MERCURY SYSTEMS INC (MRCY) FY 2024 MD&A
This page reproduces the company's own Item 7 MD&A text from the linked SEC filing. It is filer text, not grepcent analysis, scoring, or investment advice.
ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
From time to time, information provided, statements made by our employees or information included in our filings with the Securities and Exchange Commission (“SEC”) may contain statements that are not historical facts but that are “forward-looking statements,” which involve risks and uncertainties. You can identify these statements by the words “may,” “will,” “could,” “should,” “would,” “plans,” “expects,” “anticipates,” “continue,” “estimate,” “project,” “intend,” “likely,” “forecast,” “probable,” “potential,” and similar expressions. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from those projected or anticipated. Such risks and uncertainties include, but are not limited to, continued funding of defense programs, the timing and amounts of such funding, general economic and business conditions, including unforeseen weakness in the Company’s markets, effects of any U.S. federal government shutdown or extended continuing resolution, effects of geopolitical unrest and regional conflicts, competition, changes in technology and methods of marketing, delays in or cost increases related to completing development, engineering and manufacturing programs, changes in customer order patterns, changes in product mix, continued success in technological advances and delivering technological innovations, changes in, or in the U.S. government’s interpretation of, federal export control or procurement rules and regulations, changes in, or in the interpretation or enforcement of, environmental rules and regulations, market acceptance of the Company's products, shortages in or delays in receiving components, supply chain delays or volatility for critical components such as semiconductors, production delays or unanticipated expenses including due to quality issues or manufacturing execution issues, capacity underutilization, increases in scrap or inventory write-offs, failure to achieve or maintain manufacturing quality certifications, such as AS9100, the impact of supply chain disruption, inflation and labor shortages, among other things, on program execution and the resulting effect on customer satisfaction, inability to fully realize the expected benefits from acquisitions, restructurings, and operational efficiency initiatives or delays in realizing such benefits, challenges in integrating acquired businesses and achieving anticipated synergies, effects of shareholder activism, increases in interest rates, changes to industrial security and cyber-security regulations and requirements and impacts from any cyber or insider threat events, changes in tax rates or tax regulations, such as the deductibility of internal research and development, changes to interest rate swaps or other cash flow hedging arrangements, changes to generally accepted accounting principles, difficulties in retaining key employees and customers, litigation, including the dispute arising with the former CEO over his resignation, unanticipated costs under fixed-price service and system integration engagements, and various other factors beyond our control. These risks and uncertainties also include such additional risk factors as set forth under Part I-Item 1A (Risk Factors) in this Annual Report on Form 10-K. We caution readers not to place undue reliance upon any such forward-looking statements, which speak only as of the date made. We undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made.
OVERVIEW
Mercury Systems is a technology company that delivers mission-critical processing power to the edge to solve the most pressing aerospace and defense challenges. Mercury’s products and solutions are deployed in more than 300 programs and across 35 countries. The Company is headquartered in Andover, Massachusetts, and has over 20 locations worldwide.
The Mercury Processing Platform is the unique advantage we provide to our customers. It comprises the innovative technologies we’ve developed and acquired for more than 40 years that bring integrated, mission-critical processing capabilities to the edge. Our processing platform spans the full breadth of signal processing—from RF front end to the human-machine interface—to rapidly convert meaningful data, gathered in the most remote and hostile environments, into critical decisions. It allows us to offer standard products and custom solutions from silicon to system scale, including components, modules, subsystems, and systems and it embodies the customer-centric approach we take to delivering capabilities that are mission-ready, trusted and secure, software-defined, and open and modular.
As a leading manufacturer of essential components, products, modules and subsystems, we sell to all of the top defense prime contractors, the U.S. government and original equipment manufacturers (“OEM”) commercial aerospace companies. Our mission-critical products and solutions are deployed by our customers for a variety of applications including sensor and radar processing, electronic warfare, avionics, weapons, and command, control, communications, and intelligence (C4I). Mercury has built a trusted, robust portfolio of proven capabilities, leveraging the most advanced commercial silicon technologies and purpose-built to exceed the performance needs of our defense and commercial customers. Customers add their own applications and algorithms to our specialized, secure and innovative products and pre-integrated solutions. This allows them to complete their full system by integrating with their platform, the sensor technology and, increasingly, the processing from Mercury.
Our deep, long-standing relationships with leading high-tech and other commercial companies, coupled with our targeted research and development (“R&D”) investments and industry-leading trusted and secure design and manufacturing capabilities, are the foundational tenets of this highly successful model. We are leading the development and adaptation of commercial
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technology for aerospace and defense solutions. From chip-scale to system scale and from data, including RF to digital to decision, we make mission-critical technologies safe, secure, affordable and relevant for our customers.
Our capabilities, technology, people and R&D investment strategy combine to differentiate Mercury in our industry. We maintain our technological edge by investing in critical capabilities and intellectual property (“IP” or “building blocks”) in processing, leveraging open standards and open architectures to adapt quickly those building blocks into solutions for highly data-intensive applications, including emerging needs in areas such as artificial intelligence (“AI”).
As of June 28, 2024, we had 2,364 employees. Our consolidated revenues, net loss, diluted net loss per share, adjusted loss per share, and adjusted EBITDA for fiscal 2024 were $835.3 million, $(137.6) million, $(2.38), $(0.69) and $9.4 million, respectively. Our consolidated revenues, net loss, diluted net loss per share, adjusted loss per share and adjusted EBITDA for fiscal 2023 were $973.9 million, $(28.3) million, $(0.50), $1.00 and $132.3 million, respectively. See the Non-GAAP Financial Measures section for a reconciliation to our most directly comparable GAAP financial measures.
BUSINESS DEVELOPMENTS:
FISCAL 2024
On July 18, 2023, we executed the planned evolution of our 1MPACT value creation initiative, embedding the processes and execution of 1MPACT into our operations organization. The 1MPACT office concluded its responsibilities, having successfully incorporated the principles behind 1MPACT into how we think about continuous improvement at all levels of the Company.
On August 15, 2023, we announced William L. Ballhaus has been appointed President and Chief Executive Officer.
On August 9, 2023, we approved and initiated a workforce reduction that, together with the consolidation of 1MPACT into our operations organization, eliminated approximately 150 positions resulting in $9,548 of severance costs. Our plan enacted several immediate cost savings measures that simplified our organizational structure, facilitated clearer accountability, and aligned our priorities, including: (i) embedded the 1MPACT value creation initiatives and execution into the Company’s operations; (ii) streamlined organizational structure and removed areas of redundancy between corporate and divisional organizations; and (iii) reduced selling, general, and administrative headcount and rebalanced discretionary and third party spend to better align with our priority areas.
On November 7, 2023, we entered into Amendment No. 5 (“Amendment No. 5”) to the Company’s Credit Agreement dated May 2, 2016, as amended to date. Due to the uncertainty surrounding a government shutdown or prolonged continuing resolution and the potential impact on the second quarter and fiscal 2024 results, we proactively executed Amendment No. 5 to allow for a temporary increase in the Consolidated Total Net Leverage Ratio covenant requirement from 4.50 to 5.25 for the second quarter ended December 29, 2023. As part of Amendment No. 5, we agreed to a temporary reduction of Revolver capacity to $750.0 million through the earlier of May 15, 2024 or the filing of the compliance certificate for the period ended March 29, 2024. We had $576.5 million in outstanding borrowings both prior to and following the closing of Amendment No. 5. See Note L in the accompanying consolidated financial statements for further discussions of the Revolver.
