all of our tangible and intangible assets.

16


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)



On December 6, 2018, we entered into the first amendment to the Credit Facility. The purpose of the amendment is to provide for a mechanism to replace the LIBO rate for Eurodollar borrowings with an alternative benchmark interest rate, should the LIBO rate generally become unavailable in the future on an other-than-temporary basis.

The Prior Credit Facility was a $400,000,000 secured credit facility, and comprised of a senior secured term loan A facility of $250,000,000 (the "Term Loan Facility") and a secured revolving loan facility of up to $150,000,000, including a $25,000,000 letter of credit sublimit (the "Revolving Loan Facility"). The proceeds of the Prior Credit Facility were primarily used to finance our acquisition of TCS, including the repayment of certain existing indebtedness of TCS. Under the Revolving Loan Facility, during the three months ended October 31, 2018, we had outstanding balances ranging from $34,904,000 to $63,804,000.

As of July 31, 2018, the net amount outstanding under the Prior Credit Facility was as follows:
 
 
July 31, 2018

Term Loan Facility
 
$
120,121,000

Less unamortized deferred financing costs related to Term Loan Facility
 
3,427,000

Term Loan Facility, net
 
116,694,000

Revolving Loan Facility
 
48,604,000

Amount outstanding under Prior Credit Facility, net
 
165,298,000

Less current portion of long-term debt
 
17,211,000

Non-current portion of long-term debt
 
$
148,087,000


Capitalized terms used but not defined herein have the meanings set forth for such terms in the Credit Facility and the Prior Credit Facility, which have been documented and filed with the SEC.

(11)    Capital Lease and Other Obligations

We lease certain equipment under capital leases. As of October 31, 2018 and July 31, 2018, the net book value of the leased assets which collateralize the capital lease and other obligations was $2,001,000 and $2,547,000, respectively, and consisted primarily of machinery and equipment. Depreciation of leased assets is included in depreciation expense.

As of October 31, 2018, our capital lease and other obligations reflect a blended interest rate of approximately 7.1%. Our capital leases generally contain provisions whereby we can purchase the equipment at the end of the lease for a one dollar buyout.
 
Future minimum payments under capital lease and other obligations consisted of the following at October 31, 2018:
Remainder of fiscal 2019
$
1,495,000

Fiscal 2020
780,000

Fiscal 2021 and beyond

Total minimum lease payments
2,275,000

Less: amounts representing interest
110,000

Present value of net minimum lease payments
2,165,000

Current portion of capital lease and other obligations
1,579,000

Non-current portion of capital lease and other obligations
$
586,000



17


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


(12)    Income Taxes

On December 22, 2017, H.R.1, also known as the Tax Cuts and Jobs Act ("Tax Reform"), was enacted in the U.S. Tax Reform significantly lowered the amount of our current and future income tax expense primarily due to the reduction in the U.S. statutory income tax rate from 35.0% to 21.0%. This provision went into effect on January 1, 2018 and required us to remeasure our deferred tax assets and liabilities. In fiscal 2019 and beyond, Tax Reform will result in the loss of our ability to take the domestic production activities deduction, which has been repealed, and is also likely to result in lower tax deductions for certain executive compensation expenses.
 
For fiscal 2018, we were subject to a 35.0% statutory income tax rate with respect to the period August 1, 2017 through December 31, 2017 and a 21.0% statutory income tax rate with respect to the period January 1, 2018 through July 31, 2018, or a blended statutory income tax rate for fiscal 2018 of approximately 27.0%. As such, our effective tax rate for accounting purposes in fiscal 2018, excluding discrete items, was 27.0%. We expect to fully benefit from the lower statutory income tax rate in fiscal 2019 and thereafter.

The remeasurement of deferred taxes as a result of Tax Reform is an estimate and will be finalized after we file our federal and state income tax returns for fiscal 2018. The estimated impact recorded in fiscal 2018 will change if the timing of the deferred tax impacts shift between fiscal 2018 and fiscal 2019 and beyond. In addition, it is possible that the Internal Revenue Service ("IRS") will issue clarifying or interpretive guidance related to Tax Reform, which may ultimately result in a change to our estimated income tax.

At October 31, 2018 and July 31, 2018, total unrecognized tax benefits were $7,324,000 and $9,339,000, respectively, including interest of $52,000 and $202,000, respectively. At October 31, 2018 and July 31, 2018, $407,000 and $2,572,000, respectively, of our unrecognized tax benefits were recorded as non-current income taxes payable in our Condensed Consolidated Balance Sheets. The remaining unrecognized tax benefits of $6,917,000 and $6,767,000 at October 31, 2018 and July 31, 2018, respectively, were presented as an offset to the associated non-current deferred tax assets in our Condensed Consolidated Balance Sheets. Of the total unrecognized tax benefits, $6,693,000 and $8,563,000, at October 31, 2018 and July 31, 2018, respectively, net of the reversal of the federal benefit recognized as a deferred tax asset relating to state reserves, would favorably impact our effective tax rate, if recognized. Unrecognized tax benefits result from income tax positions taken or expected to be taken on our income tax returns for which a tax benefit has not been recorded in our condensed consolidated financial statements. Our policy is to recognize interest and penalties relating to uncertain tax positions in income tax expense.

During the three months ended October 31, 2018, the IRS finalized its audit of our federal income tax return for fiscal 2016 without assessing additional taxes. Our federal income tax returns for fiscal 2015 and 2017 are subject to potential future IRS audit. None of our state income tax returns prior to fiscal 2014 are subject to audit. TCS' federal income tax returns for tax year 2015 and the tax period from January 1, 2016 to February 23, 2016 are subject to potential future IRS audit. None of TCS' state income tax returns prior to calendar year 2014 are subject to audit. Future tax assessments or settlements could have a material adverse effect on our consolidated results of operations and financial condition.

(13)    Stock-Based Compensation

Overview

We issue stock-based awards to certain of our employees and our Board of Directors pursuant to our 2000 Stock Incentive Plan, as amended, (the "Plan") and our 2001 Employee Stock Purchase Plan, as amended and restated effective December 4, 2018 (the "ESPP"), and recognize related stock-based compensation in our condensed consolidated financial statements. The Plan provides for the granting to employees and consultants of Comtech (including prospective employees and consultants): (i) incentive and non-qualified stock options, (ii) restricted stock units ("RSUs"), (iii) RSUs with performance measures (which we refer to as "performance shares"), (iv) restricted stock, (v) stock units (reserved for issuance to non-employee directors) and share units (reserved for issuance to employees) (collectively, "share units") and (vi) stock appreciation rights ("SARs"), among other types of awards. Our non-employee directors are eligible to receive non-discretionary grants of stock-based awards, subject to certain limitations.


18


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


As of October 31, 2018, the aggregate number of shares of common stock which may be issued, pursuant to the Plan, may not exceed 10,362,500. Stock options granted may not have a term exceeding ten years or, in the case of an incentive stock award granted to a stockholder who owns stock representing more than 10.0% of the voting power, no more than five years. We expect to settle all outstanding awards under the Plan and employee purchases under the ESPP with the issuance of new shares of our common stock.

As of October 31, 2018, we had granted stock-based awards pursuant to the Plan representing the right to purchase and/or acquire an aggregate of 8,327,069 shares (net of 3,944,088 expired and canceled awards), of which an aggregate of 5,880,127 have been exercised or settled.

As of October 31, 2018, the following stock-based awards, by award type, were outstanding:
Stock options
1,590,045

Performance shares
260,262

RSUs and restricted stock
440,829

Share units
155,806

Total
2,446,942


Our ESPP provides for the issuance of up to 1,050,000 shares of our common stock. Our ESPP is intended to provide our eligible employees the opportunity to acquire our common stock at 85% of fair market value at the date of issuance. Through October 31, 2018, we have cumulatively issued 752,596 shares of our common stock to participating employees in connection with our ESPP.

Stock-based compensation for awards issued is reflected in the following line items in our Condensed Consolidated Statements of Operations:
 
 
Three months ended October 31,
 
 
2018
 
2017
Cost of sales
 
$
58,000

 
40,000

Selling, general and administrative expenses
 
905,000

 
654,000

Research and development expenses
 
83,000

 
53,000

Stock-based compensation expense before income tax benefit
 
1,046,000

 
747,000

Estimated income tax benefit
 
(228,000
)
 
(260,000
)
Net stock-based compensation expense
 
$
818,000

 
487,000


Stock-based compensation for equity-classified awards is measured at the date of grant, based on an estimate of the fair value of the award and is generally expensed over the vesting period of the award. At October 31, 2018, unrecognized stock-based compensation of $11,084,000, net of estimated forfeitures of $925,000, is expected to be recognized over a weighted average period of 3.2 years. Total stock-based compensation capitalized and included in ending inventory at both October 31, 2018 and July 31, 2018 was $48,000. There are no liability-classified stock-based awards outstanding as of October 31, 2018 or July 31, 2018.


