Item 1.
Business
CPI International Holding LLC (“Holding LLC”) owns all of the outstanding common stock of CPI International Holding Corp., headquartered in Palo Alto, California (“Parent”), the parent company of CPI International, Inc. (“CPII”). CPII, in turn, owns all of the outstanding equity interests of Communications & Power Industries LLC (“CPI”) and Communications & Power Industries Canada Inc. (“CPI Canada”), CPII’s main operating subsidiaries. As used herein, unless the context indicates or otherwise requires, the terms “we,” “us,” “our” and the “Company” refer to Parent, its consolidated subsidiaries and, where the context so requires, its direct and indirect parent companies. The Veritas Capital Fund IV, L.P., The Veritas Capital Fund III, L.P. and their affiliates, including CICPI Holdings LLC (collectively, “Veritas Capital”) and certain members of CPII’s management beneficially own shares of Parent’s common stock indirectly through their holdings in Holding LLC. Holding LLC, Parent and CPII are holding companies with no material assets or operations other than their respective direct or indirect equity interests in CPI and CPI Canada and activities related thereto.
Our Company
We are a provider of microwave, radio frequency (“RF”), power and control products for applications in the defense, communications, medical, industrial and scientific industries. We develop, manufacture and globally distribute components and subsystems used in the generation, amplification, transmission and reception of microwave signals for a wide variety of systems. These systems include radar, electronic warfare and communications (satellite and point-to-point) systems for military and commercial applications, specialty products used for medical diagnostic imaging and the treatment of cancer, as well as microwave and RF energy generating products for various industrial and scientific pursuits.
We have an extensive portfolio of more than 4,500 products that includes a wide range of electron device products, consisting of vacuum electron devices (“VEDs”), solid-state devices, medical x-ray generators and various electronic power supply and control equipment, as well as satellite communications (“satcom”) amplifiers, large-aperture antennas, advanced antenna technology and advanced composite radomes.
We estimate that our products are currently installed on more than 125 United States defense systems and more than 180 commercial systems. Both defense and commercial applications require the generation, control and transmission of high-power and high-frequency microwave and RF signals for which electron device products are the most efficient technology. Our products are elements of U.S. and foreign military programs and platforms, including numerous airborne, ship-borne and ground-based platforms. In addition to our strong presence in defense applications, we have successfully applied our key technologies to commercial end markets, including communications, medical, industrial and scientific applications, which provide us with a diversified base of sales. Revenues during fiscal year 2016 were split approximately evenly between defense and commercial applications.
We believe that the majority of our VED products are consumable with an average life of between three and seven years, and once they are installed in original equipment, they generate recurring sales of spares and repairs. We regularly work with our customers, often utilizing customer-funded research and development programs to create and upgrade customized products with enhanced bandwidth, power and reliability. We estimate that approximately 31% and 34% of our total sales for fiscal years 2016 and 2015, respectively, were generated from sales of spares and repairs, including upgraded replacements for existing products, providing us with a relatively stable business that is less vulnerable to dramatic shifts in market conditions. In addition, in fiscal years 2016 and 2015, we generated approximately 62% and 64% of our total sales, respectively, from products for which we believe, based on information we collect during the ordering process, that we were the only supplier solicited by the applicable customers to provide such products.
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On September 17, 2015, we completed our purchase of the outstanding stock of ASC Signal Holdings Corporation (“ASC Signal”), a Delaware corporation, for a payment of approximately $50.7 million in cash consideration, net of $2.2 million cash acquired, including a post-closing adjustment based on a determination of ASC Signal’s closing net working capital of $0.4 million paid in the first quarter of fiscal year 2016. ASC Signal designs and builds advanced satellite communications, radar and high-frequency antennas and controllers used in commercial and government satellite communications, terrestrial communications, imagery and data transmission, and radar and intelligence applications. The addition of ASC Signal’s products and technology broadens our existing offerings for communications and radar customers to now include one of the industry’s broadest portfolios of high-performance, large-aperture fixed and mobile antennas. For financial information about our ASC Signal business combination, see Note 3, “Business Combinations,” to the accompanying consolidated financial statements.
We are organized into eight divisions. We operate from a total of 12 manufacturing and engineering facilities, 11 in North America and one in Australia:
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Palo Alto, California (Microwave Power Products Division and Satcom Division),
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Beverly, Massachusetts (Beverly Microwave Division),
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Georgetown, Ontario, Canada (Satcom Division and Communications & Medical Products (“CMP”) Division),
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Lisle, Illinois (Satcom Division),
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Boalsburg, Pennsylvania (CMP Division),
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Woodland, California (Econco Division),
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Camarillo, California (Malibu Division),
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Clinton and Stow, Massachusetts (Radant Technologies Division),
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Whitby, Ontario, Canada (ASC Signal Division),
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Plano, Texas (ASC Signal Division), and
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Adelaide, Australia (CMP Division).
We sell our products and provide service to customers globally through our internal sales, marketing and service force of 180 professionals and 50 external sales organizations. Products are sold directly to the U.S. Department of Defense (“DoD”), foreign military services and commercial customers, as well as to original equipment manufacturers (“OEMs”) and systems integrators for ultimate sales to those customers. The U.S. Government is our only customer that accounted for more than 10% of our sales in fiscal year 2016. Approximately 42%, 40% and 42% of our sales in our 2016, 2015 and 2014 fiscal years, respectively, were made to the U.S. Government, either directly or indirectly through prime contractors or subcontractors.
For the fiscal year ended September 30, 2016, we generated total sales of $494.6 million, net income of $5.7 million and Adjusted EBITDA of $86.1 million. Adjusted EBITDA represents EBITDA (earnings before net interest expense, provision for income taxes, depreciation and amortization), further adjusted to exclude stock-based compensation expenses, certain refinancing expenses, acquisition-related and non-ordinary course professional expenses, Veritas Capital management fees and purchase accounting expenses. See Item 6, “Selected Financial Data,” for additional information regarding Adjusted EBITDA.
Markets
We serve five end markets: the radar and electronic warfare (or defense), communications, medical, industrial and scientific markets. Certain of our products are sold in more than one end market depending on the specific power and frequency requirements of the application and the physical operating conditions of the end product. End-use applications of these systems include:
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the transmission and reception of radar signals for navigation and location and weather prediction;
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the transmission and reception of deception signals for electronic countermeasures;
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the transmission, reception and amplification of voice, data (including IP) and video signals for broadcasting, data links, Internet, flight testing, weather detection and other types of commercial and military communications;
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the provision of power and control for medical diagnostic imaging;
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the generation of microwave energy for radiation therapy in the treatment of cancer; and
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the generation of microwave energy for various industrial and scientific applications.
Our end markets are described below.
Radar and Electronic Warfare Market (Defense)
Approximately half of our product sales for fiscal year 2016 were for U.S. and foreign government and military end use. We are one of three companies in the U.S. that have the facilities and expertise to produce a broad range of high-power microwave products customized to the demanding specifications required for advanced military applications.
We supply products used in various types of military radar systems, including search, fire control and tracking radar systems, as well as weather radar systems. In radar systems, our electron device products are used to generate or amplify electromagnetic energy pulses, which are transmitted via the radar system’s antenna through the air until they strike a target. The return “echo” is read and analyzed by the receiving portion of the radar system, which then enables the user to locate and identify the target. Our electron device products have been an integral element of radar systems for more than six decades. In addition, we supply radomes for radar applications, primarily on aircraft (either nose or belly-mounted), as well as on surface ships and submarines. Our antennas are used in radar systems for weather monitoring and prediction applications and for air-traffic control applications.
We supply microwave power amplifiers and radomes for electronic warfare programs. Electronic warfare systems provide protection for ships, aircraft and high-value land targets against radar-guided weapons by interfering with, deceiving or disabling the threats. Electronic warfare systems include onboard electronic equipment, pods that attach under aircraft wings and expendable decoys. Within an electronic warfare system, our components amplify low-level incoming signals received from enemy radar or enemy communications systems and amplify or modify those signals to enable the electronic warfare system either to jam or deceive the threat. We believe that we are a leading provider of microwave power sources for electronic warfare systems, having sold thousands of devices for those systems and having a sole-provider position in products for certain high-power phased array systems and expendable decoys. Electronic warfare programs also include devices and subsystems being developed or supplied for high-power microwave applications, such as systems to disable and destroy improvised explosive devices (“IEDs”) and Active Denial (a system that uses microwave energy to deter unfriendly personnel). Many of the electronic warfare programs on which we are a qualified supplier are well-entrenched current programs for which we believe that there is ongoing demand.
Our radar and electronic warfare products include microwave and power grid power sources, microwave amplifiers, solid-state amplifiers, receiver protectors, multifunction integrated microwave assemblies and radomes, as well as complete transmitter subsystems consisting of the microwave amplifier, power supply and control system. Our product offering in the radar and electronic warfare market also includes advanced antenna systems for radar and radar simulators. Our products are used in airborne, unmanned aerial vehicles (“UAVs”), ground, shipboard and submarine radar and electronic warfare systems. We believe that we are a leading provider of power grid and microwave power sources for government radar and electronic warfare applications, with an installed base of products on more than 125 systems and a sole-provider position in numerous landmark programs. Key defense platforms on which we provide components include the Aegis radar systems; Phalanx, Automatic Radar Periscope Detection and Discrimination (“ARPDD”), Air Traffic Navigation, Integration and Coordination System (“ATNAVICS”) and Hawk radar systems; SIRFC on-board jamming system; APN-245 Automatic Carrier Landing System (“ACLS”); and EA-18G aircraft; and many of the U.S. military radar and electronic warfare systems in service.
Our sales in the radar and electronic warfare market, which we also call our defense market, were $186.3 million, $181.2 million and $181.9 million in fiscal years 2016, 2015 and 2014, respectively. On average for the past three fiscal years, approximately 52% of our sales in the radar and electronic warfare market have been generated from recurring sales of replacements, spares and repairs, including upgraded replacements for existing products.
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As a provider of products for U.S. Government and military end use, we are subject to certain risks particular to such activities. For example, the U.S. Government has the ability to terminate or modify our contracts and to audit our contract-related costs and fees. In addition, we are subject to additional laws and regulations as a U.S. Government contractor as well as possible false claim suits and “qui tam” or “whistleblower” suits. We also are a sole provider of some business to the U.S. Government that may be subject to competitive bidding in the future. For additional information regarding these risks, see “Risk Factors - Risks Relating To Our Business - We are subject to risks particular to companies supplying defense-related equipment and services to the U.S. Government. The realization of any of these risks could cause a loss of or decline in our sales to the U.S. Government.”
Medical Market
Within the medical market, we focus on diagnostic and treatment applications. For diagnostic applications, we provide products for medical imaging applications, such as x-ray imaging, magnetic resonance imaging (“MRI”) and other applications. For these applications, we provide x-ray generators, subsystems, software and user interfaces, including state-of-the-art, high-efficiency, compact power supplies and modern operator consoles for diagnostic imaging.
X-ray generators are used to generate and control the electrical energy being supplied to an x-ray VED and, therefore, control the dose of radiation delivered to the patient during an x-ray imaging procedure. In addition, these x-ray generators include a user interface to control the operation of the equipment, including exposure times and the selection of the anatomic region of the body to be examined. These generators are interfaced with, and often power and control, auxiliary devices, such as patient positioners, cameras and automatic exposure controls, to synchronize the x-ray examination with this other equipment.
For treatment applications, we provide klystron VEDs and electron guns for high-end radiation therapy machines. Klystrons provide the microwave energy to accelerate a beam of energy toward a cancerous tumor.
Sales in the medical market were $59.6 million, $68.1 million and $73.0 million in fiscal years 2016, 2015 and 2014, respectively.
The use of high-power microwave devices in radiation treatment applications has remained strong in the last several years as major suppliers of therapy equipment have introduced a number of key technological advances that enable their equipment to treat a greater number of oncology-related problems. We believe that this trend will drive continued stable demand for our products.
For many years, we have been the sole provider of klystron high-power microwave devices to Varian Medical Systems Inc.’s oncology systems division for use in its High Energy Clinac® radiation therapy machines for the treatment of cancer, and we expect this relationship to continue. We also provide x-ray generators for use on the On-Board Imager accessory for medical linear accelerators. The On-Board Imager accessory is an automated system for image-guided radiation therapy that uses high-resolution x-ray images to pinpoint tumor sites. More than 7,000 Varian Medical Systems’ medical linear accelerators for cancer radiotherapy are in service around the world, delivering an estimated more than 50 million treatments annually.
The market for our x-ray generators and associated products is broad, ranging from dealers who buy only a few generators per year, up to large OEMs who buy hundreds per year. We sell our x-ray generators worldwide and have been growing both our geographic presence and our product portfolio. We have introduced new products, including mobile x-ray generators and “Energy Assist” generators, to assist customers in their migration from film-based radiology systems to digital radiology systems. We believe that we are one of the leading independent suppliers of x-ray generators in the world, and we believe that this market provides continued long-term growth opportunities for us.
We have traditionally focused on hospital, or “mid- to high-end,” applications, and we believe that we have become a premier supplier to this part of the market. There also exists substantial demand for “lower-end” applications, and we have families of products that allow us to participate in this part of the market.
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Communications Market
In the communications market, we provide microwave and millimeter-wave amplifiers and antenna systems for commercial and military communications links for broadcast, video, voice and data transmission. We also provide data link antenna terminals and radomes for military communications applications. Our sales in the communications market were $210.2 million, $165.8 million and $181.2 million in fiscal years 2016, 2015 and 2014, respectively. The communications market is the most dynamic of our end markets, and sales can vary significantly from quarter to quarter due, in part, to the timing and size of our shipments for specific programs during a particular quarter, including, for example, infrastructure programs for commercial direct-to-home or broadband satellite communications applications and military satellite communications programs. Approximately 48% of our total communications sales in fiscal year 2016 were for military communications purposes.
In the past few years, we have expanded our portfolio of communications products organically and through a series of acquisitions. In October 2013, we acquired Radant Technologies, Inc. (“Radant”), which manufactures advanced composite radomes, reflector antennas and structures for defense and communications markets. In September 2015, we acquired ASC Signal, which manufactures advanced satellite, radar and high-frequency antennas for broadcast, government, military and enterprise communications applications.
Our commercial communications programs include satellite, terrestrial broadcast and over-the-horizon applications. Our military communications programs include satellite, data link and over-the-horizon communications applications. For commercial and military communications applications, our VED and solid-state products amplify and transmit signals within an overall communications system:
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Ground-based satellite communications transmission systems use our products, including our satellite earth station antennas, to enable the transmission of microwave signals, carrying either analog or digital information, from a ground-based station to the transponders on an orbiting satellite by boosting the power of the low-level original signal to desired power levels for transmission over hundreds of miles to tens of thousands of miles to the satellite. The signal is received by the satellite transponder, converted to the downlink frequency and retransmitted to a ground-based receiving station.
The majority of our communications products are sold into the satellite communications market. We estimate that we have a worldwide installed base of approximately 50,000 amplifiers. We believe that we are a leading producer of power amplifiers, amplifier subsystems and high-power microwave devices for satellite uplinks, and that we offer one of the industry’s most comprehensive lines of satellite communications amplifiers, with offerings for virtually every currently applicable frequency and power requirement for both fixed and mobile satellite communications applications in the military and commercial arena. We believe that our technological expertise, our well-established worldwide service network and our ability to design and manufacture both the fully integrated amplifier and either the associated high-power microwave device or the solid-state RF device allow us to provide a superior overall service to our customers.