On January 12, 2024, we adopted a plan to consolidate our Mission Systems and Microelectronics divisions into one unified structure that incorporates multiple business units and functions, under the leadership of Charles R. Wells, IV, who was appointed as our Executive Vice President, Chief Operating Officer effective as of January 22, 2024. This consolidation was designed to simplify our organizational structure, facilitate clearer accountability, and align to our priorities. On January 12, 2024, we approved and initiated workforce reductions that eliminated approximately 100 positions resulting in an additional $9,841 of severance costs for fiscal 2024. See Note H in the accompanying consolidated financial statements for further discussions of restructuring charges incurred during the year.
On June 17, 2024, we approved the next phase of our consolidation efforts, and implemented a workforce reduction that eliminated approximately 100 positions and resulted in restructuring charges of $6,781 for employee separation costs. See Note H in the accompanying consolidated financial statements for further discussions of restructuring charges incurred during the year.
On August 13, 2024, during fiscal 2025, we entered into Amendment No. 6 (“Amendment No. 6”) to our credit agreement dated May 2, 2016, as amended to date. Amendment No. 6 permanently decreased borrowing capacity to $900.0 million, with a temporary reduction in credit availability to $750.0 million until we meet a minimum consolidated EBITDA level of $75.0 million excluding (a) adjustments for cost savings, operating expense reductions and synergies, (b) EAC charges and other non-cash expenses, charges, and losses addbacks and (c) deducts to reverse EAC charges previously added back, in each case for a last twelve-month period. We had $591.5 million in outstanding borrowings both prior to and following the closing of Amendment No. 6. See Note L in the accompanying consolidated financial statements for further discussions of the Revolver.
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FISCAL 2023
Beginning in January 2023, the Board of Directors (the “Board”) engaged in a proactive and rigorous process to evaluate strategic alternatives, focused on a potential sale of Mercury. As part of the review, the Board authorized its financial advisors to contact and hold discussions with more than 40 potential bidders, including a wide range of strategic parties and financial sponsors. The Board executed confidentiality agreements with 20 parties. The two proposals ultimately received did not yield options for a sale that would reflect the intrinsic value of Mercury. Accordingly, in a press release dated June 23, 2023, we announced, among other things, that the independent members of the Board unanimously determined to conclude the sale process and instead focus on all potential opportunities to create value, including through the enhanced execution of our strategic plan under refreshed leadership.
On June 19, 2023, the Company’s former President and Chief Executive Officer, delivered a letter to the Board resigning from his positions of President and Chief Executive Officer and the Board accepted his resignation effective as of June 24, 2023. On June 23, 2023, we announced the Board has appointed William L. Ballhaus as the Company’s interim President and Chief Executive Officer, effective as of June 24, 2023.
On June 29, 2023, we announced that David E. Farnsworth will be joining the Company as Executive Vice President, Chief Financial Officer, and Treasurer, on July 17, 2023.
RESULTS OF OPERATIONS:
FISCAL 2024 VS. FISCAL 2023
The Company has applied the FAST Act Modernization and Simplification of Regulation S-K, which limits the discussion to the two most recent fiscal years. Refer to Item 7 of the Company's Form 10-K issued on August 15, 2023 for prior year discussion related to fiscal 2023.
The following tables set forth, for the periods indicated, financial data from the Consolidated Statements of Operations and Comprehensive (Loss) Income:
| (In thousands) | Fiscal 2024 | As a % of Total Net Revenue | Fiscal 2023 | As a % of Total Net Revenue | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Net revenues | $ | 835,275 | 100.0 | % | $ | 973,882 | 100.0 | % | |||||
| Cost of revenues | 639,374 | 76.5 | 657,154 | 67.5 | |||||||||
| Gross margin | 195,901 | 23.5 | 316,728 | 32.5 | |||||||||
| Operating expenses: | |||||||||||||
| Selling, general and administrative | 166,786 | 20.1 | 160,637 | 16.5 | |||||||||
| Research and development | 101,328 | 12.1 | 108,799 | 11.2 | |||||||||
| Amortization of intangible assets | 47,661 | 5.7 | 53,552 | 5.5 | |||||||||
| Restructuring and other charges | 26,170 | 3.1 | 6,981 | 0.7 | |||||||||
| Acquisition costs and other related expenses | 1,710 | 0.2 | 8,444 | 0.8 | |||||||||
| Total operating expenses | 343,655 | 41.2 | 338,413 | 34.7 | |||||||||
| Loss from operations | (147,754) | (17.7) | (21,685) | (2.2) | |||||||||
| Interest income | 1,199 | 0.1 | 1,053 | 0.1 | |||||||||
| Interest expense | (35,015) | (4.2) | (25,159) | (2.6) | |||||||||
| Other expense, net | (7,705) | (0.9) | (2,751) | (0.3) | |||||||||
| Loss before income taxes | (189,275) | (22.7) | (48,542) | (5.0) | |||||||||
| Income tax benefit | (51,635) | (6.2) | (20,207) | (2.1) | |||||||||
| Net loss | $ | (137,640) | (16.5) | % | $ | (28,335) | (2.9) | % |
REVENUES
Total revenues decreased $138.6 million, or 14.2%, to $835.3 million during fiscal 2024, as compared to $973.9 million during fiscal 2023. Revenues decreased year over year as we continue to prioritize resources to execute our challenged programs, transition from our higher mix of development programs and aim to better align our operating cadence with prudent working capital management. As a result, we are observing a temporary volume shift in our total revenue, including our point in
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time revenue and over time revenue which decreased by approximately $56.3 million and $82.3 million, respectively. Over time revenue represented 55% of total revenues during fiscal 2024, as compared to 56% of total revenues during fiscal 2023.
During fiscal 2024, we experienced incremental net EAC change impact across various programs with revenue recognized over time, including our challenged programs. For the challenged programs, which are recognized over time, we have recognized a majority of the revenue and related cost as we acquired material and applied labor over the period of performance to progress these programs in prior periods. As we continue to resolve technical challenges and complete these programs, which consumes a significant amount of operational capacity, the remaining revenues on these challenged programs are recognized, however these revenues represent a very small proportion of the total contract value. In addition, we adjusted our estimates at completion for incremental technical and execution costs in the period, especially as related to one of our challenged programs as well as certain other development and production programs resulting in a cumulative adjustment to reduce revenues in fiscal 2024. Despite the net EAC change impact we experienced on our programs, the trend in the net EAC change impact of these programs has reduced significantly as we retire risk across the portfolio. In addition, as we transition our operating cadence with a goal of more properly balancing our material purchases with contract awards and resource availability to drive better working capital results, we are experiencing a near-term revenue timing dynamic.