19


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


Stock-based compensation expense (benefit), by award type, is summarized as follows:
 
 
Three months ended October 31,
 
 
2018
 
2017
Stock options
 
$
171,000

 
267,000

Performance shares
 
406,000

 
112,000

RSUs and restricted stock
 
547,000

 
385,000

ESPP
 
52,000

 
45,000

Share units
 
(130,000
)
 
(62,000
)
Stock-based compensation expense before income tax benefit
 
1,046,000

 
747,000

Estimated income tax benefit
 
(228,000
)
 
(260,000
)
Net stock-based compensation expense
 
$
818,000

 
487,000


ESPP stock-based compensation expense primarily relates to the 15% discount offered to participants in the ESPP. During the three months ended October 31, 2018 and 2017, we recorded benefits of $130,000 and $62,000, respectively, which primarily represents the recoupment of certain share units.

The estimated income tax benefit as shown in the above table was computed using income tax rates expected to apply when the awards are settled. Such deferred tax asset was recorded net as part of our non-current deferred tax liability in our Condensed Consolidated Balance Sheet as of October 31, 2018 and July 31, 2018. The actual income tax benefit recognized for tax reporting is based on the fair market value of our common stock at the time of settlement and can significantly differ from the estimated income tax benefit recorded for financial reporting.

Stock Options
The following table summarizes the Plan's activity during the three months ended October 31, 2018:
 
 
Awards
(in Shares)
 
Weighted Average
Exercise Price
 
Weighted Average
Remaining Contractual
Term (Years)
 
Aggregate
Intrinsic Value
Outstanding at July 31, 2018
 
1,668,975

 
$
28.72

 
 
 
 
Exercised
 
(78,930
)
 
28.37

 
 
 
 
Outstanding at October 31, 2018
 
1,590,045

 
$
28.74

 
4.27
 
$
741,000

 
 
 
 
 
 
 
 
 
Exercisable at October 31, 2018
 
1,388,123

 
$
28.74

 
3.94
 
$
574,000

 
 
 
 
 
 
 
 
 
Vested and expected to vest at October 31, 2018
 
1,555,133

 
$
28.73

 
4.22
 
$
712,000


Stock options outstanding as of October 31, 2018 have exercise prices ranging from $20.90 to $33.94, representing the fair market value of our common stock on the date of grant, a contractual term of five or ten years and a vesting period of three or five years. The total intrinsic value relating to stock options exercised during the three months ended October 31, 2018 was $561,000. There were no stock options exercised during the three months ended October 31, 2017. There were no stock options granted since fiscal 2017.

During the three months ended October 31, 2018, at the election of certain holders of vested stock options, 72,830 stock options were net settled upon exercise. As a result, 9,345 net shares of our common stock were issued during the three months ended October 31, 2018 after reduction of shares retained to satisfy the exercise price and minimum statutory tax withholding requirements.

20


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)



Performance Shares, RSUs, Restricted Stock and Share Unit Awards
The following table summarizes the Plan's activity relating to performance shares, RSUs, restricted stock and share units:
 
 
Awards
(in Shares)
 
Weighted Average
Grant Date
Fair Value
 
Aggregate
Intrinsic Value
Outstanding at July 31, 2018
 
818,438

 
$
19.78

 
 
Granted
 
177,908

 
34.27

 
 
Settled
 
(121,790
)
 
21.08

 
 
Forfeited
 
(17,659
)
 
27.23

 
 
Outstanding at October 31, 2018
 
856,897

 
$
22.44

 
$
23,925,000

 
 
 
 
 
 
 
Vested at October 31, 2018
 
216,718

 
$
27.71

 
$
6,051,000

 
 
 
 
 
 
 
Vested and expected to vest at October 31, 2018
 
819,625

 
$
22.58

 
$
22,884,000


The total intrinsic value relating to fully-vested awards settled during the three months ended October 31, 2018 and 2017 was $4,210,000 and $1,937,000, respectively.

The performance shares granted to employees since fiscal 2014 principally vest over a three-year performance period, if pre-established performance goals are attained or as specified pursuant to the Plan and related agreements. As of October 31, 2018, the number of outstanding performance shares included in the above table, and the related compensation expense prior to consideration of estimated pre-vesting forfeitures, assume achievement of the pre-established goals at a target level.

RSUs and restricted stock granted to non-employee directors have a vesting period of three years and are convertible into shares of our common stock generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. RSUs granted to employees have a vesting period of five years and are convertible into shares of our common stock, generally at the time of vesting, on a one-for-one basis for no cash consideration.

Share units granted prior to July 31, 2017 were vested when issued and are convertible into shares of our common stock, generally at the time of termination, on a one-for-one basis for no cash consideration, or earlier under certain circumstances. Share units granted on or after July 31, 2017 were granted to certain employees in lieu of non-equity incentive compensation and are convertible into shares of our common stock on the one-year anniversary of the respective grant date. Cumulatively through October 31, 2018, 270,979 share units granted have been settled.

The fair value of performance shares, RSUs, restricted stock and share units is determined using the closing market price of our common stock on the date of grant, less the present value of any estimated future dividend equivalents such awards are not entitled to receive and an applicable estimated discount for post vesting restrictions. RSUs, performance shares and restricted stock granted since fiscal 2013 are entitled to dividend equivalents unless forfeited before vesting occurs; however, performance shares granted in fiscal 2013 were not entitled to such dividend equivalents until our Board of Directors determined that the pre-established performance goals were met. Share units granted prior to fiscal 2014 are not entitled to dividend equivalents. Share units granted since fiscal 2014 are entitled to dividend equivalents while the underlying shares are unissued.

Dividend equivalents are subject to forfeiture, similar to the terms of the underlying stock-based awards, and are payable in cash generally at the time of settlement of the underlying shares into shares of our common stock. During the three months ended October 31, 2018, we accrued $82,000 of dividend equivalents (net of forfeitures) and paid out $259,000. Accrued dividend equivalents were recorded as a reduction to retained earnings. As of October 31, 2018 and July 31, 2018, accrued dividend equivalents were $536,000 and $713,000, respectively.


21


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


During the three months ended October 31, 2018, we recorded $457,000 of income tax benefits in our Condensed Consolidated Statements of Operations, which represents net excess income tax benefits from the settlement of stock-based awards. During the three months ended October 31, 2017, we recorded $85,000 of income tax expense in our Condensed Consolidated Statements of Operations, which represents net income tax shortfalls from the settlement of stock-based awards and the reversal of deferred tax assets associated with expired and unexercised stock-based awards.

(14)    Segment Information

Reportable operating segments are determined based on Comtech’s management approach. The management approach, as defined by FASB ASC 280 "Segment Reporting" is based on the way that the CODM organizes the segments within an enterprise for making decisions about resources to be allocated and assessing their performance. Our CODM, for purposes of FASB ASC 280, is our Chief Executive Officer and President.

Our Commercial Solutions segment serves commercial customers and smaller government customers, such as state and local governments, that require advanced communication technologies to meet their needs. This segment also serves certain large government customers (including the U.S. government) that have requirements for off-the-shelf commercial equipment. We believe this segment is a leading provider of satellite communications (such as satellite earth station modems and TWTAs), public safety systems (such as NG911 technologies) and enterprise application technologies (such as messaging and trusted location-based technologies).

Our Government Solutions segment serves large government end-users (including those of foreign countries) that require mission-critical technologies and systems. Government solutions products include command and control applications (such as the design, installation and operation of data networks that integrate computing and communications, including both satellite and terrestrial links), ongoing network operation and management support services (including project management and fielding and maintenance solutions related to satellite ground terminals), troposcatter communications (such as digital troposcatter multiplexers, digital over-the-horizon modems, troposcatter systems and frequency converter systems) and RF power and switching technologies (such as solid-state high-power broadband amplifiers, enhanced position location reporting system (commonly known as "EPLRS") amplifier assemblies, identification friend or foe ("IFF") amplifiers and amplifiers used in the counteraction of improvised explosive devices).