We believe that satellite communication will be a critical element for supplying real time, high data-rate communications, intelligence and battlefield information to the front-line soldier. We currently provide satellite communication amplifiers for military systems, such as the Navy Multiband Terminal (“NMT”), U.S. Special Operations Forces Deployable Node-Family of Terminals (“FoT”), Warfighter Information Network - Tactical (“WIN-T”), U.S. Army’s Deployable Ku-band Earth Terminals (“DKET”), U.S. Navy’s Commercial Broadband Satellite Program (“CBSP”) and Mobile User Objective System (“MUOS”) platforms. We also supply wideband satellite communications radomes for surface ships, aircraft and submarine platforms, and the Canadian Department of National Defence’s Mercury Global Project and Maritime Satellite Communications Upgrade (“MSCU”). We provide a wide variety of antenna systems worldwide for satellite communications applications.
We are participating in satellite communications growth areas, including:
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amplifiers and antennas for Ka-band and V-band applications, which are key enabling technologies for the growing network of high throughput satellite (“HTS”) systems, one of the major satellite communications growth areas for both commercial and military applications;
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the growing worldwide use of satellites to deliver conventional and high-definition television for broadcast and direct-to-home applications;
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the use of satellite communications for broadband data communications;
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specialized amplifiers for medium earth orbit (“MEO”) satellite constellations;
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specialized amplifiers and antennas for the emerging low earth orbit (“LEO”) satellite constellations;
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specialized amplifiers and antennas for the maritime, mobile and military communications markets; and
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high-end radomes, amplifiers and antennas for in-flight entertainment on commercial aircraft and communications connectivity on commercial and military aircraft.
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Terrestrial broadcast systems use our products to amplify and transmit signals, including television and radio signals at very high frequencies (“VHFs”) and ultra high frequencies (“UHFs”), or other signals at a variety of frequencies. Through the years, we have established a customer base of several thousand customers in the broadcast market, providing us with opportunities for replacement, spares, upgrade and rebuilding business.
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Data link communications systems use our products to transmit and receive real-time command and control, intelligence, surveillance and reconnaissance (“ISR”) data between airborne platforms, including UAVs and manned airborne platforms, and their associated ground-based and ship-based terminals via high-bandwidth digital data links. Our products are on the airborne and ground nodes of the tactical common data link (“TCDL”) network for various platforms. We currently provide the data links for several major UAV platforms.
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Over-the-horizon (also referred to as “troposcatter”) systems use our high-power amplifiers, traveling wave tubes and advanced antennas to send a signal through the atmosphere, bouncing the signal off the troposphere, the lowest atmospheric layer, and enabling receipt of the signal tens of miles to hundreds of miles away. These systems transmit voice, video and data signals without requiring the use of a satellite, providing an easy-to-install, relocatable and cost-efficient alternative to satellite-based communications.
Industrial Market
The industrial market includes applications for a wide range of systems used for material processing, instrumentation and voltage generation. We offer a number of specialized product lines to address this diverse market. We produce fully integrated amplifiers that include the associated high-power microwave devices used in instrumentation applications for electromagnetic interference and compatibility testing. Our products are also installed in the power supply modules of industrial equipment using RF energy to perform pipe and plastic welding, textile drying and semiconductor wafer fabrication. We have a line of industrial RF generators and magnetrons that use high-power microwave technology for various industrial heating, cooking and material processing applications. Our magnetrons and transmitters are also used in cargo screening applications. Our sales in the industrial market were $27.4 million, $22.7 million and $24.6 million in fiscal years 2016, 2015 and 2014, respectively.
Scientific Market
The scientific market consists primarily of equipment used in reactor fusion programs and accelerators for the study of high-energy particle physics, referred to as “Big Science.” Generally, in scientific applications, our products are used to generate high levels of microwave or RF energy to accelerate a beam of electrons in order to study the atom and its elementary particles. Our products are also used in research related to the generation of electricity from fusion reactions. Our sales in the scientific market were $11.1 million, $9.9 million and $14.6 million in fiscal years 2016, 2015 and 2014, respectively. Sales in this market are historically one-time projects and can fluctuate significantly from period to period.
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Geographic Markets
We sell our products in approximately a hundred countries. In fiscal year 2016, sales to customers in the U.S., Asia Pacific and Europe accounted for approximately 67%, 15% and 13% of our total sales, respectively. No country other than the U.S. accounted for more than 10% of our sales in fiscal year 2016. See “Sales, Marketing and Service.” For financial information about geographic areas, see Note 13, “Segments, Geographic and Customer Information,” to the accompanying consolidated financial statements.
Products
We have an extensive portfolio of more than 4,500 products that is comprised of a wide range of electron device products, including microwave and power grid VEDs and solid-state power devices, in addition to products, such as:
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satellite communications amplifier subsystems based on both VED and solid-state technology;
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radar and electronic warfare subsystems;
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specialized antenna subsystems;
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advanced composite radomes, reflector antennas and structures;
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solid-state integrated microwave assemblies;
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medical x-ray generators and control systems;
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modulators and transmitters; and
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various electronic power supply and control equipment and devices.
Additionally, we have developed complementary, more highly integrated subsystems that contain additional components for medical imaging and for satellite communications applications. These integrated subsystems generally sell for higher prices.
Generally, our products are used to:
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generate or amplify (multiply) various forms of electromagnetic energy (these products are generally referred to as VEDs, electron devices, solid-state devices or simply as devices);
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transmit, direct, measure and control electromagnetic energy;
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provide the voltages and currents to power and control devices that generate electromagnetic energy; or
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provide some combination of the above functions.
VEDs were initially developed for defense applications but have since been applied to many commercial markets. We use tailored variations of this key technology to address the different frequency and power requirements in each of our target markets. Generally our VED products derive from, or are enhancements to, the original VED technology on which our company was founded. Most of our other products were natural offshoots of the original VED technology and were developed in response to the opportunities and requirements in the market for more fully integrated products and services. The type of device selected for a specific application is based on the operating parameters required by the system.
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We sell several categories of VEDs, including:
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Klystrons and gyrotrons: Klystrons are typically high-power VEDs that operate over a narrow range of frequencies, with power output ranges from hundreds of watts to megawatts and frequencies from 500 kilohertz (KHz) to over 30 GHz. We produce and manufacture klystrons for a variety of radar, communications, medical, industrial and scientific applications. Gyrotron oscillators and amplifiers operate at very high power and VHFs. Power output of one megawatt has been achieved at frequencies greater than 100 GHz. These devices are used in areas such as fusion research, electronic warfare and high-resolution radar.
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Helix traveling wave tubes: Helix traveling wave tubes are VEDs that operate over a wide range of frequencies at moderate output power levels (tens of watts to thousands of watts). These devices are ideal for terrestrial and satellite communications and electronic warfare applications.
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Coupled cavity traveling wave tubes: Coupled cavity traveling wave tubes are VEDs that combine some of the power generating capability of a klystron with some of the increased bandwidth (wider frequency range) properties of a helix traveling wave tube. These amplifiers are medium bandwidth, high-power devices, with power output levels that can be as high as one megawatt. These devices are used primarily for high-power and multi-function radars, including frontline radar systems.
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Magnetrons: Magnetron oscillators are VEDs capable of generating high-power output at relatively low cost. Magnetrons generate power levels as high as 20 megawatts and cover frequencies up to the 40 GHz range. We design and manufacture magnetrons for radar, electronic warfare and missile programs within the defense market. Shipboard platforms include search and air traffic control radar on most aircraft carriers, cruisers and destroyers of NATO-country naval fleets. Ground-based installations include various military and civil search and air traffic control radar systems. We are also a supplier of magnetrons for use in commercial weather radar and for use in industrial applications, including industrial heating, cooking, material processing and cargo screening applications. Other potential uses for magnetrons include high-power microwave systems for disruption of enemy electronic equipment and the disabling or destruction of roadside bombs and other IEDs and to provide microwave energy to accelerate a beam of energy toward a cancerous tumor.
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Cross-field amplifiers: Cross-field amplifiers are VEDs used for high-power radar applications because they have power output capability as high as 10 megawatts. Our cross-field amplifiers are primarily used to support radar systems on the Aegis weapons systems used by the U.S. Navy and select foreign naval vessels. We supply units both for new ships and for replacements on existing ships.
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Power grid devices: Power grid devices are lower frequency electron devices that are used to generate, amplify and control electromagnetic energy. These devices are used in commercial and military communications systems and radio and television broadcasting. We also supply power grid devices for the shortwave broadcast market and for MRI and other applications for the medical market. Our products are also widely used in equipment that serves the industrial markets, such as textile drying, pipe welding and semiconductor wafer fabrication.
In addition to VEDs, we also sell:
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Microwave transmitter subsystems: Our microwave transmitter subsystems are integrated assemblies built primarily around our VED products. These subsystems incorporate specialized high-voltage power supplies to power the VED, plus cooling and control systems that are uniquely designed to work in conjunction with our devices to maximize life, performance and reliability. Microwave transmitter subsystems are used in a variety of defense and commercial applications. Our transmitter subsystems are available at frequencies ranging from one GHz all the way up to 100 GHz and beyond.
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Satellite communications amplifiers: Satellite communications amplifiers provide integrated power amplification for the transmission of voice, broadcast, data, Internet and other communications signals from ground stations to satellites in all frequency bands. We provide a broad line of complete, integrated satellite communications amplifiers that consist of a VED or solid-state microwave amplifier, a power supply to power the device, RF conditioning circuitry, cooling equipment, electronics to control the amplifier and enable it to interface with the satellite ground station, and a cabinet. These amplifiers are often combined in sub-system configurations with other components to meet specific customer requirements. We offer amplifiers both for defense and for commercial applications. Our products include amplifiers based on helix and coupled cavity traveling wave tubes, klystrons and solid-state devices, operating at frequencies ranging from microwaves to millimeter waves.
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Large-aperture antennas: The high-performance, large-aperture fixed and mobile antennas offered by ASC Signal are primarily used for satellite communications antenna systems with UHF to V-band capabilities. In addition, these high-performance antennas are used for air traffic control radar and weather radar applications. We also provide high-frequency and specialty antennas in a wide frequency range for a variety of applications.
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Receiver protectors and control components: Receiver protectors are used in the defense market in radar systems to protect sensitive receivers from high-power signals, thereby preventing damage to the receiver. We have been designing and manufacturing receiver protector products for more than 65 years. We believe that we are the world’s largest manufacturer of receiver protectors and the only manufacturer offering the full range of available technologies. We also manufacture a wide range of other components used to control the RF energy in the customer’s system. Our receiver protectors and control components are integrated into prominent fielded military programs. As radar systems have evolved to improve performance and reduce size and weight, we have invested in the latest solid-state technology to develop and manufacture the microwave control components to allow us to offer more fully integrated products, referred to as multifunction assemblies, including receivers, upconverters, pulse compression assemblies, low noise amplifiers, switches and oscillators, as required by modern radar systems.
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Medical x-ray imaging systems: We design and manufacture x-ray generators for medical imaging applications. These consist of power supplies, cooling, control and display subsystems that drive the x-ray equipment used by healthcare providers for medical imaging. The energy in an x-ray imaging system is generated by an x-ray tube, which is another version of a VED that operates in a different region of the electromagnetic spectrum. These generators use the high-voltage and control systems expertise originally developed by us while designing power systems to drive our other VEDs. We have introduced mobile x-ray generators and x-ray generators with imaging processing systems to assist our customers in their migration from film-based radiology systems to digital radiology systems. We also provide the electronics and software subsystems that control and tie together much of the other ancillary equipment in a typical x-ray imaging system.
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Advanced antenna systems: We design and manufacture advanced antenna systems for a variety of applications, including radar, electronic warfare, communications and telemetry. Along with a variety of antenna types, including phased array, edge and tilt scanning antennas, conformal electronic scanning antennas, stabilized shipboard tracking antennas and our trademark FLAPS (“Flat Parabolic Surface”) antennas, the advanced antenna systems offered by our Malibu Division also include the highly efficient harmonic drive pedestals used to support them. These advanced antenna systems are used on airborne, shipboard and ground-based platforms are designed to enable high performance, high data rate transmission at frequencies ranging from one GHz to 100 GHz.
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Advanced composite radomes, reflector antennas and structures: We design and manufacture advanced composite radomes, reflector antennas and structures for defense aerospace and naval applications and for commercial aerospace applications. A radome is a weatherproof structure that encloses and protects a microwave antenna without interfering with the antenna’s ability to transmit or receive electromagnetic signals. Our products are customized for each system and application based on the operational frequency, RF-performance, structural and environmental requirements of the end system. Our products cover frequencies up to 95 GHz.
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Solid-state products: We design and manufacture a wide variety of solid-state products for a number of applications, including defense, communications and scientific applications. These products include, but are not limited to, power amplifiers, upconverters, pulse compression assemblies, voltage controlled oscillators, high-power solid-state switches, phase shifters, PIN diode attenuators, limiters and low noise amplifiers. In the communications market, these products are specifically designed to address the demanding needs of the steadily growing commercial and government satcom on the pause/move (“SOTP/M”) applications, which are providing highly mobile interconnectivity on a global basis. Our solid-state products extend from microwave to state-of-the-art millimeter-wave frequencies, and are based on both gallium arsenide and leading-edge gallium nitride technology so that customers may employ the optimal solution for these applications.
Backlog
Backlog represents the cumulative balance, at a given point in time, of recorded customer sales orders that have not yet been shipped or recognized as sales. Backlog is increased when an order is received, and backlog is decreased when we recognize sales. As of September 30, 2016, we had an order backlog of $326.2 million compared to an order backlog of $319.9 million as of October 2, 2015. Approximately 78% of our backlog as of September 30, 2016 is expected to be filled within fiscal year 2017. Because our orders for government end-use products generally have much longer delivery terms than our orders for commercial business (which require quicker turn-around), our backlog is primarily composed of government orders.
We believe that backlog and orders information is helpful to investors because this information may be indicative of future sales results. Although backlog consists of firm orders for which goods and services are yet to be provided, customers can, and sometimes do, terminate or modify these orders. However, historically the amount of modifications and terminations has not been material compared to total contract volume.
Sales, Marketing and Service
Our global distribution system provides us with the capability to introduce, sell and service our products worldwide. Our distribution system primarily uses our direct sales professionals throughout the world. We have direct sales offices throughout North America, Europe, Asia, Australia and South America. As of September 30, 2016, we had 180 direct sales, marketing and technical support individuals on staff. Our wide-ranging distribution capabilities enable us to serve our international markets, which accounted for approximately 33% of our sales in fiscal year 2016.
Our sales professionals receive extensive technical training and focus exclusively on our products. As a result, they are able to provide knowledgeable assistance to our customers regarding product applications and the introduction and implementation of new technology, and, at the same time, provide local technical support.
In addition to our direct sales force, we use 50 external sales organizations and one significant stocking distributor, Richardson Electronics, Ltd., to service the needs of customers in certain markets. Many of the third-party sales organizations that we use are located outside the U.S. and Europe and focus primarily on customers in South America, Southeast Asia, the Middle East, Africa and Eastern Europe. Through the use of third-party sales organizations, we are better able to meet the needs of our foreign customers by establishing a local presence in lower volume markets. Using both our direct sales force and our largest distributor, Richardson Electronics, we are able to market our products both to end users and to system integrators around the world and to deliver our products with short turn-around times.
Given the complexity of our products, their critical function in customers’ systems and the unacceptably high costs to our customers of system failure and downtime, we believe that our customers view our product breadth, reliability and superior responsive service as key points of differentiation. We offer comprehensive customer support, with direct technical support provided by 36 strategically located service centers, primarily serving satellite communications customers. These service centers are located in the U.S. (California, Georgia, Illinois and Texas), Canada (Georgetown and Whitby, Ontario), Australia, Brazil (three), China (four), France, India (three), Indonesia, Japan, Peru, Russia (two), Singapore (two), South Africa, South Korea (two), Taiwan (two), Thailand, The Netherlands, Turkey, the United Arab Emirates and the United Kingdom (two). The service centers enable us to provide extensive technical support and rapid response to customers’ critical spare parts and service requirements throughout the world. In addition, we offer on-site installation assistance, on-site service contracts, a 24-hour technical support hotline and complete product training at our facilities, our service centers and customer sites. We believe that many of our customers specify our products in competitive bids due to our responsive global support and product quality.