The reduction in revenue was also contributed to by a temporary, self-imposed pause in operations at one of our sites. In the second quarter of fiscal 2024, we paused the transition of our Common Processing Architecture toward full-rate production in order to retire risk and validate the producibility and scalability of the design. We believe we drove to root cause and implemented corrective action in our common processing architecture. We initiated limited pilot production in the fourth quarter of fiscal 2024, which returned positive results in terms of yield and is an important initial step toward full-scale production. We remain confident that the significant investments we are making in this area will lead to profitable organic growth where we see robust demand for our unique ability to support our customers’ stringent mission-critical needs.
We experienced revenue decreases across all product groupings, including integrated solutions, modules and sub-assemblies and components which decreased $115.8 million, $18.4 million and $4.4 million, respectively. The decrease in total revenue was primarily driven by the radar, C4I, and electronic warfare end applications decreases of $119.1 million, $25.6 million, and $23.9 million, respectively, partially offset by increases to other sensor and effector end applications of $16.4 million. We experienced decreases across several of our platforms during fiscal 2024 when compared to fiscal 2023; Airborne, Land, and Naval platforms decreased $60.9 million, $50.3 million, and $36.0 million, respectively, partially offset by an increase to Other platforms of $8.6 million. The largest program decreases were related to the LTAMDS, THAAD and F-16 programs, partially offset by increases to the SCAR and a strategic weapons programs when compared to the prior period. There were no programs comprising 10% or more of our revenues for fiscal 2024 and 2023.
GROSS MARGIN
Gross margin was 23.5% for fiscal 2024, a decrease of 900 basis points from the 32.5% gross margin realized during fiscal 2023. The lower gross margin was driven by net EAC change impacts to revenue programs recognized over time and higher manufacturing adjustments of $44.9 million, related to inventory reserves, warranty expense, scrap, and certain other non-recurring cost adjustments. The increase in inventory reserves was primarily related to programs with end of life components, where design changes have occurred, as well as configuration changes necessary to drive efficient production in the common processing architecture. The increase in scrap was primarily a result of higher levels of discrepant material especially as related to the common processing architecture across several of our remaining challenged programs. We have several initiatives underway to address more efficient and cost-effective producibility of these subsystems.
Additionally, the growth in estimated costs to complete on our over time revenue programs during fiscal 2024 has significantly reduced the overall margins. Net margin impact of approximately $73.2 million was recorded in fiscal 2024 resulting in an incremental impact of approximately $17.0 million to gross margin, or 300 basis points, when compared to the prior period. Approximately $30.2 million of net EAC change impact in fiscal 2024 was attributable to the challenged programs, of which a total of $20.0 million related to two programs. The remaining $43.0 million was incurred across certain other development and production programs based on facts and circumstances in the year.
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We had the following aggregate effects of favorable and unfavorable margin impacts as a result of changes in estimates across our portfolio for the period presented:
| (in thousands) | June 28, 2024 | June 30, 2023 | |||||
|---|---|---|---|---|---|---|---|
| Gross favorable | $ | 17,622 | $ | 12,291 | |||
| Gross unfavorable | (90,867) | (68,557) | |||||
| Net impact of changes in estimates | $ | (73,245) | $ | (56,266) |
The changes in estimates are assessed based on historical results and cumulative adjustments are recorded to recognize revenue to date based on changes in estimated margin on programs, including impact of contract amendments, factored for potential risks and opportunities. We utilize the latest and best information available when revising our estimates and apply consistent judgement across the full portfolio of programs.
SELLING, GENERAL AND ADMINISTRATIVE
Selling, general and administrative expenses increased $6.2 million, or 3.8%, to $166.8 million during fiscal 2024 as compared to $160.6 million during fiscal 2023. The increase was primarily driven by higher bad debt expense of $15.3 million due to contract asset reserves as a result of ongoing negotiations of settlement terms with our customers to reduce scope, or otherwise exit contracts, primarily as related to certain challenged programs. This increase was partially offset by lower compensation costs of $8.5 million, including stock compensation, benefits and salary expense, as a result of the reductions in force initiated on August 9, 2023, January 12, 2024, and June 17, 2024 as well as lower consulting fees of $1.9 million compared to fiscal 2023.
RESEARCH AND DEVELOPMENT
Research and development expenses decreased $7.5 million, or 6.9%, to $101.3 million during fiscal 2024, as compared to $108.8 million for fiscal 2023. The decrease was primarily due to lower compensation expense of $1.9 million associated with headcount reductions of 128 employees in fiscal 2024 as well as higher CRAD of $15.4 million in the period, partially offset by higher bonus expenses of $3.1 million.
AMORTIZATION OF INTANGIBLE ASSETS
Amortization of intangible assets decreased $5.9 million to $47.7 million during fiscal 2024, as compared to $53.6 million for fiscal 2023, primarily due to the backlog from our Avalex acquisition becoming fully amortized in fiscal 2023, and various other developed technologies, and customer relationship intangibles from previous acquisitions becoming fully amortized during fiscal 2024.
RESTRUCTURING AND OTHER CHARGES
During fiscal 2024, we incurred $26.2 million of restructuring and other charges, as compared to $7.0 million in fiscal 2023. During fiscal 2024, we initiated several cost savings measures that simplify our organizational structure, facilitate clearer accountability, and align our priorities, including: (i) embedding the 1MPACT value creation initiatives and execution into our operations; (ii) streamlining organizational structure and removing areas of redundancy between corporate and divisional organizations; and (iii) reducing selling, general, and administrative headcount and rebalancing discretionary and third party spending to better align with our priority areas. On July 20, 2023, we executed the plan to embed the 1MPACT value creation initiatives into operations, and on August 9, 2023, we approved and initiated a workforce reduction that, together with the 1MPACT related action, eliminated approximately 150 positions resulting in $9.6 million of severance costs. On January 12, 2024, we initiated and approved a workforce reduction that eliminated approximately 100 positions resulting in $9.8 million of severance costs. On June 17, 2024, we approved and initiated workforce reductions that eliminated an additional 100 positions resulting in $6.8 million of severance costs. Restructuring and other charges during fiscal 2023 primarily related to 1MPACT including $3.4 million of severance costs, $1.8 million of third party consulting costs, $1.8 million of costs for facility optimization efforts, including $1.3 million related to lease asset impairment.
All of the Restructuring and Other Charges is classified as Operating expenses in the Consolidated Statements of Operations and Comprehensive (Loss) Income and any remaining restructuring obligations are expected to be paid within the next twelve months.
ACQUISITION COSTS AND OTHER RELATED EXPENSES
Acquisition costs and other related expenses were $1.7 million during fiscal 2024, as compared to $8.4 million during fiscal 2023. The acquisition costs and other related expenses we incurred during fiscal 2024 includes $0.7 million related to run-rate amortization of fair value adjustments from purchase accounting, $0.3 million related to the conclusion of the Board of Directors' review of strategic alternatives, as well as $0.3 million for third-party advisory fees in connection with engagements
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by activist investors. Acquisition costs during fiscal 2023 were primarily related to $3.7 million associated with the Board of Directors' review of strategic alternatives and $3.5 million for third party advisory fees in connection with engagements by activist investors.