Our CODM primarily uses a metric that we refer to as Adjusted EBITDA to measure an operating segment’s performance and to make decisions about resources to be allocated. Our Adjusted EBITDA metric for the Commercial Solutions and Government Solutions segments do not consider any allocation of indirect expenses, including the following: income taxes, interest (income) and other, interest expense, write-off of deferred financing costs, amortization of stock-based compensation, amortization of intangibles, depreciation expense, facility exit costs, settlement of intellectual property litigation, acquisition plan expenses or strategic alternatives analysis expenses and other expenses that relate to our Unallocated segment. These items, while periodically affecting our results, may vary significantly from period to period and may have a disproportionate effect in a given period, thereby affecting the comparability of results. Any amounts shown in the Adjusted EBITDA calculation for our Commercial Solutions and Government Solutions segments are directly attributable to those segments. Our Adjusted EBITDA is also used by our management in assessing the Company's operating results. Although closely aligned, the Company's definition of Adjusted EBITDA is different than the Consolidated EBITDA (as such term is defined in our Credit Facility) utilized for financial covenant calculations and also may differ from the definition of EBITDA or Adjusted EBITDA used by other companies and, therefore, may not be comparable to similarly titled measures used by other companies.


22


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)



Operating segment information, along with a reconciliation of segment net income (loss) and consolidated net income (loss) to Adjusted EBITDA is presented in the tables below:

 
 
Three months ended October 31, 2018
 
 
Commercial Solutions
 
Government Solutions
 
Unallocated
 
Total
Net sales
 
$
77,973,000

 
82,871,000

 

 
$
160,844,000

Operating income (loss)
 
$
7,058,000

 
6,644,000

 
(6,409,000
)
 
$
7,293,000

 
 
 
 
 
 
 
 
 
Net income (loss)
 
$
6,971,000

 
6,609,000

 
(10,112,000
)
 
$
3,468,000

     Provision for (benefit from) income taxes
 
12,000

 

 
(2,139,000
)
 
(2,127,000
)
     Interest (income) and other
 
53,000

 
32,000

 
(19,000
)
 
66,000

     Write-off of deferred financing costs
 

 

 
3,217,000

 
3,217,000

     Interest expense
 
22,000

 
3,000

 
2,644,000

 
2,669,000

     Amortization of stock-based compensation
 

 

 
1,046,000

 
1,046,000

     Amortization of intangibles
 
3,445,000

 
844,000

 

 
4,289,000

     Depreciation
 
2,228,000

 
379,000

 
244,000

 
2,851,000

     Acquisition plan expenses
 

 

 
1,130,000

 
1,130,000

     Facility exit costs
 

 
1,373,000

 

 
1,373,000

Adjusted EBITDA
 
$
12,731,000

 
9,240,000

 
(3,989,000
)
 
$
17,982,000

 
 
 
 
 
 
 
 
 
Purchases of property, plant and equipment
 
$
892,000

 
629,000

 
124,000

 
$
1,645,000

Total assets at October 31, 2018
 
$
602,567,000

 
222,587,000

 
41,786,000

 
$
866,940,000


 
Three months ended October 31, 2017
 
 
Commercial Solutions
 
Government Solutions
 
Unallocated
 
Total
Net sales
 
$
76,114,000

 
45,455,000

 

 
$
121,569,000

Operating income (loss)
 
$
4,792,000

 
(641,000
)
 
(3,929,000
)
 
$
222,000

 
 
 
 
 
 
 
 
 
Net income (loss)
 
$
4,702,000

 
(642,000
)
 
(5,720,000
)
 
$
(1,660,000
)
     Provision for (benefit from) income taxes
 
6,000

 

 
(751,000
)
 
(745,000
)
     Interest (income) and other
 
48,000

 
(2,000
)
 
(7,000
)
 
39,000

     Interest expense
 
36,000

 
3,000

 
2,549,000

 
2,588,000

     Amortization of stock-based compensation
 

 

 
747,000

 
747,000

     Amortization of intangibles
 
4,425,000

 
844,000

 

 
5,269,000

     Depreciation
 
2,444,000

 
616,000

 
286,000

 
3,346,000

Adjusted EBITDA
 
$
11,661,000

 
819,000

 
(2,896,000
)
 
$
9,584,000

 
 
 
 
 
 
 
 
 
Purchases of property, plant and equipment
 
$
959,000

 
93,000

 
56,000

 
$
1,108,000

Total assets at October 31, 2017
 
$
600,649,000

 
181,739,000

 
43,844,000

 
$
826,232,000




23


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


During the three months ended October 31, 2018, we exited our Government Solutions segment's manufacturing facility located in Tampa, Florida and recorded a related charge of $1,373,000 in selling, general and administrative expenses on our Condensed Consolidated Statements of Operations. See Note (9) - "Cost Reduction Actions."

Unallocated expenses result from corporate expenses such as executive compensation, accounting, legal and other regulatory compliance related costs and also includes all of our amortization of stock-based compensation. During the three months ended October 31, 2018, unallocated expenses also include $1,130,000 of acquisition plan expenses incurred as part of an ongoing effort to acquire a small but growing technology solutions company. There is no certainty that our acquisition plan efforts will be successful.

Interest expense for the three months ended October 31, 2018 and 2017 includes $2,542,000 and $2,465,000, respectively, principally related to our Prior Credit Facility and includes amortization of deferred financing costs. In addition, on October 31, 2018, we recorded a $3,217,000 loss from the write-off of deferred financing costs primarily related to the Term Loan Facility portion of our Prior Credit Facility. See Note (10) - "Credit Facility" for further discussion.

Intersegment sales for the three months ended October 31, 2018 and 2017 by the Commercial Solutions segment to the Government Solutions segment were $8,540,000 and $2,621,000, respectively. There were nominal sales by the Government Solutions segment to the Commercial Solutions segment for these periods. All intersegment sales are eliminated in consolidation and are excluded from the tables above.

Unallocated assets at October 31, 2018 consist principally of cash and cash equivalents, income taxes receivable, corporate property, plant and equipment and deferred financing costs. Substantially all of our long-lived assets are located in the U.S.

(15)    Goodwill

The following table represents goodwill by reportable operating segment as of October 31, 2018 and July 31, 2018:

 
 
Commercial Solutions
 
Government Solutions
 
Total
Goodwill
 
$
231,440,000

 
59,193,000

 
$
290,633,000

 
 
 
 
 
 
 

In accordance with FASB ASC 350 "Intangibles - Goodwill and Other," we perform a goodwill impairment analysis at least annually (in the first quarter of each fiscal year), unless indicators of impairment exist in interim periods. If we fail the quantitative assessment of goodwill impairment ("quantitative assessment"), pursuant to our adoption of FASB ASU No. 2017-04 in fiscal 2017, we would be required to recognize an impairment loss equal to the amount that a reporting unit's carrying value exceeded its fair value; however, any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.

On August 1, 2018 (the first day of our fiscal 2019), we performed our annual quantitative assessment using market participant assumptions to determine if the fair value of each of our reporting units with goodwill exceeded its carrying value. In making this assessment, we considered, among other things, expectations of projected net sales and cash flows, assumptions impacting the weighted average cost of capital, trends in trading multiples of comparable companies, changes in our stock price and changes in the carrying values of our reporting units with goodwill. We also considered overall business conditions.


24


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


In performing the quantitative assessment, we estimated the fair value of each of our reporting units using a combination of the income and market approaches. The income approach, also known as the discounted cash flow ("DCF") method, utilizes the present value of cash flows to estimate fair value. The future cash flows for our reporting units were projected based on our estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). For purposes of conducting our impairment analysis, we assumed revenue growth rates and cash flow projections that are below our actual long-term expectations. The discount rates used in our DCF method were based on a weighted-average cost of capital ("WACC") determined from relevant market comparisons, adjusted upward for specific reporting unit risks (primarily the uncertainty of achieving projected operating cash flows). A terminal value growth rate was applied to the final year of the projected period and reflected our estimate of stable, perpetual growth. We then calculated a present value of the respective cash flows for each reporting unit to arrive at an estimate of fair value under the income approach. Under the market approach, we estimated a fair value based on comparable companies' market multiples of revenues and earnings before interest, taxes, depreciation and amortization and factored in a control premium. Finally, we compared our estimates of fair values to our August 1, 2018 total public market capitalization and assessed implied control premiums based on our common stock price of $33.70 as of August 1, 2018.

Based on our quantitative evaluation, we determined that our Commercial Solutions and Government Solutions reporting units had estimated fair values in excess of their carrying values of at least 42.5% and 105.5%, respectively, and concluded that our goodwill was not impaired and that neither of our two reporting units was at risk of failing the quantitative assessment. It is possible that, during fiscal 2019 or beyond, business conditions (both in the U.S. and internationally) could deteriorate from the current state, our current or prospective customers could materially postpone, reduce or even forgo purchases of our products and services to a greater extent than we currently anticipate or our common stock price could decline. A significant decline in our customers' spending that is greater than we anticipate or a shift in funding priorities may also have a negative effect on future orders, sales, income and cash flows and we might be required to perform a quantitative assessment during fiscal 2019 or beyond. If assumed net sales and cash flow projections are not achieved in future periods or our common stock price significantly declines from current levels, our Commercial Solutions and Government Solutions reporting units could be at risk of failing the quantitative assessment and goodwill assigned to the respective reporting units could be impaired.