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Competition
The industries and markets in which we operate are competitive. We encounter competition in most of our business areas from numerous other companies, including units of e2v technologies plc; EMD Technologies, a subsidiary of HEICO Corporation; L-3 Electron Devices, a unit of L-3 Communications Holdings, Inc.; TECOM Industries, Inc., a unit of Smiths Interconnect; Teledyne Technologies, Inc.; Thales Electron Devices SA; and Xicom Technology, Inc., a subsidiary of Comtech Telecommunications Corp. (“Comtech”). Some of our competitors have parent entities that have resources substantially greater than ours. In certain markets, some of these competitors are also our customers and/or our suppliers, particularly for products for satellite communications applications. Our ability to compete in our markets depends to a significant extent on our ability to provide high-quality products with shorter lead times at competitive prices and the readiness of our facilities, equipment and personnel.
We also continually engage in research and development efforts in order to introduce innovative new products for technologically sophisticated customers and markets. There is an inherent risk that advances in existing technology or the development of new technology could adversely affect our market position and financial condition. We provide both VED and solid-state alternatives to our customers, and we invest in research and development efforts across a wide range of power and frequency levels in both VED and solid-state technologies. We believe that for the foreseeable future, solid-state devices are well suited for specific lower-power applications but will be unable to compete on a cost-effective basis in the high-power/high-frequency markets that represent the majority of our business. We believe that VED and solid-state technologies currently serve their own specialized markets without significant overlap in most applications. We also invest in research and development efforts for next-generation advanced antenna technology to address future needs for TCDL systems for land-based, ground mobile, airborne and shipboard applications. See “Risk Factors - Risks relating to our business - We face competition in the markets in which we sell our products.”
Research and Development
Total research and development spending was $30.9 million, $24.8 million and $23.9 million during fiscal years 2016, 2015 and 2014, respectively. Total research and development spending consisted of company- and customer-sponsored research and development expense. Company-sponsored research and development costs related to both present and future products are expensed as incurred. Company-sponsored research and development costs were $15.9 million, $14.9 million and $15.8 million during fiscal years 2016, 2015 and 2014, respectively. Customer-sponsored research and development spending represents development costs incurred on customer sales contracts to develop new or improved products. Customer-sponsored research and development costs are charged to cost of sales to match revenue recognized. Customer-sponsored research and development costs, based on expenditures incurred as the development work was performed, were $14.9 million, $9.8 million and $8.1 million during fiscal years 2016, 2015 and 2014, respectively.
Manufacturing
We manufacture our products at nine manufacturing facilities in North America. We have implemented modern manufacturing methodologies based upon a continuous improvement philosophy, including just-in-time materials handling, demand flow technology, statistical process control and value-managed relationships with suppliers and customers. Eight of our manufacturing facilities have achieved the ISO 9001 international certification standard, four facilities have achieved the AS9100C international certification standard for the aerospace industry and one of our operations has achieved ISO 13485 international certification standard for medical device manufacturers. We obtain certain materials necessary for the manufacture of our products, such as molybdenum, cupronickel, oxygen-free high conductivity (“OFHC”) copper, quartz cloth and some cathodes, from a limited group of, or occasionally sole, suppliers. We have long-standing relationships with our key suppliers and many of our critical commodities are covered by long-term blanket agreements. In addition, we continually pursue alternative sources, and we have established a contingency plan designed to ensure a minimal recovery period if a key supplier is lost. We also monitor our key suppliers through ongoing surveillance, using assessments as well as ongoing reviews of supplier performance.
Generally, each of our manufacturing divisions uses similar manufacturing processes consisting of product development, procurement of components and/or sub-assemblies, high-level assembly and testing. For satellite communications equipment, the process is primarily one of integration, and we use contract manufacturers to provide sub-assemblies whenever possible. Satellite communications equipment uses both VED and solid-state technology, and the Satcom Division procures certain of the critical components that it incorporates into its subsystems from our other manufacturing divisions.
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Intellectual Property
Our business is dependent, in part, on our intellectual property rights, including trade secrets, patents and trademarks. We rely on a combination of nondisclosure and other contractual arrangements, as well as trade secret, patent, trademark and copyright laws, to protect our intellectual property rights. We do not believe that any single patent or other intellectual property right or license is material to our success as a whole.
On occasion, we have entered into agreements pursuant to which we license intellectual property from third parties for use in our business, and we also license intellectual property to third parties. As a result of contracts with the U.S. Government, some of which contain patent and/or data rights clauses, the U.S. Government has acquired royalty-free licenses or other rights in inventions and technology resulting from certain work done by us on behalf of the U.S. Government. See “Risk Factors - Risks relating to our business - We have only a limited ability to protect our intellectual property rights, which are important to our success.”
U.S. Government Contracts and Regulations
We deal with numerous U.S. Government agencies and entities, including the Department of Defense, and, accordingly, we must comply with and are affected by laws and regulations relating to the formation, administration and performance of U.S. Government contracts. We are affected by government, regulatory and industry approvals/oversight. We are affected by similar government authorities and approvals/oversight with respect to our international business.
U.S. Government contracts are conditioned upon the continuing availability of Congressional appropriations. Congress usually appropriates funds on a fiscal-year basis even though contract performance may extend over many years. Therefore, long-term government contracts and related orders are subject to cancellation if appropriations for subsequent performance periods are not approved. See “Risk Factors - Risks relating to our business - A significant portion of our sales is, and is expected to continue to be, from contracts with the U.S. Government, and any significant reduction in the U.S. defense budget or any disruption or decline in U.S. Government expenditures could negatively affect our results of operations and cash flows.”
In addition, our U.S. Government contracts may span one or more base years and multiple option years. The U.S. Government generally has the right not to exercise option periods and may not exercise an option period if the applicable U.S. Government agency does not receive funding or is not satisfied with our performance of the contract. All of our government contracts and most of our government subcontracts can be terminated by the U.S. Government, or another relevant government, either for its convenience or if we default by failing to perform under the contract. Upon termination for convenience of a fixed-price contract, we normally are entitled to receive the purchase price for delivered items, reimbursement for allowable costs for work-in-process and an allowance for profit on the work performed. Upon termination for convenience of a cost-reimbursement contract, we normally are entitled to reimbursement of allowable costs plus a portion of the fee. The amount of the fee recovered, if any, is related to the portion of the work accomplished prior to termination. See “Risk Factors - Risks relating to our business - We are subject to risks particular to companies supplying defense-related equipment and services to the U.S. Government. The realization of any of these risks could cause a loss of or decline in our sales to the U.S. Government.”
Licenses or other authorizations are required from U.S. Government agencies for the export of many of our products in accordance with various regulations, including the United States Export Administration Regulations (for commercial products, including “dual use” products with military applications) and the International Traffic in Arms Regulations (“ITAR”) (for defense articles and defense services). In addition, regulations administered by the Office of Foreign Assets Control (“OFAC”) of the U.S. Department of the Treasury govern transactions with countries and persons subject to U.S. trade sanctions, including import as well as export transactions. We are also subject to U.S. Government restrictions on transactions with specific entities and individuals, including, without limitation, those set forth on the Entity List, the Specially Designated Nationals List, the Denied Persons List, the Unverified List, and the U.S. State Department’s lists of debarred parties. We are also subject to U.S. customs laws and regulations, including customs duties, when applicable. Additionally, we are subject to the Anti-Boycott Regulations administered by the U.S. Department of Commerce and the Boycott Provisions of the Internal Revenue Code (Section 999) administered by the Internal Revenue Service.
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Cybersecurity continues to receive attention at the federal, state and local levels. Congress has passed and continues to consider various forms of cybersecurity legislation focused on protecting United States industry from cyber attacks. In addition, over the past few years, the President has issued executive orders which establish measures for the voluntary sharing of cyber security information, require certain critical industry participants to adopt certain cyber security measures, and potentially may limit participation in government contracts to companies which have not adopted certain cyber security measures. As a contractor supporting national security customers, we are subject to regulatory compliance requirements under the Defense Federal Acquisition Regulation Supplement and other federal regulations requiring that our networks and information technology (“IT”) systems comply with the security and privacy controls in National Institute of Standards and Technology Special Publication 800-171. While we have adopted what we believe are industry standard cyber security measures, the new federal regulations requirements could require that we adopt additional cyber security measures. See “Risk Factors - Risks relating to our business - Our business could be negatively impacted by cyber security threats and other security threats and disruptions.”
In addition to U.S. laws and regulations, foreign countries may also have laws and regulations governing imports and exports. See “Risk Factors - Risks Relating to our Business - Laws and regulations governing the export of our products could adversely impact our business.”
Environmental Matters
We are subject to a variety of U.S. federal, state and local, as well as foreign, environmental laws and regulations relating to, among other things, wastewater discharge, air emissions, storage and handling of hazardous materials, disposal of hazardous and other wastes and remediation of soil and groundwater contamination. We use a number of chemicals or similar substances and generate wastes that are classified as hazardous, and we require environmental permits to conduct certain of our operations. Violation of such laws and regulations can result in fines, penalties and other sanctions.
We were formerly the electron device business of Varian Associates, Inc. In connection with the sale of that business to us in 1995, Varian Medical Systems, Inc. (as successor to Varian Associates) generally agreed to indemnify us for various environmental liabilities relating to Varian Associates’ electron devices business prior to August 1995. This indemnification is subject to certain exceptions and limitations, including exceptions and limitations arising from later agreements with Varian Medical Systems. In addition, we are generally not indemnified by Varian Medical Systems with respect to liabilities resulting from our operations after August 1995. Pursuant to this agreement, Varian Medical Systems is undertaking environmental investigation and remedial work at our manufacturing facilities in Palo Alto, California, Beverly, Massachusetts, and Georgetown, Ontario, Canada that are known to require remediation.
To date, Varian Medical Systems has conducted, generally at its expense, required investigation and remediation work at its predecessor’s facilities and responded to environmental claims arising from Varian Medical Systems’ (or its predecessor’s) prior operations of the electron device business.
In 2010, our subsidiary, ASC Signal, became aware of volatile organic compound and other contamination in the soil and groundwater at the Whitby, Ontario industrial site. We believe that the contamination originated from the neighboring property which reportedly is used for crystal manufacturing and secondarily from the operational practices of the prior operators of ASC Signal. We have addressed these conditions through the implementation of a remediation plan. ASC Signal holds a pair of pollution insurance policies and the insurer is indemnifying ASC Signal for the remediation costs. We expect that the total remediation costs will be less than the insurance policy limits.
We believe that we have been and are in substantial compliance with applicable environmental laws and regulations, and we do not expect to incur material costs relating to environmental compliance. However, new environmental requirements, changes in enforcement of existing environmental requirements, or discovery of previously unknown conditions, could result in additional costs that may be significant.
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Employees
As of September 30, 2016, we had approximately 1,880 employees. Of the total number of employees, 580 are located outside the U.S. (including approximately 540 in Canada). None of our employees is subject to a collective bargaining agreement, although a limited number of our sales force members located in Europe are members of work councils or unions. We have not experienced any work stoppages, and we believe that we have good relations with our employees.
Financial Information About Segments
For financial information about our segments, see Note 13, “Segments, Geographic and Customer Information,” to the accompanying consolidated financial statements.
Available Information
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports are accessible at no cost on our Web site at www.cpii.com as soon as reasonably practicable after they are filed or furnished to the Securities and Exchange Commission (the “SEC”). They are also available by contacting our Investor Relations Department at investor.relations@cpii.com and are accessible on the SEC’s Web site at www.sec.gov.
Our Web site and the information contained therein or incorporated therein are not intended to be incorporated into this Annual Report on Form 10-K or our other filings with the SEC.
Item 1A.
Item 1A.
Risk Factors
Our business, operations and financial results are subject to various risks and uncertainties. The risks and uncertainties described below are not intended to be exhaustive but represent the risks that we believe are material. If any of the following risks, and other risks and uncertainties not presently known to us or which we currently deem immaterial, actually occur, our business, results of operations or financial condition would likely suffer and could materially and adversely affect the prices of our securities.
RISKS RELATING TO OUR BUSINESS
A significant portion of our sales is, and is expected to continue to be, from contracts with the U.S. Government, and any significant reduction in the U.S. defense budget or any disruption or decline in U.S. Government expenditures could negatively affect our results of operations and cash flows.
Approximately 42%, 40% and 42% of our sales in our 2016, 2015 and 2014 fiscal years, respectively, were made to the U.S. Government, either directly or indirectly through prime contractors or subcontractors. Because our U.S. Government contracts are dependent on the U.S. defense budget, any significant disruption or decline in U.S. Government defense expenditures in the future, changes in U.S. Government spending priorities, other legislative changes or changes in our relationship with the U.S. Government could result in the loss of some or all of our government contracts, which, in turn, could result in a decrease in our sales and cash flow.
In addition, U.S. Government contracts are also conditioned upon continuing Congressional approval and the appropriation of necessary funds. Congress usually appropriates funds for a given program each fiscal year even though contract periods of performance may exceed one year. Consequently, at the outset of a major program, multi-year contracts are usually funded for only the first year, and additional monies are normally committed to the contract by the procuring agency only as Congress makes appropriations for future fiscal years. We cannot ensure that any of our government contracts will continue to be funded from year to year. If such contracts are not funded, our sales may decline, which could negatively affect our results of operations and result in decreased cash flows.
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We are subject to risks particular to companies supplying defense-related equipment and services to the U.S. Government. The realization of any of these risks could cause a loss of or decline in our sales to the U.S. Government.
U.S. Government contracts contain termination provisions and are subject to audit and modification.
The U.S. Government has the ability to:
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terminate existing contracts, including for the convenience of the government or because of a default in our performance of the contract;
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reduce the value of existing contracts;
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change the terms of performance of existing contracts;
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cancel multi-year contracts or programs;
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audit our contract-related costs and fees, including allocated indirect costs;
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suspend or debar us from receiving new contracts pending resolution of alleged violations of procurement laws or regulations or other laws that apply to the performance of government contracts; and
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control and potentially prohibit the export of our products, services, technology or other data.
Each of our U.S. Government contracts can be terminated by the U.S. Government either for its convenience or if we default by failing to perform under the contract. If such contracts are terminated or reduced in scope, our sales may decline, which would negatively affect our results of operations and result in decreased cash flow. Termination-for-convenience provisions provide only for our recovery of costs incurred or committed, settlement expenses and profit on the work completed prior to termination. Termination-for-default provisions may provide for the contractor to be liable for excess costs incurred by the U.S. Government in procuring undelivered items from another source. Our contracts with foreign governments generally contain similar provisions relating to termination at the convenience of the customer.
The U.S. Government may review or audit our direct and indirect costs and performance on certain contracts, as well as our accounting and general business practices, for compliance with complex statutes and regulations, including the Truth in Negotiations Act, Federal Acquisition Regulations, Cost Accounting Standards and other administrative regulations. The U.S. Government audits our costs and performance on a continual basis, and we have outstanding audits like most government contractors. Based on the results of these audits, the U.S. Government may reduce our contract-related costs and fees, including allocated indirect costs. In addition, under U.S. Government regulations, some of our costs, including certain financing costs, research and development costs and marketing expenses, may not be reimbursable under U.S. Government contracts.
We are subject to laws and regulations related to our U.S. Government contracts business which may impose additional costs on our business.
As a U.S. Government contractor, we must comply with, and are affected by, laws and regulations related to our performance of our government contracts and our business. These laws and regulations may impose additional costs on our business. In addition, we are subject to audits, reviews and investigations of our compliance with these laws and regulations. In the event that we are found to have failed to comply with these laws and regulations, we may be fined, we may not be reimbursed for costs incurred in performing the contracts, our contracts may be terminated and we may be unable to obtain new contracts. If a government review, audit or investigation uncovers improper or illegal activities, we may be subject to civil or criminal penalties and administrative sanctions, including forfeiture of claims and profits, suspension of payments, statutory penalties, damages related to the illegal activity, fines and suspension or debarment from government contracts.