INTEREST INCOME
Interest income remained consistent at $1.2 million in fiscal 2024 compared to $1.1 million in fiscal 2023.
INTEREST EXPENSE
Interest expense for fiscal 2024 increased to $35.0 million, as compared to $25.2 million in fiscal 2023. The increase was driven by an increase in interest rates and higher average borrowings on our Revolver. Borrowings under our Revolver were $591.5 million and $511.5 million at June 28, 2024 and June 30, 2023, respectively.
OTHER EXPENSE, NET
Other expense, net was $7.7 million during fiscal 2024, as compared to $2.8 million in fiscal 2023. Fiscal 2024 includes $4.9 million of litigation and settlement costs, $3.4 million of financing costs and $0.4 million of net foreign currency translation losses, partially offset by other income of $1.3 million during fiscal 2024. There was $2.3 million of financing costs and $2.1 million of litigation and settlement costs, partially offset by net foreign currency translation gains of $1.6 million during fiscal 2023.
INCOME TAXES
We recorded an income tax benefit of $51.6 million and $20.2 million on losses before income taxes of $189.3 million and $48.5 million for fiscal years 2024 and 2023, respectively.
The effective tax rate for fiscal 2024 differed from the federal statutory rate primarily due to federal and state research and development tax credits and state taxes, partially offset by tax provisions related to stock compensation.
The effective tax rate for fiscal 2023 differed from the federal statutory rate primarily due to federal and state research and development tax credits, releases to reserves for unrecognized income tax benefits and state taxes, partially offset by valuation allowances recorded and tax provisions related to stock compensation.
We continue to maintain a valuation allowance on the majority of our foreign net operating loss carryforwards and state research and development tax credit carryforwards. Based on forecasted taxable income and the scheduled reversal of the remaining deferred tax assets, we believe it is more likely than not that all other deferred tax assets will be realized.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of liquidity come from existing cash and cash generated from operations, our Revolver, and our ability to raise capital under our universal shelf registration statement. Our near-term fixed commitments for cash expenditures consist primarily of payments under operating leases and inventory purchase commitments. We experienced growth in our working capital balances and, in particular, related to unbilled receivables and inventory over fiscal 2022 and 2023. As we complete our challenged programs and then receive follow-on production awards, we believe that both unbilled receivables and inventory is expected to convert to cash reducing our working capital balances. During fiscal 2024, our working capital balance declined $93.3 million compared to the prior year.
Based on our current plans and business conditions, we believe that existing cash and cash equivalents, our available Revolver, cash generated from operations and our financing capabilities will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months.
Shelf Registration Statement
On October 4, 2023, we filed a shelf registration statement on Form S-3ASR with the SEC. The shelf registration statement, which was effective upon filing with the SEC, registered each of the following securities: debt securities, preferred stock, common stock, warrants and units. We intend to use the proceeds from financings using the shelf registration statement for general corporate purposes, which may include the following:
•the acquisition of other companies or businesses;
•the repayment and refinancing of debt;
•capital expenditures;
•working capital; and
•other purposes as described in the prospectus supplement.
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We have an unlimited amount available under the shelf registration statement.
Revolving Credit Facilities
On February 28, 2022, we amended the Revolver to increase and extend the borrowing capacity to a $1.1 billion, 5-year revolving credit line, with the maturity extended to February 28, 2027. The borrowing capacity as defined under the Revolver as of June 28, 2024 is approximately $986.0 million, less outstanding borrowings against of $591.5 million. See Note L in the accompanying consolidated financial statements for further discussion of the Revolver.
On November 7, 2023, due to the uncertainty surrounding a government shutdown or prolonged continuing resolution and the potential impact on the second quarter and fiscal 2024 results, we proactively executed Amendment No. 5 to the Revolver, as amended to date, with a syndicate of commercial banks and Bank of America, N.A acting as the administrative agent allowing for a temporary increase in the Consolidated Total Net Leverage Ratio covenant requirement from 4.50 to 5.25 for the second quarter ended December 29, 2023. As part of Amendment No. 5, we agreed to a temporary reduction of Revolver capacity to $750.0 million through the earlier of May 15, 2024 or the filing of the compliance certificate for the period ended March 29, 2024.
During fiscal 2024, we borrowed $105.0 million and paid down $25.0 million. As of June 28, 2024, the Company was in compliance with all covenants and conditions under the Revolver.
During fiscal 2025, on August 13, 2024, we executed Amendment No. 6 to the Revolver, decreasing the permanent borrowing capacity to $900.0 million, with a temporary reduction in credit availability to $750.0 million until we meet a minimum consolidated EBITDA level of $75.0 million excluding (a) adjustments for cost savings, operating expense reductions and synergies, (b) EAC charges and other non-cash expenses, charges, and losses addbacks and (c) deducts to reverse EAC charges previously added back, in each case for a last twelve-month period.
Receivables Purchase Agreement
On September 27, 2022, we entered into an uncommitted receivables purchase agreement (“RPA”), pursuant to which we may offer to sell certain customer receivables, subject to the terms and conditions of the RPA. The RPA is an uncommitted arrangement such that we are not obligated to sell any receivables and the party has no obligation to purchase any receivables from us. Pursuant to the RPA, the party may purchase certain of our customer receivables at a discounted rate, subject to a limit that as of any date, the total amount of purchased receivables held by the party, less the amount of all collections received on such receivables, may not exceed $20.0 million. The RPA has an indefinite term and the agreement remains in effect until it is terminated by either party. On March 14, 2023, we amended the RPA to increase the capacity from $20.0 million to $30.6 million. On June 21, 2023, we further amended the RPA to increase the capacity from $30.6 million to $60.0 million. We factored accounts receivable and incurred factoring fees of approximately $33.8 million and $1.9 million, respectively, in fiscal 2024. We factored accounts receivable and incurred factoring fees of approximately $30.5 million and $0.6 million, respectively, in fiscal 2023.
On August 13, 2024, we entered into a $60.0 million committed receivables purchase and servicing agreement (“RPSA”) with a new party. The RPSA has an initial term of two years. Pursuant to the RPSA, the new party has committed to purchase receivables at a discount rate from a list of our customers, maintaining a balance of purchased receivables at or below $60 million.
CASH FLOWS
| For the Fiscal Years Ended | ||||||
|---|---|---|---|---|---|---|
| (In thousands) | June 28, 2024 | June 30, 2023 | ||||
| Net cash provided by (used in) operating activities | $ | 60,382 | $ | (21,254) | ||
| Net cash used in investing activities | $ | (34,291) | $ | (38,561) | ||
| Net cash provided by financing activities | $ | 82,680 | $ | 65,429 | ||
| Net increase in cash and cash equivalents | $ | 108,958 | $ | 5,909 | ||
| Cash and cash equivalents at end of year | $ | 180,521 | $ | 71,563 |
Our cash and cash equivalents increased by $109.0 million during fiscal 2024 primarily as the result of $80.0 million net borrowings on our Revolver and $60.4 million provided by operating activities, partially offset by $34.3 million invested in purchases of property and equipment.