In any event, we are required to perform the next annual goodwill impairment analysis on August 1, 2019 (the start of our fiscal 2020). If our assumptions and related estimates change in the future, or if we change our reporting unit structure or other events and circumstances change (e.g., a sustained decrease in the price of our common stock (considered on both absolute terms and relative to peers)), we may be required to record impairment charges when we perform these tests, or in other future periods. Any impairment charges that we may record in the future could be material to our results of operation and financial condition.

(16)    Intangible Assets

Intangible assets with finite lives are as follows:
 
 
As of October 31, 2018
 
 
Weighted Average
Amortization Period
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
Customer relationships
 
21.0
 
$
249,831,000

 
57,969,000

 
$
191,862,000

Technologies
 
12.8
 
82,370,000

 
55,585,000

 
26,785,000

Trademarks and other
 
16.4
 
28,894,000

 
11,034,000

 
17,860,000

Total
 
 
 
$
361,095,000

 
124,588,000

 
$
236,507,000

 
 
As of July 31, 2018
 
 
Weighted Average
Amortization Period
 
Gross Carrying
Amount
 
Accumulated
Amortization
 
Net Carrying
Amount
Customer relationships
 
21.0
 
$
249,831,000

 
55,350,000

 
$
194,481,000

Technologies
 
12.8
 
82,370,000

 
54,386,000

 
27,984,000

Trademarks and other
 
16.4
 
28,894,000

 
10,563,000

 
18,331,000

Total
 
 
 
$
361,095,000

 
120,299,000

 
$
240,796,000


25


COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)



The weighted average amortization period in the above table excludes fully amortized intangible assets.

Amortization expense for the three months ended October 31, 2018 and 2017 was $4,289,000 and $5,269,000, respectively.

The estimated amortization expense consists of the following for the fiscal years ending July 31:
2019
$
17,155,000

2020
17,155,000

2021
16,196,000

2022
14,955,000

2023
14,955,000


We review net intangible assets with finite lives for impairment when an event occurs indicating the potential for impairment. No such event has occurred during the three months ended October 31, 2018. We believe that the carrying values of our net intangible assets were recoverable as of October 31, 2018. Any impairment charges that we may record in the future could be material to our results of operations and financial condition.

(17)    Stockholders’ Equity

Sale of Common Stock
In June 2016, we sold 7,145,000 shares of our common stock in a public offering at a price to the public of $14.00 per share, resulting in proceeds to us of $95,029,000, net of underwriting discounts and commissions. As of October 31, 2018 and December 6, 2018, an aggregate registered amount of $74,970,000 under our existing shelf registration statement filed with the SEC remains available for sale of various types of securities, including debt. This existing shelf registration is expected to expire on December 23, 2018. As such, on December 6, 2018, we filed a new $400,000,000 shelf registration statement with the SEC for the sale of various types of securities, including debt.

Stock Repurchase Program
As of October 31, 2018 and December 6, 2018, we were authorized to repurchase up to an additional $8,664,000 of our common stock, pursuant to our current $100,000,000 stock repurchase program. Our stock repurchase program has no time restrictions and repurchases may be made in open-market or privately negotiated transactions and may be made pursuant to SEC Rule 10b5-1 trading plans. There were no repurchases made during the three months ended October 31, 2018 or 2017.

Dividends
Since September 2010, we have paid quarterly dividends pursuant to an annual targeted dividend amount that was established by our Board of Directors. On September 26, 2018, our Board of Directors declared a dividend of $0.10 per common share, which was paid on November 16, 2018. On December 6, 2018, our Board of Directors declared a dividend of $0.10 per common share, payable on February 15, 2019 to stockholders of record at the close of business on January 16, 2019.

Future dividends remain subject to compliance with financial covenants under our Credit Facility as well as Board approval.


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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


(18)    Legal Proceedings and Other Matters

Legacy TCS Intellectual Property Matter - Vehicle IP
In December 2009, Vehicle IP, LLC ("Vehicle IP") filed a patent infringement lawsuit in the U.S. District Court for the District of Delaware (the "District Court"), seeking monetary damages, fees and expenses and other relief from, among others, our customer Verizon Wireless ("Verizon"), based on the VZ Navigator product, and TCS is defending Verizon against Vehicle IP. In 2013, the District Court granted the defendants’ motion for summary judgment on the basis that the products in question did not infringe plaintiff’s patent. Plaintiff appealed that decision and, in 2014, the U.S. Court of Appeals for the Federal Circuit reversed the District Court's claim construction, overturned the District Court's grant of summary judgment of noninfringement, and remanded the case for further proceedings. Fact discovery and expert discovery has closed. Substantive settlement conversations have occurred but, to-date, the parties have been unable to reach a settlement. As discussed in Note (8) -"Accrued Expenses and Other Current Liabilities," we have accrued certain legal and settlement costs related to the Vehicle IP matter. The accrued settlement costs related to this matter do not reflect the final amounts we actually may pay, if any.

On May 30, 2017, we received positive news that the District Court issued a supplemental claim construction order in our favor. As a result, the plaintiff agreed to file a joint status report to the District Court that requested that the District Court cancel the trial date (which was scheduled for July 2017). On July 28, 2017, the parties entered into a stipulation that the defendants’ accused products do not infringe Vehicle IP’s patent under the District Court’s current revised construction of the disputed patent claim term and requested that the District Court therefore enter a judgment of noninfringement. On August 18, 2017, the court entered such a judgment of noninfringement. As expected, following the judgment, Vehicle IP filed a notice of appeal on August 29, 2017. Vehicle IP's opening brief on appeal of the District Court's claim construction was submitted in October 2017. TCS’ brief in response was filed on January 19, 2018. Vehicle IP's reply brief was filed on February 23, 2018. Oral argument was held on August 8, 2018 and an appellate ruling may take several months to be issued. If the District Court's current claim construction is ultimately upheld at the appellate level, it is possible that we may not have to go to trial or pay any monetary damages.

Ongoing legal expenses associated with defending this matter and its ultimate resolution could vary and have a material adverse effect on our consolidated results of operations, financial position or cash flows in future periods.

Other Matters
In October 2014, we disclosed to the U.S. Department of the Treasury, Office of Foreign Assets Control ("OFAC") that we learned during a self-assessment of our export transactions that a shipment of modems sent to a Canadian customer by Comtech EF Data Corp. was incorporated into a communication system, the ultimate end user of which was the Sudan Civil Aviation Authority. The sales value of this equipment was approximately $288,000. At the time of shipment, OFAC regulations prohibited U.S. persons from doing business directly or indirectly with Sudan. In late 2015, OFAC issued an administrative subpoena seeking information about the disclosed transaction. We have responded to the subpoena, including alerting OFAC to Comtech’s repair of three modems for a customer in Lebanon who may have rerouted the modems from Lebanon to Sudan without the required U.S. licensing authorization. In September 2018, Comtech agreed to enter into a Tolling Agreement with OFAC, which extends the statute of limitations in this matter through December 31, 2019. The Tolling Agreement was shortly followed by a second administrative subpoena seeking additional information about the disclosed transaction. We are in the process of responding to OFAC’s additional request for information. U.S. sanctions with respect to Sudan were revoked in 2017. Consistent with the revocation of the Sudan Sanction Regulations ("SSR"), shipments to the Sudan Civil Aviation Authority by U.S. persons are now permissible. We are not able to predict whether OFAC will take any enforcement action against us in light of the recent revocation of the SSR. If OFAC determines that we have violated U.S. trade sanctions, civil and criminal penalties could apply, and we may suffer reputational harm. Even though we take precautions to avoid engaging in transactions that may violate U.S. trade sanctions, those measures may not be effective in every instance.