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In addition, many of our U.S. Government contracts require our employees to maintain various levels of security clearances, and we are required to maintain certain facility clearances. Complex regulations and requirements apply to obtaining and maintaining personnel and facility security clearances, and obtaining such clearances can be a lengthy process. To the extent we are not able to obtain or maintain personnel or facility security clearances, we also may not be able to seek or perform future classified contracts. If we are unable to do any of the foregoing, we will not be able to maintain or grow our business, and our revenue may decline.
As a result of our U.S. Government business, we may be subject to false claim suits, and a judgment against us in any of these suits could cause us to be liable for substantial damages.
Our business with the U.S. Government, subjects us to “qui tam,” or “whistleblower,” suits brought by private plaintiffs in the name of the U.S. Government upon the allegation that we submitted a false claim to the U.S. Government, as well as to false claim suits brought by the U.S. Government. A judgment against us in a qui tam or false claim suit could cause us to be liable for substantial damages (including treble damages and monetary penalties) and could carry penalties of suspension or debarment, which would make us ineligible to receive any U.S. Government contracts for a period of up to three years. Any material judgment, or any suspension or debarment, could result in increased costs and a loss of revenue, which could negatively affect our results of operations. In addition, any of the foregoing could cause a loss of customer confidence and could negatively harm our business and our future prospects.
Some of our sole-provider business from the U.S. Government in the future may be subject to competitive bidding.
Some of the business that we will seek from the U.S. Government in the future may be awarded through a competitive bidding process. The competitive bidding process may reduce the price at which we sell our products to the U.S. Government and reduce our net income. Competitive bidding on government contracts presents risks, such as:
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the need to bid on programs in advance of contract performance, which may result in unforeseen performance issues and costs; and
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the expense and delay that may arise if our competitors protest or challenge the award made to us, which could result in a reprocurement, modified contract, or reduced work.
If we fail to win competitively bid contracts or fail to perform under these contracts in a profitable manner, our sales and results of operations could suffer.
We generate sales from contracts with foreign governments, and significant changes in government policies or to appropriations of those governments could have an adverse effect on our business, results of operations and financial condition.
We estimate that approximately 11%, 13% and 8% of our sales in fiscal years 2016, 2015 and 2014, respectively, were made directly or indirectly to foreign governments. Significant changes to appropriations or national defense policies, disruptions of our relationships with foreign governments or terminations of our foreign government contracts could have an adverse effect on our business, results of operations and financial condition. Our contracts with foreign governments also subject us to U.S. and international anti-corruption laws, including the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act (which also reaches commercial bribery). A judgment or settlement under the provisions of these laws could subject us to substantial monetary penalties and damages, as well as suspension and/or debarment. Suspension or debarment could deny us the ability to retain or obtain U.S. Government contracts or restrict our exporting activity. In addition, any material judgment in this area could result in increased costs, which could negatively affect our results of operations, and could cause a loss of customer confidence, thus adversely affecting our business and future prospects.
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We face competition in the markets in which we sell our products.
The U.S. and foreign markets in which we sell our products are competitive. Our ability to compete in these markets depends on our ability to provide high-quality products with short lead times at competitive prices, as well our ability to create innovative new products. In addition, our competitors could introduce new products with greater capabilities, which could have a material adverse effect on our business. Certain of our competitors are owned by companies that have substantially greater financial resources than we do. Also, our foreign competitors may not be subject to U.S. Government export restrictions and may benefit from more favorable currency rates, which may make it easier in certain circumstances for them to sell to foreign customers. If we are unable to compete successfully against our current or future competitors, our business and sales will be harmed.
The end markets in which we operate are subject to technological change, and changes in technology could adversely affect our sales.
Our defense and commercial end markets are subject to technological change. Advances in existing technology, or the development of new technology, could adversely affect our business and results of operations. Historically, we have relied on a combination of internal research and development and customer-funded research and development activities. To succeed in the future, we must continually engage in effective and timely research and development efforts in order to introduce innovative new products for technologically sophisticated customers and end markets and to benefit from the activities of our customers. If we fail to adapt successfully to technological changes or fail to obtain access to important technologies, our sales could suffer.
We may not be successful in implementing part of our growth strategy if we are unable to identify and acquire suitable acquisition targets or integrate acquired companies successfully, which could adversely affect our business, results of operations and financial condition.
Finding and consummating acquisitions is one of the components of our growth strategy. In furtherance of this strategy, we acquired ASC Signal (September 2015) and Radant (October 2013), and we intend to continue to seek to make investments in complementary companies, products or technologies.
In order to pursue this strategy successfully, we must identify suitable acquisition candidates, complete these transactions, some of which may be large and complex, and integrate acquired companies. Integration and other risks of acquisitions can be more pronounced for larger and more complicated transactions or if multiple acquisitions are pursued simultaneously. If we fail to identify and complete acquisitions, we may be required to expend resources to internally develop products and technology, may be at a competitive disadvantage or may be adversely affected by negative market perceptions, which may have a material adverse effect on our business, results of operations and financial condition.
Our ability to grow by acquisition depends on the availability of acquisition candidates at acceptable prices and our ability to obtain additional acquisition financing on acceptable terms. In making acquisitions, we may experience competition from larger companies with significantly greater resources. We are likely to use significant amounts of cash and/or incur additional debt in connection with future acquisitions, each of which could have a material adverse effect on our business. There can be no assurance that we will be able to obtain the necessary funds to carry out acquisitions on commercially reasonable terms, or at all.
In addition, acquisitions could cause or result in the following:
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difficulties in assimilating and integrating the operations, technologies and products acquired;
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the diversion of our management’s attention from other business concerns;
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our operating and financial systems and controls being inadequate to deal with our growth; and
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the loss of key employees.
Acquisitions may require us to integrate different company cultures, management teams and business infrastructures and otherwise manage integration risks. Even if an acquisition is successfully integrated, we may not receive the expected benefits of the transaction. The integration of acquisitions may make the completion and integration of subsequent acquisitions more difficult.
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Managing acquisitions requires varying levels of management resources, which may divert management’s attention from our other business operations. Acquisitions, including abandoned acquisitions, also may result in significant costs and expenses and charges to earnings.
Acquisitions may also provide us with challenges in implementing the required processes, procedures and controls in our acquired operations. Acquired companies may not have disclosure controls and procedures or internal control over financial reporting that are as thorough or effective as those required by securities laws in the U.S.
Goodwill and other intangibles resulting from our acquisitions could become impaired.
As of September 30, 2016, our goodwill, developed and core technology and other intangibles amounted to $463.8 million, net of accumulated amortization. We expect to amortize developed and core technology and other definitely-lived intangibles by approximately $11.7 million in each of fiscal years 2017, 2018, 2019 and 2020, $11.0 million in fiscal year 2021 and $154.5 million in the aggregate thereafter. The remaining balance of our intangibles relate to the non-amortizable goodwill and indefinitely-lived tradenames. To the extent we do not generate sufficient cash flows to recover the net amount of any investment in goodwill and other intangibles recorded, the investment could be considered impaired and subject to a non-cash write off. We expect to record further goodwill and other intangible assets as a result of any future acquisitions. Future amortization of such other intangible assets or impairments, if any, of goodwill would adversely affect our results of operations in any given period.
Our international operations subject us to the social, political and economic risks of doing business in foreign countries.
We conduct a substantial portion of our business, employ a substantial number of employees and use external sales organizations in Canada and in other countries outside of the U.S. As a result, we are subject to certain risks of doing business internationally. Direct sales to customers located outside the U.S. were approximately 33%, 34% and 33% in fiscal years 2016, 2015 and 2014, respectively. Circumstances and developments related to international operations that could negatively affect our business, results of operations and financial condition include the following:
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changes in currency rates with respect to the U.S. dollar;
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changes in regulatory requirements;
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potentially adverse tax consequences;
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U.S. and foreign government policies;
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currency restrictions, which may prevent the transfer of capital and profits to the U.S.;
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restrictions imposed by the U.S. Government on the export of certain products and technology;
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the responsibility of complying with multiple and potentially conflicting laws;
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difficulties and costs of staffing and managing international operations;
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the impact of regional or country-specific business cycles and economic instability; and
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geopolitical developments and conditions, including international hostilities, acts of terrorism and governmental reactions, trade relationships and military and political alliances.
Limitations on imports, currency exchange control regulations, transfer pricing regulations and tax laws and regulations could adversely affect our international operations, including the ability of our non-U.S. subsidiaries to declare dividends or otherwise transfer cash among our subsidiaries to pay interest and principal on our debt.
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We are subject to risks of currency fluctuations and related hedging operations.
A portion of our business is conducted in currencies other than the U.S. dollar. In particular, we incur significant expenses in Canadian dollars in connection with our Canadian operations, but do not receive significant revenues in Canadian dollars. Changes in exchange rates among certain currencies, such as the Canadian dollar and the U.S. dollar, will affect our cost of sales, operating margins and revenues. Specifically, if the Canadian dollar strengthens relative to the U.S. dollar, our expenses will increase, and our results of operations will suffer. We use financial instruments, primarily Canadian dollar forward contracts, to hedge a portion of the Canadian dollar-denominated costs for our manufacturing operation in Canada. If these hedging activities are not successful or we change or reduce these hedging activities in the future, we may experience significant unexpected expenses from fluctuations in exchange rates. In addition, changes in exchange rates that result in the significant strengthening of the U.S. dollar relative to certain currencies may impact our ability to offer competitively priced products to foreign customers.
Laws and regulations governing the export of our products could adversely impact our business.
Licenses or other authorizations are required from U.S. Government agencies for the export of many of our products in accordance with various regulations, including the United States Export Administration Regulations (for commercial products, including “dual use” products with military applications) administered by the Bureau of Industry and Security (“BIS”) of the U.S. Department of Commerce and the International Traffic in Arms Regulations (for defense articles and defense services) administered by the Directorate of Defense Trade Controls of the U.S. Department of State. Under these regulations, a license or other authorization may be required before transferring certain export-controlled articles or technical data, or providing defense services, to foreign persons, whether in the U.S. or abroad; before exporting certain of our products, services, and technical data outside the U.S.; before engaging in brokering activities involving export-controlled defense articles; and for the temporary import of certain defense articles and technical data. In addition, regulations administered by the OFAC of the U.S. Department of the Treasury govern transactions with countries and persons subject to U.S. trade sanctions, including import as well as export transactions. We are also subject to U.S. Government restrictions on transactions with specific entities and individuals, including, without limitation, those set forth on the Entity List, the Specially Designated Nationals List, the Denied Persons List, the Unverified List, and the U.S. State Department’s lists of debarred parties. We are also subject to U.S. customs laws and regulations, including customs duties, when applicable. Additionally, we are subject to the Anti-Boycott Regulations administered by the U.S. Department of Commerce’s Office of Antiboycott Compliance (“OAC”) and the Boycott Provisions of the Internal Revenue Code (Section 999) administered by the Internal Revenue Service. These laws and regulations could materially adversely impact our sales and business in the following scenarios:
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In order to obtain the license for the sale of such a product, we are required to obtain information from the potential customer and provide it to the U.S. Government. If the U.S. Government determines that the sale presents national security risks or is otherwise contrary to U.S. policy, it may not approve the sale.
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Delays caused by the requirement to obtain a required license or other authorization may cause delays in our production, sales and export activities, and may cause us to lose potential sales.
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If we violate these laws and regulations, we could be subject to fines or penalties, including debarment as an exporter and/or debarment or suspension as a government contractor.
In addition to U.S. laws and regulations, foreign countries may also have laws and regulations governing imports and exports.
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Environmental and zoning laws and regulations and other obligations relating to environmental matters could subject us to liability for fines, clean-ups and other damages, require us to incur significant costs to modify our operations and/or increase our manufacturing costs.
Environmental and zoning laws and regulations could limit our ability to operate as we are currently operating and could result in additional costs.
We are subject to a variety of U.S. federal, state and local, as well as foreign, environmental and zoning laws and regulations relating, among other things, to wastewater discharge, air emissions, storage and handling of hazardous materials, disposal of hazardous and other wastes and remediation of soil and groundwater contamination. We use a number of chemicals or similar substances and generate wastes that are classified as hazardous. We require permits to conduct many of our operations. Violations of environmental and zoning laws and regulations could result in substantial fines, penalties and other sanctions. Changes in environmental and zoning laws or regulations (or in their enforcement) affecting or limiting, for example, our chemical uses and storage, certain of our manufacturing processes or our disposal practices, could restrict our ability to operate as we are currently operating or could impose additional costs. The City of Palo Alto, in March 2016, adopted zoning changes which prohibit the use of certain hazardous chemicals above set quantities within 300 feet of residential homes. We currently use some of the stated hazardous chemicals above the set quantities within 300 feet of residential homes as part of our manufacturing operations at our Palo Alto facilities. The City of Palo Alto also adopted a schedule by which we must bring our Palo Alto facilities into conformance with the new law. To be in conformance, we must reduce the use of the stated hazardous chemicals below the set quantities or relocate the use to a distance greater than 300 feet from the residential homes. We have until December 31, 2026, to relocate to a distance greater than 300 feet, or until December 31, 2031, if we elect to terminate the non-conforming use of hazardous chemicals. Although we have a number of years to comply, the possible relocation of those operations could significantly increase our operating costs, could result in delays in our manufacturing process and, therefore, could have a material adverse impact on our results of operations.
We may experience releases of regulated materials or discover existing contamination, which could cause us to incur material cleanup costs or other damages. Some environmental laws impose strict, and in certain circumstances joint and several, liability for costs of investigation and remediation of contaminated sites on current and former owners and operators of those sites, and also impose liability for related damages to natural resources. In addition, owners and operators of contaminated sites may be subject to claims for damage to property or personal injury alleged to result from the contamination. In 2010, ASC Signal became aware of volatile organic compound and other contamination in the soil and groundwater at the Whitby, Ontario industrial site. We believe that the contamination originated from the neighboring property which reportedly is used for crystal manufacturing and secondarily from the operational practices of the prior operators of ASC Signal. We have addressed these conditions through the implementation of a remediation plan. ASC Signal holds a pair of pollution insurance policies and the insurer is indemnifying ASC Signal for the remediation costs. We expect that the total remediation costs will be less than the insurance policy limits. In addition, ASC Signal has filed civil actions against the neighbor and certain other parties to recover certain consequential damages resulting from the contamination. We have been informed that one of the defendants in this lawsuit has filed for bankruptcy. Although we have accrued reasonably estimable costs associated with remediation at the Whitby site, the estimate of costs and their timing could change as a result of a number of factors, including (i) input from applicable regulatory agencies on the our remediation plan and any changes which they may subsequently require,(ii) refinement of cost estimates and length of time required to complete remediation and post-remediation operations and maintenance, (iii) changes in technology and information related to the affected site, and (iv) unforeseen circumstances existing at the site. As a result of these factors, the actual amount of costs we will incur in connection with the said remediation could exceed the amount accrued at this time. Additional environmental liabilities could cause a material adverse effect on our results of operations.
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We could be subject to significant environmental liabilities related to our business.
When we purchased our electron devices business in 1995, a number of the facilities of the business were subject to environmental contamination and remediation. In connection with the sale, Varian Medical Systems generally agreed to indemnify us for various environmental liabilities relating to the business prior to the purchase. This indemnification is subject to certain exceptions and limitations, including exceptions and limitations arising from later agreements with Varian Medical Systems. Varian Medical Systems is undertaking the environmental investigation and remedial work at the manufacturing facilities that are known to require environmental remediation. In addition, Varian Medical Systems has been sued or threatened with suit with respect to environmental obligations related to certain of these manufacturing facilities. If Varian Medical Systems does not comply fully with its indemnification obligations to us or does not continue to have the financial resources to comply fully with those obligations, or if environmental issues arise that are not subject to the Varian Medical Systems’ indemnification, we could be subject to significant liabilities.