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Operating Activities
During fiscal 2024, we had an inflow of $60.4 million in cash from operating activities compared to a $21.3 million outflow during fiscal 2023. The increase during fiscal 2024 was primarily due to an inflow of $76.5 million from accounts receivable, unbilled receivables and costs in excess of billings as compared to a $58.7 million outflow in fiscal 2023. Fiscal 2024 included a lower outflow due to the benefit for deferred income taxes. Fiscal 2024 also included inflows of $0.1 million and $0.7 million due to inventory and accounts payable, accrued expenses, and accrued compensation, respectively as compared to outflows of $64.1 million and $16.7 million in fiscal 2023, respectively. This activity was partially offset by a net loss of $137.6 million, a $17.3 million inflow from deferred revenues and customer advances, and an outflow of $11.2 million due to income taxes payable in fiscal 2024, as compared to a net loss of $28.3 million, a $40.7 million inflow from deferred revenues and customer advances, and an inflow of $9.9 million due to income taxes payable in fiscal 2023.
Investing Activities
During fiscal 2024, we invested $34.3 million, a decrease of $4.3 million, as compared to $38.6 million during fiscal 2023 primarily due to lower purchases of property and equipment.
Financing Activities
During fiscal 2024, we had $82.7 million in cash provided by financing activities, as compared to $65.4 million during fiscal 2023. During fiscal 2024, we had $80.0 million of net borrowings on our Revolver as compared to $60.0 million of net borrowings during fiscal 2023. In fiscal 2024, we also had $4.6 million of proceeds from employee stock plans, as compared to $5.5 million in fiscal 2023.
COMMITMENTS AND CONTRACTUAL OBLIGATIONS
The following is a schedule of our commitments and contractual obligations outstanding at June 28, 2024:
| (In thousands) | Total | Less Than 1 Year | 1-3 Years | 3-5 Years | More Than 5 Years | |||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Operating leases | $ | 89,190 | $ | 15,286 | $ | 27,516 | $ | 23,482 | $ | 22,906 | ||||||||
| Purchase obligations | 122,195 | 122,195 | — | — | — | |||||||||||||
| $ | 211,385 | $ | 137,481 | $ | 27,516 | $ | 23,482 | $ | 22,906 |
See Note B and Note I to the consolidated financial statements for more information regarding our obligations under leases.
Purchase obligations represent open non-cancelable purchase commitments for certain inventory components and services used in normal operations. The purchase commitments covered by these agreements are for less than one year and aggregated $122.2 million at June 28, 2024.
We had a liability at June 28, 2024 of $7.7 million for uncertain tax positions that have been taken or are expected to be taken in various income tax returns. We do not know the ultimate resolution of these uncertain tax positions and as such, do not know the ultimate timing of payments related to this liability. Accordingly, these amounts are not included in the above table.
Our standard product sales and license agreements entered into in the ordinary course of business typically contain an indemnification provision pursuant to which we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred in connection with certain intellectual property infringement claims by any third party with respect to our products. Such provisions generally survive termination or expiration of the agreements. The potential amount of future payments we could be required to make under these indemnification provisions is, in some instances, unlimited.
As part of our strategy for growth, we continue to explore acquisitions or strategic alliances. The associated acquisition costs incurred in the form of professional fees and services may be material to the future periods in which they occur, regardless of whether the acquisition is ultimately completed.
We may elect from time to time to purchase and subsequently retire shares of common stock in order to settle employees’ tax liabilities associated with vesting of a restricted stock award. These transactions would be treated as a use of cash in financing activities in our Consolidated Statements of Cash Flows.
OFF-BALANCE SHEET ARRANGEMENTS
Other than certain indemnification provisions, we do not have any off-balance sheet financing arrangements or liabilities, guarantee contracts, retained or contingent interests in transferred assets, or any obligation arising out of a material variable interest in an unconsolidated entity. We do not have any majority-owned subsidiaries that are not consolidated in the financial statements. Additionally, we do not have an interest in, or relationships with, any special purpose entities.
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RELATED PARTY TRANSACTIONS
During fiscal 2024 and 2023, we did not engage in any related party transactions.
NON-GAAP FINANCIAL MEASURES
In our periodic communications, we discuss certain important measures that are not calculated according to U.S. generally accepted accounting principles (“GAAP”), including adjusted EBITDA, adjusted loss, adjusted loss per share, and free cash flow.
Adjusted EBITDA is defined as net income before other non-operating adjustments, interest income and expense, income taxes, depreciation, amortization of intangible assets, restructuring and other charges, impairment of long-lived assets, acquisition, financing and other third party costs, fair value adjustments from purchase accounting, litigation and settlement income and expense, COVID related expenses, and stock-based and other non-cash compensation expense. We use adjusted EBITDA as an important indicator of the operating performance of our business. We use adjusted EBITDA in internal forecasts and models when establishing internal operating budgets, supplementing the financial results and forecasts reported to our board of directors, determining a portion of bonus compensation for executive officers and other key employees based on operating performance, evaluating short-term and long-term operating trends in our operations and allocating resources to various initiatives and operational requirements. We believe that adjusted EBITDA permits a comparative assessment of our operating performance, relative to our performance based on our GAAP results, while isolating the effects of charges that may vary from period to period without any correlation to underlying operating performance. We believe that these non-GAAP financial adjustments are useful to investors because they allow investors to evaluate the effectiveness of the methodology and information used by management in our financial and operational decision-making. We believe that trends in our adjusted EBITDA are valuable indicators of our operating performance.
Adjusted EBITDA is a non-GAAP financial measure and should not be considered in isolation or as a substitute for financial information provided in accordance with GAAP. This non-GAAP financial measure may not be computed in the same manner as similarly titled measures used by other companies. We expect to continue to incur expenses similar to the adjusted EBITDA financial adjustments described above, and investors should not infer from our presentation of this non-GAAP financial measure that these costs are unusual, infrequent or non-recurring.
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The following table reconciles our net (loss) income, the most directly comparable GAAP financial measure, to our adjusted EBITDA:
| For the Fiscal Years Ended | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands) | June 28, 2024 | June 30, 2023 | July 1, 2022 | |||||||
| Net (loss) income | $ | (137,640) | $ | (28,335) | $ | 11,275 | ||||
| Other non-operating adjustments, net | (592) | (1,589) | 2,932 | |||||||
| Interest (expense) income, net | 33,816 | 24,106 | 5,663 | |||||||
| Income tax (benefit) provision | (51,635) | (20,207) | 7,120 | |||||||
| Depreciation | 40,369 | 43,777 | 33,150 | |||||||
| Amortization of intangible assets | 47,661 | 53,552 | 60,267 | |||||||
| Restructuring and other charges(1) | 26,170 | 6,981 | 27,445 | |||||||
| Impairment of long-lived assets | — | — | — | |||||||
| Acquisition, financing and other third party costs(2) | 4,370 | 10,019 | 13,608 | |||||||
| Fair value adjustments from purchase accounting | 710 | 356 | (2,009) | |||||||
| Litigation and settlement expense, net | 4,927 | 495 | 1,908 | |||||||
| COVID related expenses | — | 67 | 689 | |||||||
| Stock-based and other non-cash compensation expense(3) | 41,257 | 43,031 | 38,459 | |||||||
| Adjusted EBITDA | $ | 9,413 | $ | 132,253 | $ | 200,507 |
(1) Restructuring and other charges for fiscal 2024 are related to management's decision to undertake certain actions to realign our cost structure through workforce reductions and the closure of certain facilities, businesses and product lines. These charges are typically related to acquisitions and organizational redesign programs initiated as part of discrete post-acquisition integration activities. We believe these items are non-routine and may not be indicative of ongoing operating results.