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COMTECH TELECOMMUNICATIONS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(Unaudited)


In May 2018, we were informed by the Office of Export Enforcement ("OEE") of the Department of Commerce ("DoC") that it was forwarding to the DoC's Office of Chief Counsel, the results of its audit of international shipments by Comtech Xicom Technology, Inc. for further review and possible determination of an administrative penalty. We fully cooperated with the OEE in their audit and, based on our self-assessment of the approximately 7,800 individual transactions audited, have determined that six (6) transactions may not have been fully in compliance with the Export Administration Regulations ("EAR"). These six (6) items, for which export licenses were not obtained, were either spares or repaired power amplifier subassembly components valued at less than $100,000 (in aggregate) and were shipped to Brazil, Italy, Russia, Thailand and the United Arab Emirates. The EAR provides an exception to the requirement to obtain an export license for the replacement of a defective or damaged component. During our self-assessment, we determined that we inadvertently did not obtain export licenses for the spares, or had evidence of the return or destruction of the defective or damaged components necessary to authorize our use of the export license exception for the replacements. Since discovering this issue, we have implemented additional controls and procedures and have increased awareness of these specific export requirements throughout the Company to help avoid similar occurrences in the future. Administrative penalties under the EAR can range from a warning letter to a denial of export privileges. A civil monetary penalty not to exceed the amount set forth in the Export Administration Act ("EAA") may be imposed for each violation, and in the event that any provision of the EAR is continued by any other authority, the maximum monetary civil penalty for each violation shall be that provided by such other authority. Administrative penalties under the EAR are currently determined pursuant to the International Emergency Economic Powers Act ("IEEPA"), which can reach the greater of twice the amount of the transaction that is the basis of the violation or approximately $300,000 per violation. We have not recorded an accrual related to a possible administrative penalty and continue to work cooperatively with the OEE.

In the ordinary course of business, we include indemnification provisions in certain of our customer contracts to indemnify, hold harmless and reimburse such customers for certain losses, including but not limited to losses related to third-party claims of intellectual property infringement arising from the customer’s use of our products or services. We may also, from time to time, receive indemnification requests from customer related to third-party claims that 911 calls were improperly routed during an emergency. We evaluate such claims as and when they arise. We do not always agree with customers that they are entitled to indemnification and in such cases reject their claims. Despite maintaining that we have properly carried out our duties, we may seek coverage under our various insurance policies; however, we cannot be sure that we will be able to maintain or obtain insurance coverage at acceptable costs or in sufficient amounts or that our insurer will not disclaim coverage as to such claims. Accordingly, pending or future claims asserted against us by a party that we agree to indemnify could result in legal costs and damages that could have a material adverse effect on our consolidated results of operations and financial condition.

There are certain other pending and threatened legal actions which arise in the normal course of business. Although the ultimate outcome of litigation is difficult to accurately predict, we believe that the outcome of these other pending and threatened actions will not have a material adverse effect on our consolidated financial condition or results of operations.


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ITEM 2. 
 
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS


CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Certain information in this Quarterly Report on Form 10-Q contains forward-looking statements, including but not limited to, information relating to our future performance and financial condition, plans and objectives of our management and our assumptions regarding such future performance, financial condition, and plans and objectives that involve certain significant known and unknown risks and uncertainties and other factors not under our control which may cause our actual results, future performance and financial condition, and achievement of our plans and objectives to be materially different from the results, performance or other expectations implied by these forward-looking statements. These factors include, among other things: the risk that Comtech will be unsuccessful in implementing a tactical shift in its Government Solutions segment away from bidding on large commodity service contracts and toward pursuing contracts for its niche products with higher margins; the nature and timing of receipt of, and our performance on, new or existing orders that can cause significant fluctuations in net sales and operating results; the timing and funding of government contracts; adjustments to gross profits on long-term contracts; risks associated with international sales; rapid technological change; evolving industry standards; new product announcements and enhancements, including the risks associated with Comtech's recent launch of HeightsTM Dynamic Network Access Technology ("HEIGHTS" or "HDNA"); changing customer demands; changes in prevailing economic and political conditions; changes in the price of oil in global markets; changes in foreign currency exchange rates; risks associated with Comtech's and TeleCommunication Systems, Inc.'s ("TCS") legacy legal proceedings, customer claims for indemnification, and other similar matters; risks associated with our obligations under our Credit Facility; risks associated with our large contracts; the impact of H.R.1, also known as the Tax Cuts and Jobs Act ("Tax Reform"), which was enacted in December 2017 in the U.S.; and other factors described in this and our other filings with the Securities and Exchange Commission ("SEC").

OVERVIEW

We are a leading provider of advanced communications solutions for both commercial and government customers worldwide. Our solutions fulfill our customers’ needs for secure wireless communications in some of the most demanding environments, including those where traditional communications are unavailable or cost-prohibitive, and in mission-critical and other scenarios where performance is crucial.

We manage our business through two reportable operating segments:

Commercial Solutions - serves commercial customers and smaller governments, such as state and local governments, that require advanced communication technologies to meet their needs. This segment also serves certain large government customers (including the U.S. government) that have requirements for off-the-shelf commercial equipment. We believe this segment is a leading provider of satellite communications (such as satellite earth station modems and traveling wave tube amplifiers ("TWTA")), public safety systems (such as next generation 911 ("NG911") technologies) and enterprise application technologies (such as a messaging and trusted location-based technologies).

Government Solutions - serves large government end-users (including those of foreign countries) that require mission critical technologies and systems. We believe this segment is a leading provider of command and control applications (such as the design, installation and operation of data networks that integrate computing and communications (including both satellite and terrestrial links)), ongoing network operation and management support services including project management and fielding and maintenance solutions related to satellite ground terminals), troposcatter communications (such as digital troposcatter multiplexers, digital over-the-horizon modems, troposcatter systems, and frequency converter systems) and RF power and switching technologies (such as solid state high-power broadband amplifiers, enhanced position location reporting system (or commonly known as "EPLRS") amplifier assemblies, identification friend or foe amplifiers, and amplifiers used in the counteraction of improvised explosive devices).


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Our Quarterly Financial Information
Quarterly and period-to-period sales and operating results may be significantly affected by either short-term or long-term contracts with our customers. In addition, our gross profit is affected by a variety of factors, including the mix of products, systems and services sold, production efficiencies, estimates of warranty expense, price competition and general economic conditions. Our gross profit may also be affected by the impact of any cumulative adjustments to contracts that are accounted for over time.

Our contracts with the U.S. government can be terminated for convenience by it at any time and orders are subject to unpredictable funding, deployment and technology decisions by the U.S. government. Some of these contracts are indefinite delivery/indefinite quantity ("IDIQ") contracts and, as such, the U.S. government is not obligated to purchase any equipment or services under these contracts. We have, in the past, experienced and we continue to expect significant fluctuations in sales and operating results from quarter-to-quarter and period-to-period. As such, comparisons between periods and our current results may not be indicative of a trend or future performance.

CRITICAL ACCOUNTING POLICIES

We consider certain accounting policies to be critical due to the estimation process involved in each.

Revenue Recognition. On August 1, 2018, we adopted ASU No. 2014-09 "Revenue from Contracts with Customers (Topic 606)” or “ASC 606” applying the modified retrospective transition method. Except for new presentation or disclosure requirements, the impact of adoption, both as of August 1, 2018 and for the three months ended October 31, 2018, was not material to our business, results of operations or financial condition. As a practical expedient, we adopted the new standard only for existing contracts as of August 1, 2018. All periods prior to August 1, 2018 will continue to be reported under the accounting standards in effect in those periods.

The core principle of ASC 606 is that revenue should be recorded in an amount that reflects the consideration to which we expect to be entitled in exchange for goods or services promised to customers. Under ASC 606, we follow a five-step model to (1) identify the contract with our customer; (2) identify our performance obligations in our contract; (3) determine the transaction price for our contract; (4) allocate the transaction price to our performance obligations; and (5) recognize revenue using one of the following two methods:

Over time - We recognize revenue using the over time method when there is a continuous transfer of control to the customer over the contractual period of performance. This generally occurs when we enter into a long-term contract relating to the design, development or manufacture of complex equipment or technology platforms to a buyer’s specification (or to provide services related to the performance of such contracts). Continuous transfer of control is typically supported by contract clauses which allow our customers to unilaterally terminate a contract for convenience, pay for costs incurred plus a reasonable profit and take control of work-in-process. Revenue recognized over time is generally based on the extent of progress toward completion of the related performance obligations. The selection of the method to measure progress requires judgment and is based on the nature of the products or services provided. In certain instances, typically for firm fixed-price contracts, we use the cost-to-cost measure because it best depicts the transfer of control to the customer which occurs as we incur costs on our contracts. Under the cost-to-cost measure, the extent of progress toward completion is measured based on the ratio of costs incurred to date to the total estimated costs at completion, including warranty costs. Revenues, including estimated fees or profits, are recorded proportionally as costs are incurred. Costs to fulfill generally include direct labor, materials, subcontractor costs, other direct costs and an allocation of indirect costs. When these contracts are modified, the additional goods or services are generally not distinct from those already provided. As a result, these modifications form part of an existing contract and we must update the transaction price and our measure of progress for the single performance obligation and recognize a cumulative catch-up to revenue and gross profits.