As of September 30, 2016, we have environmental loss reserves totaling $1.6 million for remaining potential remediation costs related to VOC and other contamination in our ASC Signal division's Whitby, Ontario industrial site. The calculation of environmental loss reserves is based on the evaluation of currently available information. Actual costs to be incurred in future periods may vary from the amount of reserves given the uncertainties regarding the status of laws, regulations, enforcement policies, the impact of potentially responsible parties, technology and information related to the affected site. ASC Signal’s insurer has an obligation to indemnify ASC Signal for the estimated liabilities. If ASC Signal’s insurer is unable or unwilling to honor its indemnity obligation, we would seek to enforce our legal rights, including the enforcement of the indemnity obligation and redress from all parties at fault, including certain third parties against whom ASC Signal has filed civil actions. If both insurance and indemnity protection were unavailable or insufficient, there could be a material adverse effect on our results of operations, financial condition or liquidity.
We believe that we have been and are in substantial compliance with applicable environmental laws and regulations, and we do not expect to incur material costs relating to environmental compliance. However, new environmental requirements, changes in enforcement of existing environmental requirements, or discovery of previously unknown conditions, could result in additional costs that may be significant.
Our inability to obtain certain necessary raw materials and key components could disrupt the manufacture of our products and cause our sales and results of operations to suffer.
We obtain certain raw materials and key components necessary for the manufacture of our products, such as molybdenum, cupronickel, OFHC copper, quartz cloth and some cathodes, from a limited group of, or occasionally sole, suppliers. We have long-standing business relationships with our key suppliers and many of our critical commodities are covered by long-term blanket agreements. If any of our suppliers fails to meet our needs, we may not have readily available alternatives. Delays in component deliveries could cause delays in product shipments and require the redesign of certain products. If we are unable to obtain necessary raw materials and key components from our suppliers under favorable purchase terms and/or on a timely basis or to develop alternative sources, our ability to manufacture products could be disrupted or delayed, and our sales and results of operations could suffer.
If we are unable to retain key management and other personnel, our business and results of operations could be adversely affected.
Our business and future performance depends on the continued contributions of key management personnel. Our current management team has an average of more than 30 years experience with us (and our predecessors) in various capacities. Since assuming their current leadership roles in 2002, this team has increased our sales, reduced our costs and grown our business. The unanticipated departure of any key member of our management team could have an adverse effect on our business and our results of operations. In addition, some of our technical personnel, such as our key engineers, could be difficult to replace.
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Our business and operating results could be adversely affected by losses under fixed-price contracts.
Most of our governmental and commercial contracts are fixed-price contracts. Fixed-price contracts require us to perform all work under the contract for a specified lump-sum price. Fixed-price contracts expose us to a number of risks, including underestimation of costs, ambiguities in specifications, unforeseen costs or difficulties, problems with new technologies, delays beyond our control, failure of subcontractors to perform and economic or other changes that may occur during the contract period. In addition, some of our fixed-price contracts contain termination provisions that permit our customer to terminate the contract if we are unsuccessful in fulfilling our obligations under the contract. In that event, we could be liable for the excess costs incurred by our customer in completing the contract.
We have only a limited ability to protect our intellectual property rights, which are important to our success.
Our success depends, in part, upon our ability to protect our proprietary technology and other intellectual property. We rely on a combination of trade secrets, confidentiality policies, nondisclosure and other contractual arrangements and patent, copyright and trademark laws to protect our intellectual property rights. The steps we take to protect our intellectual property may not be adequate to prevent or deter infringement or other violations of our intellectual property, and we may not be able to detect unauthorized use or to take appropriate and timely steps to enforce our intellectual property rights. In addition, we cannot be certain that our processes and products do not or will not infringe or otherwise violate the intellectual property rights of others. Infringement or other violations of intellectual property rights could cause us to incur significant costs, prevent us from selling our products and have a material adverse effect on our business, results of operations and financial condition.
Veritas Capital controls us and may have conflicts of interest with us or holders of our debt in the future.
Veritas Capital indirectly beneficially owns substantially all of our outstanding voting shares. As a result of this ownership, Veritas Capital is entitled to elect all or substantially all of our directors, to appoint new management and to approve actions requiring the approval of our stockholder, including approving or rejecting proposed mergers or sales of all or substantially all of our assets, regardless of whether holders of our debt believe that any such transactions are in their own best interests.
The interests of Veritas Capital may differ from those of the holders of our debt in material respects. For example, if we encounter financial difficulties or are unable to pay our debts as they mature, the interests of the equity holders might conflict with the interests of the holders of our debt. Veritas Capital also may have an interest in pursuing acquisitions, divestitures, financings (including financings that are secured) or other transactions that, in their judgment, could enhance their equity investments, even though such transactions might involve risks to holders of our debt. Additionally, the indenture governing our notes permits us to pay management advisory fees, dividends or make other restricted payments under certain circumstances, and Veritas Capital may have an interest in our doing so.
Veritas Capital is in the business of making investments in companies, and owns, or may from time to time in the future acquire, interests in businesses or provide advice that directly or indirectly compete with certain portions of our business or are suppliers or customers of ours. Veritas Capital may also pursue acquisition opportunities that may be complementary to our business and, as a result, those acquisition opportunities may not be available to us. See “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” and “Certain Relationships and Related Transactions, and Director Independence.”
Our backlog is subject to modifications and terminations of orders, which could negatively impact our sales.
Backlog represents firm orders for which goods and services are yet to be provided, including with respect to government contracts that are cancelable at will. As of September 30, 2016, we had an order backlog of $326.2 million. Although historically the amount of modifications and terminations of our orders has not been material compared to our total contract volume, customers can, and sometimes do, terminate or modify these orders. Cancellations of purchase orders or reductions of product quantities in existing contracts could substantially and materially reduce our backlog and, consequently, our future sales. Our failure to replace canceled or reduced backlog could negatively impact our sales and results of operations.
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We have experienced and expect to experience fluctuations in our operating results.
We have experienced, and in the future expect to experience, fluctuations in our operating results, including net orders and sales. The timing of customers’ order placement and customers’ willingness to commit to purchase products at any particular time are inherently difficult to predict or forecast. Once orders are received, factors that may affect whether these orders become sales and translate into revenues in a particular quarter include:
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delay in shipments due to various factors, including cancellations by a customer, delays in a customer’s own production schedules, natural disasters or manufacturing difficulties;
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delay in a customer’s acceptance of a product; or
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a change in a customer’s financial condition or ability to obtain financing.
Our operating results may also be affected by a number of other factors, including:
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general economic conditions in the geographical markets that we serve;
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reduction in the U.S. defense budget or any disruption or decline in U.S. Government expenditures;
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sensitivity to rapid technological innovation and obsolescence of existing products;
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changes or anticipated changes in third-party reimbursement amounts or policies applicable to treatments using our products;
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revenues becoming affected by seasonal influences;
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changes in foreign currency exchange rates;
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changes in the relative portion of our revenues represented by our various products;
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timing of the announcement, introduction and delivery of new products or product enhancements by us or by our competitors;
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disruptions in the supply or changes in the costs of raw materials, labor, product components or transportation services;
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the impact of changing levels of sales to sole purchasers of certain of our products; and
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the unfavorable outcome of any litigation.
Changes in our effective tax rate may have an adverse effect on our results of operations.
Our future effective tax rates may be adversely affected by a number of factors including:
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the jurisdictions in which profits are determined to be earned and taxed;
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the resolution of issues arising from tax audits with various tax authorities;
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changes in the valuation of our deferred tax assets and liabilities;
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adjustments to estimated taxes upon finalization of various tax returns;
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increases in expenses not deductible for tax purposes;
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changes in available tax credits, including foreign tax credits;
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changes in stock-based compensation expense;
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fluctuations in tax effects of purchase accounting for acquisitions;
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changes in tax laws, or the interpretation of such tax laws, and changes in generally accepted accounting principles; and/or
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the repatriation of non-U.S. earnings for which we have not previously provided for U.S. taxes.
Any significant increase in our future effective tax rates could adversely impact net income for future periods.
Our business could be negatively impacted by cyber security threats and other security threats and disruptions.
We face various cyber security threats, including cyber security attacks to our IT infrastructure and attempts to gain access to proprietary or classified information and threats to physical security. Cybersecurity threats in particular are persistent, evolve quickly and include, but are not limited to, computer viruses, attempts to access information, denial of service and other electronic security breaches. Our IT networks and related systems are critical to the operation of our business and essential to our ability to successfully perform day-to-day operations. Although we have invested in highly skilled IT resources and utilized various procedures and controls to monitor threats and mitigate our exposure to such threats, there can be no assurance that these procedures and controls will be sufficient to prevent cyber security threats from materializing. If any of these threats were to materialize, they could:
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disrupt the proper functioning of our IT networks, data center facilities and systems and therefore our operations and/or those of certain of our customers;
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result in unauthorized access to, and destruction, loss, theft, misappropriation or release of, proprietary, confidential, sensitive or otherwise valuable information of ours or our customers, including trade secrets, which others could use to compete against us or for disruptive, destructive or otherwise harmful purposes and outcomes;
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compromise national security and other sensitive government functions;
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require significant management attention and resources to remedy the damages that result; and
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result in legal claims or proceedings against us and damage our reputation with our customers (particularly agencies of the U.S. government) and the public generally.
As a contractor supporting national security customers, we are also subject to regulatory compliance requirements under the Defense Federal Acquisition Regulation Supplement and other federal regulations requiring that our networks and IT systems comply with the security and privacy controls in National Institute of Standards and Technology Special Publication 800-171. We must comply with the security control requirements by a certain deadline. We may also be responsible if our suppliers do not comply with these requirements. Our or our suppliers' failure to comply with the requirements could result in cancellation of our existing government contracts and our ineligibility to bid for certain agency contracts in the future, which would have a material adverse effect on our business and financial results.
In addition, the cost of remediating gaps in our security posture and continually defending against cyber-attacks and breaches has increased in recent years and future costs could have a material adverse effect on our business, results of operation and financial condition.
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Compliance with new regulations and customer demands regarding “conflict minerals” could significantly increase costs and affect the manufacturing and sale of our products.
In August 2012, under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“the Dodd-Frank Act”), the SEC adopted new requirements for companies that use certain minerals and derivative metals (referred to as “conflict minerals,” regardless of their actual country of origin) in their products. Some of these metals, such as gold, tantalum, tin and tungsten, are commonly used in electronic equipment and devices, including our products. These requirements require companies to annually investigate, disclose and report whether or not such metals originated from the Democratic Republic of Congo or adjoining countries. We are required to file our own report with the SEC regarding the sourcing of minerals used in our products. In addition, many of our customers require that we provide sourcing information to them to enable them to comply with their own reporting obligations. Our first three reports were filed with the SEC on June 2, 2014, May 29, 2015 and May 31, 2016 for the 2013, 2014 and 2015 calendar years, respectively. Complying with these rules requires investigative efforts and cooperation and assistance from our suppliers, which have caused, and will continue to cause, us to incur associated costs and could adversely affect the sourcing, supply and pricing of materials used in our products, or result in process or manufacturing modifications, all of which could adversely affect our results of operations.
RISKS RELATED TO OUR INDEBTEDNESS
The term loans under our first and second lien credit facilities will become due in November 2017 unless we can refinance at least 65% of our outstanding senior notes and satisfy certain other conditions. There is no guarantee that we will be successful in refinancing our existing indebtedness.
We are highly leveraged. As of September 30, 2016, excluding approximately $4.5 million of undrawn letters of credit, our total indebtedness was $545.3 million before unamortized original issue discount of $2.6 million and debt issuance costs of $8.2 million, including our outstanding senior notes and borrowings under our first and second lien credit facilities. We also had an additional $25.5 million available for borrowing under the revolving credit facility included in our first lien credit facility. Unless certain terms and conditions in our first and second lien credit agreements are met, including having no less than 65% of our outstanding senior notes repaid or refinanced on or prior to November 17, 2017, the term loans under our first and second lien credit facilities will become due and payable in November 2017.
On December 12, 2016, we entered into a commitment letter (the “Commitment Letter”) with UBS AG, Stamford Branch and UBS Securities LLC (collectively, “UBS”), pursuant to which UBS has committed (subject to certain customary conditions) to provide and arrange a bridge loan facility of $245 million (“Bridge Facility”) to refinance 100% of our existing senior notes (if we are otherwise unable to refinance our senior notes with certain other financing) and 100% of our second lien credit facility. The Commitment Letter expires on April 12, 2017. If we are unable to refinance at least 65% of our outstanding senior notes and satisfy certain other conditions prior to November 17, 2017, we will be unable to meet our repayment obligations when the term loans under our first and second lien credit facilities mature, which would have a material adverse impact on our financial condition.
Our substantial leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under our outstanding senior notes and senior secured credit facility.
Our high degree of leverage could have important consequences for the holders of our debt, including:
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increasing our vulnerability to adverse economic, industry or competitive developments;
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requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on our indebtedness, therefore reducing our ability to use our cash flow to fund our operations, capital expenditures and future business opportunities;
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exposing us to the risk of increased interest rates because certain of our borrowings, including borrowings under our senior secured credit facilities, will be at variable rates of interest;
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making it more difficult for us to satisfy our obligations with respect to our indebtedness and any failure to comply with the obligations of any of our debt instruments, including restrictive covenants and borrowing conditions, could result in an event of default under the indenture governing our senior notes due 2018 and the agreements governing such other indebtedness;
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restricting us from making strategic acquisitions or causing us to make non-strategic divestitures;
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limiting our ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes; and
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limiting our flexibility in planning for, or reacting to, changes in our business or market conditions and placing us at a competitive disadvantage compared to our competitors who are less highly leveraged and who, therefore, may be able to take advantage of opportunities that our leverage prevents us from exploiting.
Our cash interest expense for fiscal years 2016, 2015 and 2014 was $34.6 million, $32.3 million and $28.3 million, respectively. At September 30, 2016, we had $330.3 million aggregate principal amount of variable interest rate indebtedness under our term loan facilities.
Despite the high level of our indebtedness, which includes our senior notes, we and our subsidiaries may still be able to incur significant additional amounts of debt, which could further exacerbate the risks associated with our substantial indebtedness.
We and our subsidiaries may be able to incur substantial additional indebtedness in the future. Although the indenture governing our outstanding senior notes and senior secured credit facilities contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of indebtedness that could be incurred in compliance with these restrictions could be substantial. In addition to the $25.5 million that was available to us as of September 30, 2016 for borrowing under our revolving credit facility, we may request, through an incremental facility and subject to certain conditions, additional commitments under our first lien term loan facility of up to $75.0 million plus the aggregate amount of first lien term loan repayments and revolving commitment reductions (subject to certain exceptions), and additional commitments under our second term loan facility of up to $10.0 million plus the aggregate amount of all prepayments of the second lien term loan made prior to or simultaneously with the incurrence of new incremental commitments (subject to certain exceptions), plus an unlimited amount at any time so long as, after giving effect to such additional commitments, certain specified leverage ratios are not exceeded. If new debt is added to our and our subsidiaries’ existing debt levels, the related risks that we now face will increase. In addition, the indenture governing our outstanding notes would not prevent us from incurring obligations that do not constitute indebtedness under those agreements.
We will require a significant amount of cash to service our indebtedness.