(2) Acquisition, financing and other third party costs for fiscal 2024 are related to financing costs, and the conclusion of the Board's review of strategic alternatives.
(3) Effective in the first quarter of fiscal 2023, the Company increased the rate of its matching contributions from 3% to 6% of participants' eligible annual compensation and changed the form of these contributions from cash to company stock. Fiscal 2023 also includes forfeitures of $6.8 million of stock-based compensation from the Company's former CEO's resignation.
Adjusted income and adjusted EPS exclude the impact of certain items and, therefore, have not been calculated in accordance with GAAP. We believe that exclusion of these items assists in providing a more complete understanding of our underlying results and trends and allows for comparability with our peer company index and industry. These non-GAAP financial measures may not be computed in the same manner as similarly titled measures used by other companies. We use these measures along with the corresponding GAAP financial measures to manage our business and to evaluate our performance compared to prior periods and the marketplace. We define adjusted income as net income before other non-operating adjustments, amortization of intangible assets, restructuring and other charges, impairment of long-lived assets, acquisition, financing and other third party costs, fair value adjustments from purchase accounting, litigation and settlement income and expense, COVID related expenses, and stock-based and other non-cash compensation expense. The impact to income taxes includes the impact to the effective tax rate, current tax provision and deferred tax provision. Adjusted EPS expresses adjusted income on a per share basis using weighted average diluted shares outstanding.
Adjusted income and adjusted EPS are non-GAAP financial measures and should not be considered in isolation or as a substitute for financial information provided in accordance with GAAP. We expect to continue to incur expenses similar to the adjusted income and adjusted EPS financial adjustments described above, and investors should not infer from our presentation of these non-GAAP financial measures that these costs are unusual, infrequent or non-recurring.
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The following table reconciles net (loss) income and diluted (loss) earnings per share, the most directly comparable GAAP financial measures, to adjusted income and adjusted EPS:
| For the Fiscal Years Ended | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands, except per share data) | June 28, 2024 | June 30, 2023 | July 1, 2022 | |||||||||||||||||||
| Net (loss) income and diluted (loss) earnings per share | $ | (137,640) | $ | (2.38) | $ | (28,335) | $ | (0.50) | $ | 11,275 | $ | 0.20 | ||||||||||
| Other non-operating adjustments, net | (592) | (1,589) | 2,932 | |||||||||||||||||||
| Amortization of intangible assets | 47,661 | 53,552 | 60,267 | |||||||||||||||||||
| Restructuring and other charges(1) | 26,170 | 6,981 | 27,445 | |||||||||||||||||||
| Impairment of long-lived assets | — | — | — | |||||||||||||||||||
| Acquisition, financing and other third party costs(2) | 4,370 | 10,019 | 13,608 | |||||||||||||||||||
| Fair value adjustments from purchase accounting | 710 | 356 | (2,009) | |||||||||||||||||||
| Litigation and settlement expense, net | 4,927 | 495 | 1,908 | |||||||||||||||||||
| COVID related expenses | — | 67 | 689 | |||||||||||||||||||
| Stock-based and other non-cash compensation expense(3) | 41,257 | 43,031 | 38,459 | |||||||||||||||||||
| Impact to income taxes(4) | (26,621) | (27,776) | (32,309) | |||||||||||||||||||
| Adjusted (loss) income and adjusted (loss) earnings per share | $ | (39,758) | $ | (0.69) | $ | 56,801 | $ | 1.00 | $ | 122,265 | $ | 2.19 | ||||||||||
| Diluted weighted-average shares outstanding | 57,738 | 56,874 | 55,901 |
(1) Restructuring and other charges for fiscal 2024 are related to management's decision to undertake certain actions to realign our cost structure through workforce reductions and the closure of certain facilities, businesses and product lines. These charges are typically related to acquisitions and organizational redesign programs initiated as part of discrete post-acquisition integration activities. We believe these items are non-routine and may not be indicative of ongoing operating results.
(2) Acquisition, financing and other third party costs for fiscal 2024 are related to financing costs, and the conclusion of the Board's review of strategic alternatives.
(3) Effective in the first quarter of fiscal 2023, the Company increased the rate of its matching contributions from 3% to 6% of participants' eligible annual compensation and changed the form of these contributions from cash to company stock. Fiscal 2023 also includes forfeitures of $6.8 million of stock-based compensation from the Company's former CEO's resignation.
(4) Impact to income taxes is calculated by recasting income before income taxes to include the add-backs involved in determining adjusted income and recalculating the income tax provision using this adjusted income from operations before income taxes. The impact to income taxes includes the impact to the effective tax rate, current tax provision and deferred tax provision.
Free cash flow, a non-GAAP measure for reporting cash flow, is defined as cash provided by operating activities less capital expenditures for property and equipment, which includes capitalized software development costs. We believe free cash flow provides investors with an important perspective on cash available for investments and acquisitions after making capital investments required to support ongoing business operations and long-term value creation. We believe that trends in our free cash flow can be valuable indicators of our operating performance and liquidity.
Free cash flow is a non-GAAP financial measure and should not be considered in isolation or as a substitute for financial information provided in accordance with GAAP. This non-GAAP financial measure may not be computed in the same manner as similarly titled measures used by other companies. We expect to continue to incur expenditures similar to the free cash flow adjustment described above, and investors should not infer from our presentation of this non-GAAP financial measure that these expenditures reflect all of our obligations which require cash.
The following table reconciles cash provided by (used in) operating activities, the most directly comparable GAAP financial measure, to free cash flow:
| For the Fiscal Years Ended | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| (In thousands) | June 28, 2024 | June 30, 2023 | July 1, 2022 | |||||||
| Net cash provided by (used in) operating activities | $ | 60,382 | $ | (21,254) | $ | (18,869) | ||||
| Purchase of property and equipment | (34,291) | (38,796) | (27,656) | |||||||
| Free cash flow | $ | 26,091 | $ | (60,050) | $ | (46,525) |
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CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES
We have identified the policies discussed below as critical to understanding our business and our results of operations. The impact and any associated risks related to these policies on our business operations are discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations where such policies affect our reported and expected financial results. We believe the following critical accounting policies to be those most important to the portrayal of our financial position and results of operations and those that require the most subjective judgment.
REVENUE RECOGNITION
We recognize revenue at a point in time or over time as the performance obligations are met. A performance obligation is a promise in a contract to transfer a distinct good or service to the customer. Contracts with distinct performance obligations recognized at a point in time, with or without an allocation of the transaction price, totaled 45% and 44% of revenues for the fiscal years ended June 28, 2024 and June 30, 2023, respectively. Total revenue recognized under contracts over time was 55% and 56% of revenues for the fiscal years ended June 28, 2024 and June 30, 2023, respectively.