For over time contracts using a cost-to-cost measure of progress, we have an estimate at completion (“EAC”) process in which management reviews the progress and execution of our performance obligations. This EAC process requires management judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Since certain contracts extend over a long period of time, the impact of revisions in revenue and or cost estimates during the progress of work may impact current period earnings through a cumulative adjustment. Additionally, if the EAC process indicates a loss, a provision is made for the total anticipated loss in the period that it becomes evident. Contract revenue and cost estimates for significant contracts are generally reviewed and reassessed at least quarterly.


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The cost-to-cost method is principally used to account for contracts in our command and control solutions and over-the-horizon microwave systems product lines and, to a lesser extent, certain location based and messaging infrastructure contracts in our enterprise technology solutions product line. For service-based contracts in both our enterprise technology solutions and safety and security technology solutions product lines, we recognize revenue over time. These services are typically recognized as a series of services performed over the contract term using the straight-line method, or based on our customers’ actual usage of the networks and platforms which we provide.

Point in time - When a performance obligation is not satisfied over time, we must record revenue using the point in time accounting method which generally results in revenue being recognized upon shipment or delivery of a promised good or service to a customer. This generally occurs when we enter into short term contracts or purchase orders where items are provided to customers with relatively quick turn-around times. Modifications to such contracts and or purchase orders, which typically provide for additional quantities or services, are accounted for as a new contract because the pricing for these additional quantities or services are based on standalone selling prices.

Point in time accounting is principally applied to contracts in our satellite earth station product line (which includes satellite modems, traveling wave tube amplifiers (“TWTAs”) and solid-state power amplifiers ("SSPAs")) and solid-state high-power narrow and broadband amplifiers. Point in time accounting is also applied to certain contracts in our command and control solutions product line. The contracts related to these product lines do not meet the requirements for over time revenue recognition because our customers cannot utilize the equipment for its intended purpose during any phase of our manufacturing process; customers do not simultaneously receive and or consume the benefits provided by our performance; customers do not control the asset (i.e., prior to delivery, customers cannot direct the use of the asset, sell or exchange the equipment, etc.); and, although many of our contracts have termination for convenience clauses and or an enforceable right to payment for performance completed to date, our performance creates an asset with an alternative use through the point of delivery.

In determining that our equipment has alternative use, we considered the underlying manufacturing process for our products. In the early phases of manufacturing, raw materials and work in process (including subassemblies) consist of common parts that are highly fungible among many different types of products and customer applications. Finished products are either configured to our standard configuration or based on our customers’ specifications. Finished products, whether built to our standard specification or to a customers’ specification, can be sold to a variety of customers and across many different end use applications with minimal rework, if needed, and without incurring a significant economic loss.

When identifying a contract with our customer, we consider when it has approval and commitment from both parties, if the rights of the parties are identified, if the payment terms are identified, if it has commercial substance and if collectability is probable.

When identifying performance obligations, we consider whether there are multiple promises and how to account for them. In our contracts, multiple promises are separated if they are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or comprise a series of distinct services performed over time, they are combined into a single performance obligation. In some cases, we may also provide the customer with an additional service-type warranty, which we recognize as a separate performance obligation. Service-type warranties do not represent a significant portion of our consolidated net sales. When service-type warranties represent a separate performance obligation, the revenue is deferred and recognized ratably over the extended warranty period. Our contracts, from time-to-time, may also include options for additional goods and services. To-date, these options have not represented material rights to the customer as the pricing for them reflects standalone selling prices. As a result, we do not consider options we offer to be performance obligations for which we must allocate a portion of the transaction price. In many cases, we provide assurance-type warranty coverage for some of our products for a period of at least one year from the date of delivery.

When identifying the transaction price, we typically utilize the contract's stated price as a starting point. The transaction price in certain arrangements may include estimated amounts of variable consideration, including award fees, incentive fees or other provisions that can either increase or decrease the transaction price. We estimate variable consideration as the amount to which we expect to be entitled, and we include estimated amounts in the transaction price to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the estimation uncertainty is resolved. The estimation of this variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on an assessment of our anticipated performance and all information (e.g., historical, current and forecasted) that is reasonably available to us.


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When allocating the contract’s transaction price, we consider each distinct performance obligation. For contracts with multiple performance obligations, we allocate the contract’s transaction price to each performance obligation using our best estimate of the standalone selling price of each distinct good or service in the contract. We determine standalone selling price based on the price at which the performance obligation is sold separately. If the standalone selling price is not observable through past transactions, we estimate the standalone selling price taking into account available information such as market conditions, including geographic or regional specific factors, competitive positioning, internal costs, profit objectives and internally approved pricing guidelines related to the performance obligations.

Almost all of our contracts with customers are denominated in U.S. dollars and typically either firm-fixed price or cost reimbursable type contracts (including fixed-fee, incentive-fee and time-and-material type contracts). In almost all of our contracts with customers, we are the principal in the arrangement and report revenue on a gross basis. Transaction prices for contracts with U.S. domestic and international customers are usually based on specific negotiations with each customer and in the case of the U.S. government, sometimes based on estimated or actual costs of providing the goods or services in accordance with applicable regulations.

The timing of revenue recognition, billings and collections results in receivables, unbilled receivables and contract liabilities on our Condensed Consolidated Balance Sheet. Under typical payment terms for our contracts accounted for over time, amounts are billed as work progresses in accordance with agreed-upon contractual terms, either at periodic intervals (e.g., monthly) or upon achievement of contractual milestones. For certain contracts with provisions that are intended to protect customers in the event we do not satisfy our performance obligations, billings occur subsequent to revenue recognition, resulting in what we have historically presented as unbilled receivables. Under ASC 606, unbilled receivables constitute contract assets. On large long term contracts, and for contracts with international customers that do not do business with us regularly, payment terms typically require advanced payments and deposits. Under ASC 606, payments received from customers in excess of revenue recognized to-date results in a contract liability. These contract liabilities are not considered to represent a significant financing component of the contract because we believe these cash advances and deposits are generally used to meet working capital demands which can be higher in the earlier stages of a contract. Also, advanced payments and deposits provide us with some measure of assurance that the customer will perform on its obligations under the contract. Under the typical payment terms for our contracts accounted for at a point in time, costs are accumulated in inventory until the time of billing, which generally coincides with revenue recognition.

We recognize the incremental costs to obtain or fulfill a contract as expense when incurred if the amortization period of the asset is one year or less. Incremental costs to obtain or fulfill contracts with an amortization period greater than one year were not material. As commissions payable to our sales and marketing employees or contractors are contingent upon multiple factors, such commissions are not considered direct costs to obtain or fulfill a contract with a customer and are expensed as incurred in selling, general and administrative expenses on our Condensed Consolidated Statements of Operations. Commissions payable to our third party sales representatives related to large long-term contracts are included in total estimated costs at completion for such contracts and are expensed over time through cost of sales on our Condensed Consolidated Statements of Operations, as we consider these types of commissions direct and incremental costs to obtain and fulfill such contracts.

Remaining performance obligations represent the transaction price of firm orders for which work has not been performed as of the end of a fiscal period. Remaining performance obligations, which we refer to as backlog, exclude unexercised contract options and potential orders under indefinite delivery / indefinite quantity ("IDIQ") contracts.

Impairment of Goodwill and Other Intangible AssetsAs of October 31, 2018, total goodwill recorded on our Condensed Consolidated Balance Sheet aggregated $290.6 million (of which $231.4 million relates to our Commercial Solutions segment and $59.2 million relates to our Government Solutions segment). Additionally, as of October 31, 2018, net intangibles recorded on our Condensed Consolidated Balance Sheet aggregated $236.5 million (of which $195.6 million relates to our Commercial Solutions segment and $40.9 million relates to our Government Solutions segment). Each of our two operating segments constitutes a reporting unit and we must make various assumptions in determining their estimated fair values.

In accordance with FASB ASC 350 "Intangibles - Goodwill and Other," we perform a goodwill impairment analysis at least annually (in the first quarter of each fiscal year), unless indicators of impairment exist in interim periods. If we fail the quantitative assessment of goodwill impairment ("quantitative assessment"), pursuant to our adoption of FASB ASU No. 2017-04 in fiscal 2017, we would be required to recognize an impairment loss equal to the amount that a reporting unit's carrying value exceeded its fair value; however, any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.