Based on our current level of operations, we believe that our cash flow from operations, available cash and available borrowings under our senior secured credit facilities, will be adequate to meet our future liquidity needs for at least the next 12 months, barring any unforeseen circumstances that are beyond our control. There can be no assurance that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our senior secured credit facilities or otherwise in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. In addition, the indenture governing our notes allows us to make significant restricted payments and other dividends. The making of such restricted payments or other dividend payments could affect our ability to pay principal and interest on our debt. We may need to refinance all or a portion of our indebtedness, including our notes, on or before the stated maturity of such indebtedness, such as the current case with our existing senior notes, at least 65% of which we plan to refinance prior to November 17, 2017 in order to extend the maturity of the term loans under our first and second lien credit facilities. There can be no assurance that we will be able to refinance any of our indebtedness, including our senior secured credit facilities and outstanding notes, on commercially reasonable terms, on terms acceptable to us or at all.
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Our outstanding senior notes and the guarantees are unsecured and effectively subordinated to our and each guarantor’s existing and future secured indebtedness.
Our outstanding notes and guarantees are not secured by any of our or the guarantors’ assets. The indenture governing these notes permits us and the guarantors to incur secured debt, including pursuant to our senior secured credit facilities and other forms of secured debt. As a result, these notes and the guarantees are effectively subordinated to all of our and each guarantor’s secured obligations to the extent of the value of the assets securing such obligations. If we or the guarantors were to become insolvent or otherwise fail to make payment on our outstanding senior notes or the guarantees, holders of any of our and each guarantor’s secured obligations would be paid first and would receive payments from the assets securing such obligations before the holders of our notes would receive any payments. The noteholders may therefore not be fully repaid if we or the guarantors become insolvent or otherwise fail to make payment on our senior notes.
Claims of noteholders are structurally subordinated to claims of creditors of our subsidiaries that do not guarantee our outstanding notes.
Claims of holders of our outstanding notes are structurally subordinated to the claims of creditors of our subsidiaries that do not guarantee the senior notes, including trade creditors. All obligations of these subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or creditors of us, including the holders of our outstanding notes. Our non-guarantor subsidiaries accounted for approximately $192.5 million, or 39%, of our net sales for fiscal year 2016, and approximately $249.5 million, or 35%, of our total assets (net of cash and cash equivalents and restricted cash) as of September 30, 2016. Amounts are presented after giving effect to intercompany eliminations.
Our ability to repay our indebtedness, including our outstanding senior notes, is dependent on the cash flow generated by our operating subsidiaries.
Our operating subsidiaries own substantially all of our assets and conduct all of our operations. Accordingly, repayment of our indebtedness, including our outstanding notes, will be dependent on the generation of cash flow by the operating subsidiaries and their ability to make such cash available to CPII, directly or indirectly, by dividend, debt repayment or otherwise. The operating subsidiaries may not be able to or may not be permitted to, make distributions to enable CPII to make payments in respect of its indebtedness, including the senior notes. Each operating subsidiary is a distinct legal entity and, under certain circumstances, legal and contractual restrictions may limit CPII’s ability to obtain cash from the operating subsidiaries. While the indenture governing our notes limits the ability of the operating subsidiaries to incur consensual encumbrances or restrictions on their ability to pay dividends or make other intercompany payments, those limitations are subject to waiver and certain qualifications and exceptions.
The agreements and instruments governing our debt impose restrictions that may limit our operating and financial flexibility.
Our senior secured credit facilities and the indenture governing our outstanding senior notes contain a number of significant restrictions and covenants that limit our ability to:
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incur additional indebtedness or issue equity interests;
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sell assets or consolidate or merge with or into other companies;
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pay dividends or repurchase or redeem capital stock;
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make certain investments and loans;
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incur liens;
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prepay, redeem or repurchase subordinated debt;
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enter into certain types of transactions with our affiliates;
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enter into sale and leaseback transactions; and
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amend or waive provisions of charter documents in a manner materially adverse to the lenders.
These covenants could have the effect of limiting our flexibility in planning for or reacting to changes in our business and the markets in which we compete. If we violate these covenants and are unable to obtain waivers from our lenders, our debt under these agreements would be in default and could be accelerated by our lenders. Because of cross-default provisions in the agreements and instruments governing our indebtedness, a default under one agreement or instrument could result in a default under, and the acceleration of, our other indebtedness. In addition, the lenders under our senior secured credit facilities could proceed against the collateral securing that indebtedness. If our indebtedness is accelerated, we may not be able to repay our debt or borrow sufficient funds to refinance it. Even if we are able to obtain new financing, it may not be on commercially reasonable terms, on terms that are acceptable to us or at all. If our debt is in default for any reason, our business, financial condition and results of operations could be materially and adversely affected. In addition, complying with these covenants may also cause us to take actions that are not favorable to holders of our outstanding notes and may make it more difficult for us to successfully execute our business strategy and compete against companies that are not subject to such restrictions.
The lenders under our senior secured credit facilities have the discretion to release any subsidiary guarantor under our senior secured credit facilities in a variety of circumstances, which would cause those subsidiary guarantors to be released from their guarantees of our outstanding notes.
While any obligations under our senior secured credit facilities remain outstanding, any subsidiary guarantee of our outstanding notes may be released without action by, or consent of, any holder of our senior notes or the trustee under the indenture governing the senior notes, at the discretion of lenders under the senior secured credit facilities, if the related subsidiary guarantor is no longer a guarantor of obligations under our senior secured credit facilities or any other indebtedness. The lenders under our senior secured credit facilities would have the discretion to release the subsidiary guarantees under our senior secured credit facilities in a variety of circumstances. Any holder of our notes will not have a claim as a creditor against any subsidiary that is no longer a guarantor of the senior notes, and the indebtedness and other liabilities, including trade payables, whether secured or unsecured, of those subsidiaries will effectively be senior to claims of noteholders.
The Parent’s guarantee of our outstanding notes may not provide any additional credit support for our senior notes.
Since the Parent has no significant operations or assets, its guarantee of our senior notes provides little, if any, additional credit support for the senior notes and investors should not rely on this guarantee in evaluating an investment in the senior notes. The indenture permits the Parent to be released from its guarantee of the senior notes at any time without the consent of any holder of the senior notes.
Federal and state statutes may allow courts, under specific circumstances, to void the guarantees and require noteholders to return payments received from guarantors.
Under federal bankruptcy law and comparable provisions of state fraudulent transfer laws, a guarantee could be deemed a fraudulent transfer if the guarantor received less than a reasonably equivalent value in exchange for giving the guarantee and
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was insolvent on the date that it gave the guarantee or became insolvent as a result of giving the guarantee, or
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was engaged in business or a transaction, or was about to engage in business or a transaction, for which property remaining with the guarantor was an unreasonably small capital, or
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intended to incur, or believed that it would incur, debts that would be beyond the guarantor’s ability to pay as those debts matured.
A guarantee could also be deemed a fraudulent transfer if it was given with actual intent to hinder, delay or defraud any entity to which the guarantor was or became, on or after the date the guarantee was given, indebted.
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The measures of insolvency for purposes of the foregoing considerations will vary depending upon the law applied in any proceeding with respect to the foregoing. Generally, however, a guarantor would be considered insolvent if:
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the sum of its debts, including contingent liabilities, is greater than all its assets, at a fair valuation, or
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the present fair saleable value of its assets is less than the amount that would be required to pay its probable liability on its existing debts, including contingent liabilities, as they become absolute and mature, or
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it could not pay its debts as they become due.
The indenture contains a “savings” provision intended to limit each subsidiary guarantor’s liability under its guarantee to the maximum amount that it could incur without causing the guarantee to be a fraudulent transfer. This provision may not be effective to protect the subsidiary guarantees from being voided under fraudulent transfer law. There can be no assurance that this provision will be upheld as intended. In a recent case, the U.S. Bankruptcy Court in the Southern District of Florida found the “savings” provision in that case to be ineffective, and held the subsidiary guarantees to be fraudulent transfers and voided them in their entirety.
If a guarantee is deemed to be a fraudulent transfer, it could be voided altogether, or it could be subordinated to all other debts of the guarantor. In such case, any payment by the guarantor pursuant to its guarantee could be required to be returned to the guarantor or to a fund for the benefit of the creditors of the guarantor. If a guarantee is voided or held unenforceable for any other reason, holders of our outstanding notes would cease to have a claim against the subsidiary based on the guarantee and would be creditors only of CPII and any guarantor whose guarantee was not similarly voided or otherwise held unenforceable.
We may not have the ability to raise funds necessary to finance any change of control offer required under the indenture.
If a change of control (as defined in the indenture) occurs, we will be required to offer to purchase our outstanding notes at 101% of their principal amount plus accrued and unpaid interest. If a purchase offer obligation arises under the indenture governing our senior notes, a change of control could also occur under our new senior secured credit facilities, which could result in the acceleration of the indebtedness outstanding thereunder. Any of our future debt agreements may contain similar restrictions and provisions. If a purchase offer were required under the indenture for our debt, we may not have sufficient funds to pay the purchase price of all debt, including our outstanding notes, that we are required to purchase or repay.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
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Item 2.
Item 2.
Properties
We own, lease or sublease manufacturing, assembly, warehouse, service and office properties having an aggregate floor space of approximately 1.2 million square feet, as well as land measuring in aggregate approximately 173 acres. The table that follows provides summary information regarding principal properties owned or leased by us:
The lenders under our senior secured credit facilities have a security interest in certain of our interests in the real property that we own and lease. Our headquarters and one principal complex, including one of our manufacturing facilities, located in Palo Alto, California, are subleased from Varian Medical Systems or one of its affiliates or former affiliates. Therefore, our occupancy rights are dependent on our sublessor’s fulfillment of its responsibilities to the master lessor, including its obligation to continue environmental remediation activities under a consent order with the California Environmental Protection Agency. The consequences of the loss by us of such occupancy rights could include the loss of valuable improvements and favorable lease terms, the incurrence of substantial relocation expenses and the disruption of our business operations.
Item 3.
Item 3.
Legal Proceedings
We are, from time to time, threatened with, or may become a party to, lawsuits, claims, investigations and proceedings, including commercial, environmental and employment matters, which arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm our business. We are currently not aware of any existing proceedings that we believe will have a material adverse effect on our business, financial condition, results of operation or liquidity.
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Item 4.
Item 4.
Mine Safety Disclosures
Not applicable.
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PART II
Item 5.
Item 5.
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
There is no established public trading market for our common stock. All of our outstanding shares of common stock are held by our parent, CPI International Holding LLC (“Holding LLC”). We are a holding company that does not conduct any business operations of our own. As a result, we are dependent upon cash dividends and distributions and other transfers from our subsidiaries to make dividend payments on our common stock. The amounts available to us to pay cash dividends are generally restricted by our senior secured credit facility covenants and the indenture for the senior subordinated notes. The declaration and payment of dividends also is subject to the discretion of our board of directors and depends on various factors, including our net income, financial condition, cash requirements, future prospects and other factors deemed relevant by our board of directors. We did not declare or pay dividends during fiscal years 2016 and 2015.
Item 6.
Item 6.
Selected Financial Data
The following table presents our selected historical consolidated financial information as of and for the periods presented. The selected historical financial information as of September 30, 2016 and October 2, 2015, and for the fiscal years ended September 30, 2016, October 2, 2015 and October 3, 2014 has been derived from our audited financial statements included elsewhere in this Annual Report. The selected historical financial information as of October 3, 2014, September 27, 2013, and September 28, 2012, and for the fiscal years ended September 27, 2013 and September 28, 2012 has been derived from our audited financial statements that are not included in this Annual Report. Fiscal year 2014 comprised 53 weeks and all other fiscal years presented comprised 52 weeks each.
The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and the related notes included elsewhere in this Annual Report.
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Footnotes (dollars in thousands):
(1)
For fiscal years 2016, 2015, 2014, 2013 and 2012, includes $906, $150, $1,539, $391 and $248, respectively, of utilization of the net increase in cost basis of inventory due to purchase accounting.
(2)
For fiscal year 2014, represents the write-offs of deferred debt issuance costs and unamortized debt discount of approximately $3,850 associated with the refinancing of CPI International, Inc.’s (“CPII’s”) senior secured credit facilities and incurred fees and costs of $3,385 associated with the consent solicitation relating to the amendment of the indenture governing the CPII’s senior notes due 2018.
(3)
For fiscal years 2016 and 2015, includes $363 and $50,377, respectively, of cash used for the acquisition of ASC Signal. For fiscal years 2014, 2013 and 2012, includes $36,776, $5,982 and $7,516 of cash used for the acquisition of Radant, M C L, Inc. (“MCL”) and Codan Satcom, respectively.
(4)
Excludes amortization of deferred debt issuance costs and issue discount, which are included in interest expense, net.
(5)
Operating income margin represents operating income divided by sales.
(6)
Net income margin represents net income divided by sales.
(7)
EBITDA represents earnings before net interest expense, provision for income taxes and depreciation and amortization. We believe that EBITDA is useful to assess our ability to generate cash from operations sufficient to pay taxes, to service debt and to undertake capital expenditures.
Adjusted EBITDA represents EBITDA further adjusted to exclude stock-based compensation expenses, certain refinancing expenses, acquisition-related and non-ordinary course professional expenses, Veritas Capital management fees and purchase accounting expenses. Adjusted EBITDA is calculated in accordance with the definitions contained in our debt agreements and is the basis for the calculations to determine our compliance with various covenants contained therein. We believe that Adjusted EBITDA is a useful financial metric to assess our operating performance from period to period by excluding certain items that we believe are not representative of our core business and to monitor compliance with certain covenants contained in our debt agreements.
For the reasons listed below, we believe that U.S. generally accepted accounting principles (“GAAP”) based financial information for leveraged businesses like ours should be supplemented by EBITDA and Adjusted EBITDA so that investors better understand our financial performance in connection with their analysis of our business:
•
EBITDA and Adjusted EBITDA are components of the measures used by our board of directors and management team to evaluate our operating performance;
•
our first lien senior credit facility contains covenants that require us to maintain a total leverage ratio in certain circumstances that contains Adjusted EBITDA as a component, and our management team uses Adjusted EBITDA to monitor compliance with these covenants; see “Management’s discussion and analysis of financial condition and results of operations-Liquidity and Capital Resources-Debt Obligations;”
•
EBITDA and Adjusted EBITDA are components of the measures used by our management team to make day-to-day operating decisions;
•
EBITDA and Adjusted EBITDA facilitate comparisons between our operating results and those of competitors with different capital structures and, therefore, are components of the measures used by the management to facilitate internal comparisons to competitors’ results and our industry in general; and
•
the payment of management bonuses is contingent upon, among other things, the satisfaction by us of certain targets that contain EBITDA or Adjusted EBITDA as a component.
EBITDA and Adjusted EBITDA are not presentations made in accordance with U.S. GAAP and have important limitations as analytical tools. EBITDA and Adjusted EBITDA should not be considered as alternatives to net income, operating income or any other performance measures derived in accordance with U.S. GAAP as measures of operating performance or operating cash flows as measures of liquidity. Our use of the terms EBITDA and Adjusted EBITDA varies from others in our industry. The calculation of Adjusted EBITDA in accordance with our debt agreements allows us to add back certain charges described above that are deducted in calculating EBITDA and/or net income (loss). However, some of these expenses may recur, vary greatly and are difficult to predict. Our presentation of EBITDA and Adjusted EBITDA should not be construed to imply that our future results will be unaffected by the items added back or excluded in the calculation of EBITDA and Adjusted EBITDA.
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The following table reconciles net income to EBITDA and Adjusted EBITDA:
(a)
Excludes amortization of deferred debt issuance costs and issue discount, which are included in interest expense, net.
(b)
Represents a non-cash charge for Class B membership interests in Holding LLC.
(c)
Represents loss on debt restructuring as described in footnote 2 above and expenses related to issuance of a special dividend.
(d)
Represents transaction costs related to evaluation, negotiation, closing and integration of acquisitions, as well as costs related to other special projects. Costs include fees for attorneys and other professional services, expenses related to integration of these new operations into those of CPI and a charge of $300, $2,100 and $3,300 for fiscal years 2016, 2015 and 2014, respectively, for an increase in the fair value of the Radant contingent consideration liability.