Revenue recognized at a point in time generally relates to contracts that include a combination of components, modules and sub-assemblies, integrated subsystems and related system integration or other services. Revenue is recognized at a point in time for these products and services (versus over time recognition) due to the following: (i) customers are only able to consume the benefits provided by us upon completion of the product or service; (ii) customers do not control the product or service prior to completion; and (iii) we do not have an enforceable right to payment at all times for performance completed to date. Accordingly, there is little judgment in determining when control of the good or service transfers to the customer, and revenue is recognized upon shipment (for goods) or completion (for services).
For contracts with multiple performance obligations, the transaction price is allocated to each performance obligation using the standalone selling price of each distinct good or service in the contract. Standalone selling prices of our goods and services are generally not directly observable. Accordingly, the primary method used to estimate standalone selling price is the expected cost plus a margin approach, under which we forecast the expected costs of satisfying a performance obligation and then add an appropriate margin for that distinct good or service. The objective of the expected cost plus a margin approach is to determine the price at which we would transact if the product or service were sold by us on a standalone basis. Our determination of the expected cost plus a margin approach involves the consideration of several factors based on the specific facts and circumstances of each contract. Specifically, we consider the cost to produce the deliverable, the anticipated margin on that deliverable, the selling price and profit margin for similar parts, our ongoing pricing strategy and policies, often based on the price list established and updated by management on a regular basis, the value of any enhancements that have been built into the deliverable and the characteristics of the varying markets in which the deliverable is sold.
Revenue is recognized over time (versus point in time recognition) for long-term contracts with development, production and service activities where the performance obligations are satisfied over time. These over time contracts involve the design, development, manufacture, or modification of complex modules and sub-assemblies or integrated subsystems and related services. Revenue is recognized over time, given: (i) our performance creates or enhances an asset that the customer controls as the asset is created or enhanced; or (ii) our performance creates an asset with no alternative use to us and (iii) we have an enforceable right to payment for performance completed to date. We consider the nature of these contracts and the types of products and services provided when determining the proper accounting for a particular contract. These contracts include both fixed-price and cost reimbursable contracts. Our cost reimbursable contracts typically include cost-plus fixed fee and time and material (“T&M”) contracts. We consider whether contracts should be combined or segmented, and based on this assessment, we combine closely related contracts when all the applicable criteria are met. The combination of two or more contracts requires judgment in determining whether the intent of entering into the contracts was effectively to enter into a single contract, which should be combined to reflect an overall profit rate. Similarly, we may separate an arrangement, which may consist of a single contract or group of contracts, with varying rates of profitability, only if the applicable criteria are met. Judgment also is involved in determining whether a single contract or group of contracts may be segmented based on how the arrangement and the related performance criteria were negotiated. The decision to combine a group of contracts or segment a contract could change the amount of revenue and gross profit recorded in a given period. For all types of contracts, we recognize anticipated contract losses as soon as they become known and estimable. These losses are recognized in advance of contract performance and as of June 28, 2024, approximately $4.6 million of these costs were in Accrued expenses on our Consolidated Balance Sheet.
For over time contracts, we typically leverage the input method, using a cost-to-cost measure of progress. We believe that this method represents the most faithful depiction of our performance because it directly measures value transferred to the customer. Contract estimates and estimates of any variable consideration are based on various assumptions to project the outcome of future events that may span several years. These assumptions include: the amount of time to complete the contract, including the assessment of the nature and complexity of the work to be performed; the cost and availability of materials; the availability of subcontractor services and materials; and the availability and timing of funding from the customer. We bear the
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risk of changes in estimates to complete on a fixed-price contract which may cause profit levels to vary from period to period. For cost reimbursable contracts, we are reimbursed periodically for allowable costs and are paid a portion of the fee based on contract progress. In the limited instances where we enter into T&M contracts, revenue recognized reflects the number of direct labor hours expended in the performance of a contract multiplied by the contract billing rate, as well as reimbursement of other direct billable costs. For T&M contracts, we elected to use a practical expedient permitted by ASC 606 whereby revenue is recognized in the amount for which we have a right to invoice the customer based on the control transferred to the customer. For over time contracts, we recognize anticipated contract losses as soon as they become known and estimable.
Accounting for contracts recognized over time requires significant judgment relative to estimating total contract revenues and costs, in particular, assumptions relative to the amount of time to complete the contract, including the assessment of the nature and complexity of the work to be performed. Our estimates are based upon the professional knowledge and experience of our engineers, program managers and other personnel, who review each over time contract monthly to assess the contract’s schedule, performance, technical matters and estimated cost at completion. Changes in estimates are applied retrospectively and when adjustments in estimated contract costs are identified, such revisions may result in current period adjustments to earnings applicable to performance in prior periods.
We generally do not provide our customers with rights of product return other than those related to assurance warranty provisions that permit repair or replacement of defective goods over a period of 12 to 36 months. We accrue for anticipated warranty costs upon product shipment. We do not consider activities related to such assurance warranties, if any, to be a separate performance obligation. We offer separately priced extended warranties which generally range from 12 to 36 months that are treated as separate performance obligations. The transaction price allocated to extended warranties is recognized over time in proportion to the costs expected to be incurred in satisfying the obligations under the contract.
On over time contracts, the portion of the payments retained by the customer is not considered a significant financing component because most contracts have a duration of less than one year and payment is received as progress is made. Many of our over time contracts have milestone payments, which align the payment schedule with the progress towards completion on the performance obligation. On some contracts, we may be entitled to receive an advance payment, which is not considered a significant financing component because it is used to facilitate inventory demands at the onset of a contract and to safeguard us from the failure of the other party to abide by some or all of their obligations under the contract.
We define service revenues as revenue from activities that are not associated with the design, development, production, or delivery of tangible assets, software or specific capabilities sold by us. Examples of our service revenues include: analyst services and systems engineering support, consulting, maintenance and other support, testing and installation. We combine our product and service revenues into a single class as services revenues are less than 10 percent of total revenues.
INVENTORY VALUATION
We value our inventory at the lower of cost (first-in, first-out) or its net realizable value. We write down inventory for excess and obsolescence based upon assumptions about future demand, product mix and possible alternative uses. Actual demand, product mix and alternative usage may be higher or lower resulting in variations in on our gross margin.
GOODWILL, INTANGIBLE ASSETS AND LONG-LIVED ASSETS
We evaluate our goodwill for impairment annually in the fourth quarter and in any interim period in which events or circumstances arise that indicate our goodwill may be impaired. Indicators of impairment include, but are not limited to, a significant deterioration in overall economic conditions, a decline in our market capitalization, the loss of significant business, significant decreases in funding for our contracts, or other significant adverse changes in industry or market conditions.