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On August 1, 2018 (the first day of our fiscal 2019), we performed our annual quantitative assessment using market participant assumptions to determine if the fair value of each of our reporting units with goodwill exceeded its carrying value. In making this assessment, we considered, among other things, expectations of projected net sales and cash flows, assumptions impacting the weighted average cost of capital, trends in trading multiples of comparable companies, changes in our stock price and changes in the carrying values of our reporting units with goodwill. We also considered overall business conditions.

In performing the quantitative assessment, we estimated the fair value of each of our reporting units using a combination of the income and market approaches. The income approach, also known as the discounted cash flow ("DCF") method, utilizes the present value of cash flows to estimate fair value. The future cash flows for our reporting units were projected based on our estimates, at that time, of future revenues, operating income and other factors (such as working capital and capital expenditures). For purposes of conducting our impairment analysis, we assumed revenue growth rates and cash flow projections that are below our actual long-term expectations. The discount rates used in our DCF method were based on a weighted-average cost of capital ("WACC") determined from relevant market comparisons, adjusted upward for specific reporting unit risks (primarily the uncertainty of achieving projected operating cash flows). A terminal value growth rate was applied to the final year of the projected period and reflected our estimate of stable, perpetual growth. We then calculated a present value of the respective cash flows for each reporting unit to arrive at an estimate of fair value under the income approach. Under the market approach, we estimated a fair value based on comparable companies' market multiples of revenues and earnings before interest, taxes, depreciation and amortization and factored in a control premium. Finally, we compared our estimates of fair values to our August 1, 2018 total public market capitalization and assessed implied control premiums based on our common stock price of $33.70 as of August 1, 2018.

Based on our quantitative evaluation, we determined that our Commercial Solutions and Government Solutions reporting units had estimated fair values in excess of their carrying values of at least 42.5% and 105.5%, respectively, and concluded that our goodwill was not impaired and that neither of our two reporting units was at risk of failing the quantitative assessment. It is possible that, during fiscal 2019 or beyond, business conditions (both in the U.S. and internationally) could deteriorate from the current state, our current or prospective customers could materially postpone, reduce or even forgo purchases of our products and services to a greater extent than we currently anticipate, or our common stock price could decline. A significant decline in our customers' spending that is greater than we anticipate or a shift in funding priorities may also have a negative effect on future orders, sales, income and cash flows and we might be required to perform a quantitative assessment during fiscal 2019 or beyond. If assumed net sales and cash flow projections are not achieved in future periods or our common stock price significantly declines from current levels, our Commercial Solutions and Government Solutions reporting units could be at risk of failing the quantitative assessment and goodwill and intangibles assigned to the respective reporting units could be impaired.

In any event, we are required to perform the next annual goodwill impairment analysis on August 1, 2019 (the start of our fiscal 2020). If our assumptions and related estimates change in the future, or if we change our reporting unit structure or other events and circumstances change (e.g., a sustained decrease in the price of our common stock (considered on both absolute terms and relative to peers)), we may be required to record impairment charges when we perform these tests, or in other future periods. In addition to our impairment analysis of goodwill, we also review net intangible assets with finite lives when an event occurs indicating the potential for impairment. We believe that the carrying values of our net intangible assets were recoverable as of October 31, 2018. Any impairment charges that we may record in the future could be material to our results of operations and financial condition.

Provision for Assurance-Type Warranty Obligations.  We provide assurance-type warranty coverage for most of our products, including products under long-term contracts, for a period of at least one year from the date of shipment. We record a liability for estimated warranty expense based on historical claims, product failure rates and other factors. Costs associated with some of our warranties that are provided under long-term contracts are incorporated into our estimates of total contract costs. There exist inherent risks and uncertainties in estimating warranty expenses, particularly on larger or longer-term contracts. If we do not accurately estimate our warranty costs, any changes to our original estimates could be material to our results of operations and financial condition.

Accounting for Income Taxes.  Our deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities, and applying enacted tax rates expected to be in effect for the year in which we expect the differences to reverse. Our provision for income taxes is based on domestic (including federal and state) and international statutory income tax rates in the tax jurisdictions where we operate, permanent differences between financial reporting and tax reporting and available credits and incentives. We recognize interest and penalties related to uncertain tax positions in income tax expense. The U.S. federal government is our most significant income tax jurisdiction.


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Significant judgment is required in determining income tax provisions and tax positions. We may be challenged upon review by the applicable taxing authority and positions taken by us may not be sustained. We recognize all or a portion of the benefit of income tax positions only when we have made a determination that it is more likely than not that the tax position will be sustained upon examination, based upon the technical merits of the position and other factors. For tax positions that are determined as more likely than not to be sustained upon examination, the tax benefit recognized is the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The development of valuation allowances for deferred tax assets and reserves for income tax positions requires consideration of timing and judgments about future taxable income, tax issues and potential outcomes, and are subjective critical estimates. A portion of our deferred tax assets consist of federal net operating losses and federal research and experimentation tax credit carryforwards, most of which was acquired in connection with our acquisition of TCS. No valuation allowance has been established on these deferred tax assets based on our evaluation that our ability to realize such assets has met the criteria of "more likely than not." We continuously evaluate additional facts representing positive and negative evidence in determining our ability to realize these deferred tax assets. In certain circumstances, the ultimate outcome of exposures and risks involves significant uncertainties. If actual outcomes differ materially from these estimates, they could have a material impact on our results of operations and financial condition.

On December 22, 2017, H.R.1, also known as the Tax Cuts and Jobs Act ("Tax Reform"), was enacted in the U.S. Tax Reform significantly lowered the amount of our current and future income tax expense primarily due to the reduction in the U.S. statutory income tax rate from 35.0% to 21.0%. This provision went into effect on January 1, 2018 and required us to remeasure our deferred tax assets and liabilities. In fiscal 2019 and beyond, Tax Reform will result in the loss of our ability to take the domestic production activities deduction, which has been repealed, and is also likely to result in lower tax deductions for certain executive compensation expenses.

During the fiscal year ended July 31, 2018, we remeasured our deferred tax assets and liabilities. The remeasurement was recorded pursuant to ASC 740 "Income Taxes" and SEC Staff Accounting Bulletin ("SAB") 118. All amounts recorded were based on available guidance on interpretation of Tax Reform and what we believe to be reasonable approaches to estimating its impact; however, such amounts are provisional estimates at this time and are subject to adjustment as future guidance becomes available, additional facts become known or estimation approaches are refined. See "Notes to Condensed Consolidated Financial Statements - Note (12) - Income Taxes" included in "Part I - Item 1.- Condensed Consolidated Financial Statements," included in this Quarterly Report on Form 10-Q, for further information on the provisions of Tax Reform and its currently expected impact on our business. The overall actual impact of Tax Reform is currently uncertain, and could have a material adverse effect on our consolidated results of operations and financial condition.

During the three months ended October 31, 2018, the Internal Revenue Service ("IRS") finalized its audit of our federal income tax return for fiscal 2016 without assessing additional taxes. Our federal income tax returns for fiscal 2015 and 2017 are subject to potential future IRS audit. None of our state income tax returns prior to fiscal 2014 are subject to audit. TCS' federal income tax returns for tax year 2015 and the tax period from January 1, 2016 to February 23, 2016 are subject to potential future IRS audit. None of TCS' state income tax returns prior to calendar year 2014 are subject to audit. Future tax assessments or settlements could have a material adverse effect on our consolidated results of operations and financial condition.

Research and Development Costs.  We generally expense all research and development costs. Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other personnel-related expenses associated with product development. Research and development expenses also include third-party development and programming costs. Costs incurred internally in researching and developing software to be sold are charged to expense until technological feasibility has been established for the software. Judgment is required in determining when technological feasibility of a product is established. Technological feasibility for our advanced communication software solutions is generally reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to customers and when we are able to validate the marketability of such product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. To date, capitalized internally developed software costs were not material.

Provisions for Excess and Obsolete Inventory.  We record a provision for excess and obsolete inventory based on historical and future usage trends. Other factors may also influence our provision, including decisions to exit a product line, technological change and new product development. These factors could result in a change in the amount of excess and obsolete inventory on hand. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. In the future, if we determine that our inventory was overvalued, we would be required to recognize such costs in our financial statements at the time of such determination. Any such charge could be material to our results of operations and financial condition.


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Allowance for Doubtful Accounts.  We perform credit evaluations of our customers and adjust credit limits based upon customer payment history and current creditworthiness, as determined by our review of our customers’ current credit information. Generally, we will require cash in advance or payment secured by irrevocable letters of credit before an order is accepted from an international customer that we do not do business with regularly. In addition, we seek to obtain insurance for certain domestic and international customers.