(e)
Represents a management fee payable to Veritas Capital for advisory and consulting services.
(f)
Represents utilization of the net increase in cost basis of inventory and net decrease in deferred revenue due to purchase accounting associated with, for fiscal years 2016 and 2015, the ASC Signal acquisition; for fiscal year 2014, the Radant acquisition; for fiscal year 2013, the MCL acquisition; and for fiscal year 2012, the Codan Satcom acquisition.
(8)
EBITDA margin represents EBITDA divided by sales. Adjusted EBITDA margin represents Adjusted EBITDA divided by sales.
(9)
For purposes of computing the ratio of earnings to fixed charges, earnings consist of income from continuing operations before income taxes and fixed charges less capitalized interest. Fixed charges consist of interest expense, including amortization of debt issuance costs and that portion of rental expenses that management considers to be a reasonable approximation of interest.
(10)
Working capital represents current assets minus current liabilities.
(11)
Working capital, total assets and long-term debt have been adjusted on a retrospective basis for our early adoption of certain recent accounting standard updates. Accordingly, current deferred tax assets have been reclassified to noncurrent assets and liabilities, and certain debt issuance costs previously included within other long-term assets have been reclassified as a reduction in long-term debt. See Note 2, “Recent Accounting Pronouncements,” to the accompanying consolidated financial statements for additional information on these updates.
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Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Our fiscal years are the 52- or 53-week periods that end on the Friday nearest September 30. Fiscal years 2016 and 2015 comprised the 52-week periods ended September 30, 2016 and October 2, 2015, respectively, and fiscal year 2014 comprised the 53-week period ended October 3, 2014. The following discussion should be read in conjunction with the accompanying consolidated financial statements, and the notes thereto, of CPI International Holding Corp.
Overview
CPI International Holding LLC (“Holding LLC”) owns all of the outstanding common stock of CPI International Holding Corp. (“Parent”), headquartered in Palo Alto, California, which is the parent company of CPI International, Inc. (“CPII”), which in turn is a parent company of Communications & Power Industries LLC (“CPI”) and Communications & Power Industries Canada Inc. (“CPI Canada”). The Veritas Capital Fund IV, L.P. and its affiliates, (“Veritas Capital”) and certain members of CPII’s management beneficially own shares of Parent’s common stock indirectly through their holdings in Holding LLC. CPI and CPI Canada, CPII’s main operating subsidiaries, together develop, manufacture and globally distribute components and subsystems used in the generation, amplification, transmission and reception of microwave signals for a wide variety of systems including radar, electronic warfare and communications (satellite and point-to-point) systems for military and commercial applications, specialty products for medical diagnostic imaging and the treatment of cancer, as well as microwave and radio frequency (“RF”) energy generating products for various industrial and scientific pursuits.
Business Combination
On September 17, 2015, we completed our purchase of the outstanding stock of ASC Signal Holdings Corporation (“ASC Signal”), a Delaware corporation, for a payment of approximately $50.7 million in cash consideration, net of $2.2 million cash acquired, including a post-closing adjustment based on a determination of ASC Signal’s closing net working capital of $0.4 million paid in the first quarter of fiscal year 2016. ASC Signal designs and builds advanced satellite communications, radar and high-frequency antennas and controllers used in commercial and government satellite communications, terrestrial communications, imagery and data transmission, and radar and intelligence applications. See Note 3, “Business Combinations,” to the accompanying consolidated financial statements for more information about the ASC Signal acquisition.
Orders
We sell our products into five end markets: defense (radar and electronic warfare), medical, communications, industrial and scientific.
Our customer sales contracts are recorded as orders when we accept written customer purchase orders or contracts. Customer purchase orders with an undefined delivery schedule, or blanket purchase orders, are not reported as orders until the delivery date is determined. Our government sales contracts are not reported as orders until we have been notified that the contract has been funded. Total orders for a fiscal period represent the total dollar amount of customer orders recorded by us during the fiscal period, reduced by the dollar amount of any order cancellations or terminations during the fiscal period.
Our orders by market for fiscal years 2016 and 2015 are summarized as follows (dollars in millions):
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Orders of $500.6 million for fiscal year 2016 were $63.2 million, or approximately 14%, higher than orders of $437.4 million for fiscal year 2015. Our ASC Signal operations, which resulted from our acquisition of ASC Signal in September 2015, contributed approximately $50 million in radar and communications orders for fiscal year 2016, of which the significant majority were in the communications market. Explanations for the order increase or decrease by market for fiscal year 2016 compared to fiscal year 2015 are as follows:
•
Radar and Electronic Warfare: The majority of our products in the radar and electronic warfare markets are for domestic and international defense and government end uses. Orders in these markets are typically characterized by many smaller orders of less than $3.0 million, and the timing of these orders may vary from year to year. Orders for the radar and electronic warfare markets increased 1%. Increased orders for a variety of radar programs, including the Aegis radar systems, and an airborne electronic countermeasure system, were partially offset by decreased orders for an airborne radome program and certain other radar systems. These changes were primarily the result of the timing of orders for these programs.
•
Medical: Orders for our medical products consist of orders for medical imaging applications, such as x-ray imaging, MRI and other applications, and for radiation therapy applications for the treatment of cancer. The 17% increase in medical orders was primarily due to higher orders of radiation therapy products as a result of the placement of multi-year orders for these products. This increase was partially offset by lower orders of x-ray imaging products for foreign customers, largely resulting from challenging global economic conditions, and lower orders to support MRI applications.
•
Communications: Orders for our communications products consist of orders for commercial and military communications applications. The 35% increase in communications orders was due to higher orders for both military and commercial communications applications, primarily resulting from the inclusion of orders from the ASC Signal operations in fiscal year 2016. In addition, orders for military communications applications benefited from increased orders for radomes to support a shipboard program and continuing demand for advanced tactical common data link (“TCDL”) antenna products for unmanned aerial vehicle (“UAV”) programs, while orders for commercial communications applications benefited from significant strength in satellite communications orders, particularly to support commercial high-throughput satellite systems and other fixed satellite services applications.
•
Industrial: Orders for our industrial market consist of products to support a wide range of systems used for applications including material processing, instrumentation and testing. Orders in this market are cyclical and generally follow the state of the economy. The $4.4 million decrease in industrial orders was primarily due to lower orders for cargo screening applications and electromagnetic vulnerability testing.
•
Scientific: Orders in the scientific market consist of equipment used in accelerators for the study of high-energy particle physics and in reactor fusion programs. Orders in this market are historically one-time projects and can fluctuate significantly from period to period. The $1.0 million decrease in scientific orders was primarily due to lower orders to support a domestic linear accelerator program.
Incoming order levels can fluctuate significantly on a quarterly or annual basis, and a particular quarter’s or year’s order rate may not be indicative of future order levels. In addition, our sales are highly dependent upon manufacturing scheduling and performance and, accordingly, it is not possible to accurately predict when orders will be recognized as sales.
Backlog
Backlog represents the cumulative balance, at a given point in time, of recorded customer sales orders that have not yet been shipped or recognized as sales. Backlog is increased when an order is received, and backlog is decreased when we recognize sales. As of September 30, 2016, we had an order backlog of $326.2 million compared to an order backlog of $319.9 million as of October 2, 2015. Because our orders for government end-use products generally have much longer delivery terms than our orders for commercial business (which require quicker turn-around), our backlog is primarily composed of government orders.
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We believe that backlog and orders information is helpful to investors because this information may be indicative of future sales results. Although backlog consists of firm orders for which goods and services are yet to be provided, customers can, and sometimes do, terminate or modify these orders. However, historically the amount of modifications and terminations has not been material compared to total contract volume.
Results of Operations
We derive our revenue primarily from the sale of a wide range of power generation and conversion products, consisting of vacuum electron devices (“VEDs”), solid-state devices, medical x-ray generators and various electronic power supply and control equipment, as well as satellite communications amplifiers, large-aperture antennas, advanced antenna technology and advanced composite radomes. We generally recognize revenue upon shipment of product, following receipt of written purchase orders, when the price is fixed or determinable, title has transferred and collectability is reasonably assured. Revenue recognized under the percentage-of-completion method of accounting is determined on the basis of costs incurred and estimates of costs at completion, which require management estimates of future costs.
Cost of goods sold generally includes costs for raw materials, manufacturing costs, including allocation of overhead and other indirect costs, charges for reserves for excess and obsolete inventory, warranty claims, losses on fixed price contracts and, normally upon a business combination, utilization of the net increase in cost basis of acquired inventory. Operating expenses generally consist of research and development, selling and marketing, general and administrative expenses and amortization of acquisition-related intangibles.
Fiscal year 2014 consisted of 53 weeks, compared to 52 weeks for each of fiscal years 2016 and 2015.
The second lien credit agreement we entered into in September 2015 resulted in, and will continue to result in, an increase in interest expense and in amortization of debt issuance costs and issue discount. The annual increase in cash interest expense due to term loan borrowing under our second lien credit agreement is estimated at approximately $2.2 million throughout its remaining term. The annual effect on amortization of debt issuance costs and issue discount on the second lien credit agreement averages $0.3 million throughout its remaining term.
We believe that our acquisition of ASC Signal in September 2015 resulted in, and will continue to result in, certain benefits, including cost savings, broader market opportunities, product innovations and operational efficiencies. However, the acquisition of ASC Signal also increased, and will continue to increase, certain of our noncash expenses. The noncash expenses (on a pretax basis) related to the acquisition of ASC Signal include (i) a $1.1 million charge, distributed over the three months following the date of the acquisition, for the utilization of the net increase in cost basis of inventory, and (ii) also as a result of the additional intangibles and property, plant and equipment, an average of approximately $2.0 million annual increase in depreciation and amortization expense until said assets are fully amortized or depreciated at various dates through 2039.
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The following table sets forth our historical results of operations for each of the periods indicated (dollars in millions):
Note: Totals may not equal the sum of the components due to independent rounding. Percentages are calculated based on rounded dollar amounts presented.
(a)
Cost of sales for fiscal years 2016, 2015 and 2014 includes $0.9 million, $0.2 million and $1.5 million, respectively, of utilization of the net increase in cost basis of inventory that resulted from purchase accounting in connection with acquisitions.
(b)
EBITDA represents earnings before net interest expense, provision for income taxes and depreciation and amortization. For the reasons listed below, we believe that U.S. generally accepted accounting principles (“GAAP”) based financial information for leveraged businesses, such as ours, should be supplemented by EBITDA so that investors better understand our financial performance in connection with their analysis of our business:
•
EBITDA is a component of the measures used by our board of directors and management team to evaluate our operating performance;
•
our first lien senior credit facility contains covenants that require us to maintain a total leverage ratio in certain circumstances that contains EBITDA as a component, and our management team uses EBITDA to monitor compliance with these covenants;
•
EBITDA is a component of the measures used by our management team to make day-to-day operating decisions;
•
EBITDA facilitates comparisons between our operating results and those of competitors with different capital structures and, therefore, is a component of the measures used by the management to facilitate internal comparisons to competitors’ results and our industry in general; and
•
the payment of management bonuses is contingent upon, among other things, the satisfaction by us of certain targets that contain EBITDA as a component.
Other companies may define EBITDA differently and, as a result, our measure of EBITDA may not be directly comparable to EBITDA of other companies. Although we use EBITDA as a financial measure to assess the performance of our business, the use of EBITDA is limited because it does not include certain material costs, such as interest and taxes, necessary to operate our business. When analyzing our performance, EBITDA should be considered in addition to, and not as a substitute for or superior to, net income, cash flows from operating activities or other statements of income or statements of cash flows data prepared in accordance with GAAP.
For a reconciliation of net income to EBITDA, see footnote 7 under Selected Financial Data above.
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Our results for fiscal year 2016 compared to our results for fiscal year 2015
Sales: Our sales by market for fiscal years 2016 and 2015 are summarized as follows (dollars in millions):
Sales of $494.6 million for fiscal year 2016 were $46.9 million, or approximately 10%, higher than sales of $447.7 million for fiscal year 2015. Our ASC Signal operations contributed approximately $47 million in radar and communications sales for fiscal year 2016, of which the significant majority were in the communications market. Explanations for the sales increase or decrease by market for fiscal year 2016 compared to fiscal year 2015 are as follows:
•
Radar and Electronic Warfare: The majority of our products in the radar and electronic warfare markets are for domestic and international defense and government end uses. The timing of order receipts and subsequent shipments in these markets may vary from year to year. Sales for the radar and electronic warfare markets increased 3%, primarily due to the inclusion of sales from the ASC Signal operations in fiscal year 2016 and higher sales for a variety of radar programs. These increases were partially offset by lower sales to support electronic warfare applications.
•
Medical: Sales of our medical products consist of sales for medical imaging applications, such as x-ray imaging, MRI and other applications, and for radiation therapy applications for the treatment of cancer. The 12% decrease in sales in the medical market was primarily due to lower sales of x-ray imaging products for foreign customers, largely resulting from challenging global economic conditions, and lower sales to support MRI applications. Sales to support radiation therapy applications increased.
•
Communications: Sales of our communications products consist of sales for commercial and military communications applications. The 27% increase in sales in the communications market was primarily due to the inclusion of sales from the ASC Signal operations in fiscal year 2016 and increased sales to support military communications applications. Partially offsetting these increases, sales to support commercial direct-to-home broadcast programs, which generally have cyclical timing, decreased.
•
Industrial: Sales for our industrial market consist of sales to support a wide range of systems used for applications including material processing, instrumentation and testing. Sales in this market are cyclical and generally follow the state of the economy. The $4.7 million increase in sales of industrial products was primarily the result of higher sales to support material analysis and electromagnetic vulnerability testing applications.
•
Scientific: Sales in the scientific market consist of sales of equipment used in accelerators for the study of high-energy particle physics and in reactor fusion programs. Sales in this market are historically one-time projects and can fluctuate significantly from period to period. The $1.2 million increase in sales of scientific products was primarily the result of higher sales to support large foreign and domestic linear accelerator programs, and was partially offset by decreased sales for several small scientific programs.
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Gross Profit. Gross profit was $139.0 million, or 28.1% of sales, for fiscal year 2016 compared to $125.6 million, or 28.1% of sales, for fiscal year 2015. The $13.4 million increase in gross profit was primarily due to a full-year of gross profit from ASC Signal and the favorable impact of Canadian costs due to the strength of the U.S. dollar, partially offset by a less favorable mix of product shipments and a $0.9 million charge for utilization of the net increase in cost basis of inventory acquired from ASC Signal.
Research and Development. Research and development expenses were $15.9 million, or 3.2% of sales, for fiscal year 2016 and $14.9 million, or 3.3% of sales, for fiscal year 2015. The $1.0 million increase in research and development expenses was primarily due to a full-year of ASC Signal Division expenses, partially offset by higher spending on customer-sponsored research and development which is charged to cost of sales.
Total spending on research and development, including customer-sponsored research and development, was as follows (in millions):
Customer-sponsored research and development represents development costs incurred on customer sales contracts to develop new or improved products.
Selling and Marketing. Selling and marketing expenses were $25.5 million, or 5.2% of sales, for fiscal year 2016, and $22.5 million, or 5.0% of sales, for fiscal year 2015. The $3.0 million increase in selling and marketing expenses was primarily due to the inclusion of a full-year of ASC Signal Division expenses.
General and Administrative. General and administrative expenses were $31.0 million, or 6.3% of sales, for fiscal year 2016, and $31.5 million, or 7.0% of sales, for fiscal year 2015. The $0.5 million decrease in general and administrative expenses was primarily due to a reduction in acquisition closing, integration and evaluation expenses, lower contingent consideration expense related to our October 2013 acquisition of Radant Technologies, Inc. (“Radant”) and a lower allowance for doubtful accounts in fiscal year 2016, partially offset by the inclusion of a full-year of ASC Signal Division expenses for fiscal year 2016.