We test goodwill for impairment at the reporting unit level. Goodwill impairment guidance provides entities an option to perform a qualitative assessment (commonly known as “step zero”) to determine whether further impairment testing is necessary before performing the two-step test. The qualitative assessment requires significant judgments by management about macro-economic conditions including our operating environment, industry and other market considerations, entity-specific events related to financial performance or loss of key personnel, and other events that could impact the reporting unit. If we conclude that further testing is required, the impairment test is completed. Step one compares the fair value of the reporting unit with its carrying value, including goodwill. If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the amount by which the carrying value exceeds the fair value is recognized as an impairment loss. We estimate the fair value of our reporting units using the income approach based upon a discounted cash flow ("DCF") model. The income approach requires the use of many assumptions and estimates including future revenues, expenses, capital expenditures, and working capital, as well as discount factors and income tax rates. The discount rates used in the DCF model were based on a weighted-average cost of capital (“WACC”) determined from relevant market comparisons, adjusted upward for specific reporting unit risks (primarily the uncertainty of achieving projected operating cash flows). A terminal value growth rate was applied to the final year of the projected period, which reflects our estimate of stable, perpetual growth. We then calculated a present value of the respective cash flows for each reporting unit to arrive at an estimate of fair value under the income approach. Finally, we
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compared the estimates of our fair values to our total market capitalization to assess the reasonableness of our reporting units’ combined determined fair value.
Key assumptions of the forecast model over expected revenues, expenses, capital expenditures, and working capital, as well as discount factors and income tax rates are subject to a high degree of judgement and complexity. We make every effort to forecast future financial performance as accurately as possible with the information available at the time the forecast is developed. These assumptions were reviewed by management and compared to assumptions used in prior analyses and were deemed reasonable. There were no material changes in the key assumptions during the periods presented.
There are inherent uncertainties and management judgement required in these determinations and risks to the forecast included but are not limited to program/product execution, transition from development to production programs, industry related make-buy decisions, and global market conditions. Changes in these estimates and assumptions could materially affect the results of our tests for goodwill impairment. We continuously monitor and evaluate relevant events and circumstances that could unfavorably impact our significant assumptions used in testing goodwill, including macroeconomic conditions, industry and market considerations, financial performance and expectations of projected financial performance and cash flows, and changes in our stock price in relation to the carrying value of its reporting units, among other relevant factors. It is possible that future changes in such circumstances, or in the inputs and assumptions used in estimating the fair value of our reporting units, could require us to perform an interim impairment assessment and record an impairment charge. In addition, we use the market approach, which compares the reporting unit to publicly traded companies and transactions involving similar businesses, to support the conclusions of the income approach.
The Company utilizes the management approach for determining its operating segment in accordance with ASC 280. There has been no change to the Company's conclusion of one operating and reportable segment in fiscal 2024.
In accordance with FASB ASC 350, Intangibles-Goodwill and Other (“ASC 350”), the Company determines its reporting units based upon whether discrete financial information is available, if management regularly reviews the operating results of the component, the nature of the products offered to customers and the market characteristics of each reporting unit. A reporting unit is considered to be an operating segment or one level below an operating segment also known as a component. Component level financial information is reviewed by management across two divisions: Microelectronics, and Mission Systems. Accordingly, these were determined to be the Company's reporting units.
As part of our annual goodwill impairment testing, we utilized a discount rate for each of our reporting units, as defined by ASC 350, that we believe represents the risks that our businesses face, considering their sizes, the current economic environment, and other industry data we believe is appropriate. The discount rates for Microelectronics and Mission Systems were 9.0%, and 8.5%, respectively. The annual testing indicated that the Mission Systems reporting unit had an estimated fair value in excess of their carrying value of 5.0% and the Microelectronics reporting unit had an estimated fair value that substantially exceeded its carrying value. The carrying value of goodwill for the Mission Systems reporting unit was $622 million as of June 28, 2024. We concluded that the Mission Systems reporting unit's goodwill was not impaired. In order to evaluate the sensitivity of the estimated fair value for Mission Systems, we assessed an increase of 1.0% in the WACC under the DCF approach would have a material impact to the Mission Systems reporting unit's fair value determination. If there are adverse trends in the Mission Systems reporting unit's expected future operating results, business plans, economic projections, anticipated future cash flows, business trends, and our market capitalization, then it could result in the carrying value of the Mission Systems reporting unit exceeding its estimated fair value and impairment charges.
We also review finite-lived intangible assets and long-lived assets when indications of potential impairment exist, such as a significant reduction in undiscounted cash flows associated with the assets. Should the fair value of our finite-lived intangible assets or long-lived assets decline because of reduced operating performance, market declines, or other indicators of impairment, a charge to operations for impairment may be necessary.
INCOME TAXES
The determination of income tax expense requires us to make certain estimates and judgments concerning the calculation of deferred tax assets and liabilities, as well as the deductions and credits that are available to reduce taxable income. We recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been included in our consolidated financial statements. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using enacted tax rates for the year in which the differences are expected to reverse.
In evaluating our ability to recover deferred tax assets, we consider all available positive and negative evidence, including our past operating results, our forecast of future earnings, future taxable income and tax planning strategies. The assumptions utilized in determining future taxable income require significant judgment. We record a valuation allowance against deferred tax assets if, based upon the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. If it becomes more likely than not that a tax asset will be used for which a reserve has been provided, we reverse the
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related valuation allowance. If our actual future taxable income by tax jurisdiction differs from estimates, additional allowances or reversals of reserves may be necessary.
We use a two-step approach to recognize and measure uncertain tax positions. First, the tax position must be evaluated to determine the likelihood that it will be sustained upon external examination. If the tax position is deemed more-likely-than-not to be sustained, the tax position is then assessed to determine the amount of benefit to recognize in the financial statements. The amount of the benefit that may be recognized is the largest amount that has a greater than 50% likelihood of being realized upon ultimate settlement. We reevaluate our uncertain tax positions on a quarterly basis and any changes to these positions as a result of tax audits, tax laws or other facts and circumstances could result in additional charges to operations.
BUSINESS COMBINATIONS
We utilize the acquisition method of accounting for business combinations and allocate the purchase price of an acquisition to the various tangible and intangible assets acquired and liabilities assumed based on their estimated fair values. We primarily establish fair value using the income approach based upon a discounted cash flow model. The income approach requires the use of many assumptions and estimates including future revenues and expenses, as well as discount factors and income tax rates. Other estimates include:
•estimated step-ups for the over time contracts fixed assets, leasehold interests and inventory;
•estimated fair values of intangible assets; and
•estimated income tax assets and liabilities assumed from the acquiree.
While we use our best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the business acquisition date, our estimates and assumptions are inherently uncertain and subject to refinement. As a result, during the purchase price allocation period, which is generally one year from the business acquisition date, we record adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill. For changes in the valuation of intangible assets between preliminary and final purchase price allocation, the related amortization is adjusted in the period it occurs. Subsequent to the purchase price allocation period any adjustment to assets acquired or liabilities assumed is included in operating results in the period in which the adjustment is determined.
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
See Note B to consolidated financial statements (under the caption “Recently Issued Accounting Pronouncements”).
RECENTLY ADOPTED ACCOUNTING PRONOUNCEMENTS
See Note B to consolidated financial statements (under the caption “Recently Adopted Accounting Pronouncements”).