We monitor collections and payments from our customers and maintain an allowance for doubtful accounts based upon our historical experience and any specific customer collection issues that we have identified. In light of ongoing tight credit market conditions, we continue to see requests from our customers for higher credit limits and longer payment terms. Because of our strong cash position and the nominal amount of interest we are earning on our cash and cash equivalents, we have, on a limited basis, approved certain customer requests.

We continue to monitor our accounts receivable credit portfolio. Our overall credit losses have historically been within our expectations of the allowances established; however, we cannot guarantee that we will continue to experience the same credit loss rates that we have in the past. Measurement of credit losses requires consideration of historical loss experience, including the need to adjust for changing business conditions, and judgments about the probable effects of relevant observable data, including present economic conditions such as delinquency rates and the financial health of specific customers. Changes to the estimated allowance for doubtful accounts could be material to our results of operations and financial condition.

Business Outlook for Fiscal 2019

Fiscal 2019 is off to a great start and we generated consolidated:

Net sales of $160.8 million;
Operating income of $7.3 million;
Net income of $3.5 million; and
Adjusted EBITDA (a Non-GAAP financial measure discussed below) of $18.0 million.
Our first quarter of fiscal 2019 results were significantly above our expectations and reflect higher net sales in many of our key product lines. In addition, our first quarter benefited from a shift in sales of approximately $10.0 million in our Government Solutions segment that primarily occurred due to accelerated customer fielding schedules. These Government Solutions segment sales were originally expected to occur throughout the last three quarters of fiscal 2019.

Demand for our products remains strong. We experienced strong bookings and achieved a consolidated book-to-bill ratio (a measure defined as bookings divided by net sales) of 0.98 and finished the quarter with a near record high consolidated backlog of $627.3 million. Our pipeline is filled with many prospects and we are pursuing a number of large opportunities. Our backlog is more fully defined in our most recent Annual Report on Form 10-K. As such, the total value of multi-year contracts that we have received is substantially higher than our reported backlog.

In addition to generating strong operating results, we took several steps to improve operating efficiencies and make progress on achieving our long-term business goals. For example,

We successfully consolidated our Government Solutions segment’s manufacturing facility located in Tampa, Florida with another facility that we maintain in Orlando, Florida; and in doing so, we incurred $1.4 million of facility exit costs;
We initiated a targeted acquisition plan related to a small but growing technology solutions company and incurred $1.1 million of acquisition plan expenses through our first quarter of fiscal 2019. Our acquisition plan efforts are ongoing and we currently expect to incur approximately $1.0 million of additional expenses in the second quarter of fiscal 2019. We anticipate making an announcement related to this potential acquisition in the near term. There is no certainty that our acquisition plan efforts will be successful;
We entered into a new $550.0 million credit facility (the “Credit Facility”) and wrote-off $3.2 million of deferred financing costs. Our new Credit Facility is intended to provide us with, among other things, increased balance sheet flexibility, improved interest rate pricing and less restrictive covenants as compared to our prior credit facility; and
We recorded a net discrete tax benefit of approximately $2.4 million primarily related to the favorable resolution with the IRS with respect to their audit of our fiscal 2016 federal income tax return and for tax benefits associated with stock-based awards that were settled during the quarter.


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Excluding these aforementioned items, our consolidated operating income and net income for the first quarter of fiscal 2019 would have been $9.8 million and $5.5 million, respectively, or 6.1% and 3.4% of consolidated net sales, respectively, a significant improvement from the amounts and related percentages we achieved in the first quarter of fiscal 2018.

As of October 31, 2018, our cash and cash equivalents were $42.9 million and our total debt outstanding (including capital leases and other obligations) was $195.6 million. In connection with our new Credit Facility, we expect our interest rate (including amortization of deferred financing costs) in fiscal 2019 to range from 5.4% to 5.6%. Our current cash borrowing rate, excluding amortization of deferred financing costs, is approximately 4.5%.

Based on our outstanding first quarter performance, our Business Outlook has improved since September 26, 2018 (the date we filed our Annual Report on Form 10-K with the Securities Exchange Commission (the “SEC”)) and we are increasing our targeted goals for consolidated net sales, net income per diluted share and Adjusted EBITDA for fiscal 2019.

Our fiscal 2019 consolidated net sales goal is now expected to be higher and within a range of approximately $625.0 million to $640.0 million as compared to our prior range of $600.0 million to $625.0 million. Our updated GAAP net income per diluted share ("EPS") target for fiscal 2019 is now $0.95 to $1.08. This GAAP EPS metric reflects all facility exit costs, acquisition plan expenses, write-off of deferred financing costs and net discrete tax benefits. In addition, we are increasing our Adjusted EBITDA goal to a higher range of $84.0 million to $88.0 million as compared to our prior range of $80.0 million to $86.0 million. If order flow remains strong and we are able to achieve all of our fiscal 2019 business goals, it is possible that financial results could be higher than our targeted amounts. In fiscal 2018, we reported revenues of $570.6 million and Adjusted EBITDA of $78.4 million.

In addition to increasing our targeted goals for consolidated net sales, net income per diluted share and Adjusted EBITDA, we are also adjusting our expectations of the timing of our financial performance given actual first quarter 2019 performance, changes in expected fielding schedules from our customers and an overall updated assessment of our assumptions. Although our GAAP consolidated operating income and Adjusted EBITDA in the second half of fiscal 2019 are still expected to be higher than the first half of fiscal 2019, we now expect a more balanced year. In this regard, our second quarter consolidated net sales, operating income and Adjusted EBITDA are expected to be nearly the same as our first quarter results of fiscal 2019. Our third quarter results for fiscal 2019 are expected to be better than our expected results for the second quarter of fiscal 2019. We still expect our fourth quarter of fiscal 2019 to be the peak quarter for consolidated net sales, operating income and Adjusted EBITDA.

Despite incurring facility exit costs and acquisition plan expenses, we anticipate consolidated operating income, both in dollars and as a percentage of consolidated net sales, to be higher in fiscal 2019 as compared to the $35.1 million or 6.2% we achieved in fiscal 2018. Also, our estimated effective income tax rate for fiscal 2019 (excluding net discrete items) is now expected to approximate 22.75%. Additionally, as a percentage of consolidated net sales, Adjusted EBITDA in fiscal 2019 is expected to be similar to the percentage we achieved in fiscal 2018.

Our updated 2019 fiscal year financial targets include a number of items, the timing of which can still shift and impact our quarterly financial performance. However, we currently do not believe that changes in such timing would negatively impact our ability to achieve our revised consolidated net sales, operating income and Adjusted EBITDA targets for fiscal 2019. Additionally, there is no certainty that our acquisition plan efforts will be successful and except for the impact of acquisition plan expenses discussed above, our updated 2019 fiscal year financial targets do not include the impact of such acquisition.

Our updated 2019 fiscal year financial targets depend, in large part, on timely deliveries and the receipt of, and performance on, orders from our customers and could be adversely impacted if orders and/or deliveries are delayed, business conditions deteriorate, or our current or prospective customers materially postpone, reduce or even forgo purchases of our products and services. Additionally, we continue to evaluate cost reduction initiatives in our business. Such actions primarily relate to reducing the size and cost of our facilities. Our updated 2019 fiscal year financial targets do not consider the financial impact of any such future actions we may take in this regard.

On December 6, 2018, our Board of Directors declared a dividend of $0.10 per common share, payable on February 15, 2019 to stockholders of record at the close of business on January 16, 2019. Future dividends remain subject to compliance with financial covenants under our Credit Facility as well as Board approval.

Additional information related to our Business Outlook for Fiscal 2019 and a definition and explanation of Adjusted EBITDA is included in the below section "Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of the Results of Operations for the Three Months Ended October 31, 2018 and 2017."

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COMPARISON OF THE RESULTS OF OPERATIONS FOR THREE MONTHS ENDED OCTOBER 31, 2018 AND 2017

Net Sales. Consolidated net sales were $160.8 million and $121.6 million for the three months ended October 31, 2018 and 2017, respectively, representing an increase of $39.2 million, or 32.2%. The significant period-over-period increase in net sales reflects significantly higher net sales in our Government Solutions segment and to a lesser extent, our Commercial Solutions segment. Net sales by operating segment are discussed below.

Commercial Solutions
Net sales in our Commercial Solutions segment were $78.0 million for the three months ended October 31, 2018, as compared to $76.1 million for the three months ended October 31, 2017, an increase of $1.9 million, or 2.5%. Our Commercial Solutions segment represented 48.5% of consolidated net sales for the three months ended October 31, 2018 as compared to 62.6% for the three months ended October 31, 2017.