Amortization of Acquisition-related Intangibles. Amortization of acquisition-related intangibles consists of purchase accounting charges for technology and other intangible assets. Amortization of acquisition-related intangibles was $13.8 million for fiscal year 2016 and $10.4 million for fiscal year 2015. The $3.4 million increase in amortization of acquisition-related intangibles was primarily due to a full-year of amortization expense for intangibles acquired from the ASC Signal acquisition.
Interest Expense, Net (“Interest Expense”). Interest expense was $39.1 million, or 7.9% of sales, for fiscal year 2016 and $36.5 million, or 8.2% of sales, for fiscal year 2015. The $2.6 million increase in interest expense was primarily due to debt financing of $28 million in September 2015 used to partially fund the ASC Signal acquisition.
Income Tax Expense. We recorded an income tax expense of $8.0 million and $4.8 million for fiscal years 2016 and 2015, respectively. The effective income tax rate for fiscal years 2016 and 2015 was 58% and 49%, respectively. The 58% effective income tax rate for fiscal year 2016 was lower than our estimated tax rate of approximately 60% for fiscal year 2016 primarily due to the favorable resolution of and the expiration of the statute of limitations for uncertain tax positions and a tax benefit from a change in state income apportionment. The 49% tax rate for fiscal year 2015 was approximately the same as our estimated effective tax rate for fiscal year 2015 of approximately 50%. The increase in the estimated tax rate from 50% for fiscal year 2015 to 60% for fiscal year 2016 was primarily due to an increase in foreign earnings and in our foreign tax credit limitation. The foreign tax credit limitation increased our effective income tax rate by 18% for fiscal year 2016 and 17% for fiscal year 2015.
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Net Income. Net income was $5.7 million, or 1.2% of sales, for fiscal year 2016 compared to $4.9 million, or 1.1% of sales, for fiscal year 2015. The $0.8 million increase in net income was primarily due to a full-year of gross profit from ASC Signal, the favorable impact of Canadian costs due to the strength of the U.S. dollar, lower acquisition closing and integration expenses, lower Radant contingent consideration expense and lower allowance for doubtful accounts, partially offset by a full-year of ASC Signal operating expenses, amortization expense and interest expense for debt financing used to partially fund the ASC Signal acquisition, and higher income tax expense in fiscal year 2016.
EBITDA. EBITDA was $79.2 million, or 16.0% of sales, for fiscal year 2016 compared to $69.5 million, or 15.5% of sales, for fiscal year 2015. The $9.7 million increase in EBITDA was primarily due to a full-year of gross profit from ASC Signal, the favorable impact of Canadian costs due to the strength of the U.S. dollar, lower acquisition closing and integration expenses, lower Radant contingent consideration expense and lower allowance for doubtful accounts, partially offset by a full-year of ASC Signal operating expenses in fiscal year 2016.
Calculation of Management Bonuses. Management bonuses were $1.0 million in fiscal year 2016 compared to $0.9 million in fiscal year 2015. Management bonuses for fiscal year 2016 and fiscal year 2015 were calculated pursuant to our Management Incentive Plan (“MIP”) and were based on three factors: (1) EBITDA as adjusted for purposes of calculating management bonuses; (2) a measure of cash generated by operations; and (3) individual goals that were customized for certain participating members of management. The weight given to each of these factors varied for each person. Generally, for fiscal year 2016 for our officers, the EBITDA factor was weighted at 50% and cash generated by operations at 50%, and individual goals were not applicable. For our other members of management, generally equal weight was given to each EBITDA factor, cash generated by operations and individual goals. Management bonuses are paid in cash approximately three months after the end of the fiscal year. EBITDA as adjusted for purposes of calculating management bonuses is equal to EBITDA for the fiscal year adjusted to exclude the impact of certain charges as pre-determined in our MIP for the fiscal year. EBITDA for purposes of calculating management bonuses for fiscal year 2016 was $86.1 million compared to $78.6 million in fiscal year 2015. For fiscal year 2016, the excluded charges from EBITDA in calculating management bonuses were acquisition-related and non-ordinary course professional expenses of $2.3 million, stock-based compensation expense of $0.6 million, Veritas Capital management fees of $2.6 million and purchase accounting expenses of $1.3 million. For fiscal year 2015, the charges that were excluded from EBITDA in calculating management bonuses were acquisition-related expenses of $6.0 million, stock-based compensation expense of $1.0 million, Veritas Capital management fees of $2.4 million and purchase accounting expenses of $0.2 million. Also excluded from EBITDA for purposes of calculating management bonuses for fiscal year 2015 was EBITDA generated by the ASC Signal acquisition of $0.6 million. We are presenting EBITDA as adjusted for purposes of calculating management bonuses here to help investors understand how our management bonuses were calculated, and not as a measure to be used by investors to evaluate our operating results or liquidity.
Our results for fiscal year 2015 compared to our results for fiscal year 2014
Sales: Our sales by market for fiscal year 2015, which included 52 weeks, and for fiscal year 2014, which included 53 weeks, are summarized as follows (dollars in millions):
Sales of $447.7 million for fiscal year 2015 were $27.6 million, or approximately 6%, lower than sales of $475.3 million for fiscal year 2014. Our ASC Signal operations, which resulted from our acquisition of ASC Signal in September 2015, contributed approximately $3 million in radar and communications sales for fiscal year 2015. Explanations for the sales decrease by market for fiscal year 2015 compared to fiscal year 2014 are as follows:
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•
Radar and Electronic Warfare: The majority of our products in the radar and electronic warfare markets are for domestic and international defense and government end uses. The timing of order receipts and subsequent shipments in these markets may vary from year to year. Sales for these two markets were essentially unchanged. An increase in sales to support certain naval radar programs, including Aegis radar systems, was offset by a decrease in sales to support a radar program with fluctuating annual demand levels and an airborne electronic warfare program that has been completed.
•
Medical: Sales of our medical products consist of sales for medical imaging applications, such as x-ray imaging, MRI and other applications, and for radiation therapy applications for the treatment of cancer. The 7% decrease in sales in the medical market was primarily due to a decrease in sales of x-ray imaging products, in part due to lower sales for customers in Asia, and was partially offset by an increase in sales for MRI applications. Sales for our x-ray imaging products were negatively impacted by foreign economic conditions and the relative strength of the U.S. dollar in fiscal year 2015.
•
Communications: Sales of our communications products consist of sales for commercial and military communications applications, and the 8% decrease in sales in the communications market was due to lower sales for both types of applications. The decrease in commercial communications sales was primarily due to the timing of large direct-to-home and fixed satellite services programs for which orders were received, and shipments were made, in fiscal year 2014 but not in fiscal year 2015. We also believe that economic conditions in Russia caused recent program delays for certain sizable commercial communications programs. The decrease in military communications sales was primarily the result of lower sales of advanced TCDL antenna products for a specific program, as expected, due to the completion of shipments for the large original order; shipments are continuing for smaller, follow-on orders subsequently received for this program.
•
Industrial: Sales for our industrial market consist of sales to support a wide range of systems used for applications including material processing, instrumentation and testing. Sales in this market are cyclical and generally follow the state of the economy. The $1.9 million decrease in sales of industrial products was due to lower sales to support electromagnetic vulnerability testing, material analysis and industrial fabrication applications and was partially offset by an increase in sales to support cargo screening applications.
•
Scientific: Sales in the scientific market consist of sales of equipment used in accelerators for the study of high-energy particle physics and in reactor fusion programs. Sales in this market are historically one-time projects and can fluctuate significantly from period to period. The $4.7 million decrease in scientific sales was the result of a decrease in sales for certain foreign linear accelerator programs.
Gross Profit. Gross profit was $125.6 million, or 28.1% of sales, for fiscal year 2015 compared to $138.6 million, or 29.2% of sales, for fiscal year 2014. The $13.0 million decrease in gross profit was primarily due to lower shipment volume and a less favorable mix of product shipments for fiscal year 2015, partially offset by the favorable impact from currency translation of Canadian costs due to the strength of the U.S. dollar for fiscal year 2015 and the absence of a $1.5 million charge for utilization of the net increase in cost basis of inventory acquired in the acquisition of Radant for fiscal year 2014.
Research and Development. Research and development expenses were $14.9 million, or 3.3% of sales, for fiscal year 2015 and $15.8 million, or 3.3% of sales, for fiscal year 2014. The $0.9 million decrease in research and development expenses was primarily due to higher spending on customer funded programs which is charged to cost of sales.
Total spending on research and development, including customer-sponsored research and development, was as follows (in millions):
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Customer-sponsored research and development represents non-recurring development costs incurred on customer sales contracts to develop new or improved products.
Selling and Marketing. Selling and marketing expenses were $22.5 million, or 5.0% of sales, for fiscal year 2015, and $23.5 million, or 4.9% of sales, for fiscal year 2014. The $1.0 million decrease in selling and marketing expenses was primarily due to lower sales incentive expenses and the favorable impact of foreign currency denominated expenses, due to the strength of the U.S. dollar for fiscal year 2015, and the absence of the additional work week in fiscal year 2015 compared to fiscal year 2014.
General and Administrative. General and administrative expenses were $31.5 million, or 7.0% of sales, for fiscal year 2015, and $32.5 million, or 6.8% of sales, for fiscal year 2014. The $1.0 million decrease in general and administrative expenses was primarily due to $2.4 million lower accruals for management incentives in fiscal year 2015 than in fiscal year 2014, a $1.2 million reduction in the Radant contingent consideration expense and the favorable impact from currency translation of foreign expenses due to the strength of the U.S. dollar, and the absence of the additional work week in fiscal year 2015 compared to fiscal year 2014. The decrease in general and administrative expenses was partially offset by a $2.8 million increase in acquisition-related expenses, primarily related to the ASC Signal acquisition and a $0.6 million increase in allowance for doubtful accounts in fiscal year 2015 compared to fiscal year 2014.
Amortization of Acquisition-related Intangibles. Amortization of acquisition-related intangibles consists of purchase accounting charges for technology and other intangible assets. Amortization of acquisition-related intangibles was $10.4 million for fiscal year 2015 and $10.5 million for fiscal year 2014. There was no significant change in the amortization of acquisition-related intangibles for fiscal year 2015 compared to fiscal year 2014.
Interest Expense, Net (“Interest Expense”). Interest expense was $36.5 million, or 8.2% of sales, for fiscal year 2015 and $32.2 million, or 6.8% of sales, for fiscal year 2014. The $4.3 million increase in interest expense was primarily due to the approximately $170.0 million increase in borrowings under the first lien term loan facility in connection with the April 2014 debt restructuring, partially offset by the absence of the additional work week in fiscal year 2015.
Loss on Debt Restructuring. Loss on debt restructuring of $7.2 million for fiscal year 2014 was due to expenses incurred in connection with the April 2014 debt restructuring. The loss on debt restructuring consisted of non-cash write-offs of unamortized debt issuance costs and original issue discount of $3.8 million for the termination of the previous senior secured credit facilities, as well as cash payments to third-party consultants of $3.4 million for services to modify the indenture governing our senior notes.
Income Tax Expense. We recorded an income tax expense of $4.8 million and $7.7 million for fiscal years 2015 and 2014, respectively. The effective income tax rate for fiscal year 2015 was 49%, and the effective income tax rate for fiscal year 2014 was 46%. The 49% tax rate for fiscal year 2015 was approximately the same as our estimated normalized effective tax rate for fiscal year 2015 of approximately 50%. Fiscal year 2015 included several discrete tax benefits that essentially offset discrete tax charges during the year. Fiscal year 2015 discrete tax benefits included $0.7 million for a change in state income apportionment and $1.0 million from the release of tax reserves, primarily for closure of California tax audit. Fiscal year 2015 discrete tax charges included $0.7 million for nondeductible acquisition earn-out expense, $0.6 million for an uncertain tax position attributable to amortizable basis and $0.5 million for nondeductible acquisition expenses. The 46% income tax rate for fiscal year 2014 was higher than our estimated normalized effective income tax rate of 38% for fiscal year 2014 primarily due to a change in our ability to utilize foreign tax credits generated or to be generated upon repatriation of certain earnings and nondeductible acquisition earn-out expense. This increase in tax was partially offset by discrete income tax benefits from the expiration of the statute of limitations on certain tax contingency reserves and a provision to tax return true-up. The increase in our estimated normalized tax rate of 38% for fiscal year 2014 to 50% for fiscal year 2015 is primarily due to foreign tax credit limitations.
Net Income. Net income was $4.9 million, or 1.1% of sales, for fiscal year 2015 compared to $9.1 million, or 1.9% of sales, for fiscal year 2014. The $4.2 million decrease in net income was primarily due to lower gross profit from lower shipment volume and a less favorable mix of product shipments, higher interest expense due primarily to the April 2014 debt restructuring, and higher acquisition-related expenses, partially offset by the absence of a loss on debt extinguishment, lower income tax expense, lower management incentive accruals, a lower increase in the fair value of the Radant contingent consideration liability, and the favorable currency translation effect of expenses denominated in foreign currencies due to the strength of the U.S. dollar for fiscal year 2015 compared to fiscal year 2014.
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EBITDA. EBITDA was $69.5 million, or 15.5% of sales, for fiscal year 2015 compared to $72.9 million, or 15.3% of sales, for fiscal year 2014. The $3.4 million decrease in EBITDA was primarily due to lower gross profit from lower shipment volume and a less favorable mix of product shipments and higher acquisition-related expenses, partially offset by the absence of a loss on debt extinguishment, lower management incentive accruals, a lower increase in the fair value of the Radant contingent consideration liability, and the favorable currency translation effect of expenses denominated in foreign currencies due to the strength of the U.S. dollar for fiscal year 2015 compared to fiscal year 2014.
Calculation of Management Bonuses. Management bonuses were $0.9 million in fiscal year 2015 compared to $3.6 million in fiscal year 2014. Management bonuses for fiscal year 2015 and fiscal year 2014 were calculated pursuant to our MIP and were based on three factors: (1) EBITDA as adjusted for purposes of calculating management bonuses; (2) a measure of cash generated by operations; and (3) individual goals that were customized for certain participating members of management. The weight given to each of these factors varied for each person. Generally, for fiscal year 2015 for our officers, the EBITDA factor was weighted at 50% and cash generated by operations at 50%, and individual goals were not applicable. For our other members of management, generally equal weight was given to each EBITDA factor, cash generated by operations and individual goals. Management bonuses are paid in cash approximately three months after the end of the fiscal year. EBITDA as adjusted for purposes of calculating management bonuses is equal to EBITDA for the fiscal year adjusted to exclude the impact of certain charges as pre-determined in our MIP for the fiscal year. EBITDA for purposes of calculating management bonuses for fiscal year 2015 was $78.6 million compared to $89.8 million in fiscal year 2014. For fiscal year 2015, the excluded charges from EBITDA in calculating management bonuses were acquisition-related expenses of $6.0 million, stock-based compensation expense of $1.0 million, Veritas Capital management fees of $2.4 million and purchase accounting expenses of $0.2 million. Also excluded from EBITDA for purposes of calculating management bonuses for fiscal year 2015 was EBITDA generated by the ASC Signal acquisition of $0.6 million. For fiscal year 2014, the charges that were excluded from EBITDA in calculating management bonuses were acquisition-related expenses of $4.2 million, stock-based compensation expense of $1.0 million, Veritas Capital management fees of $2.7 million, purchase accounting expenses of $1.5 million and expenses related to refinancing and issuance of a special dividend of $7.5 million. We are presenting EBITDA as adjusted for purposes of calculating management bonuses here to help investors understand how our management bonuses were calculated, and not as a measure to be used by investors to evaluate our operating results or liquidity.
Liquidity and Capital Resources
Overview
Our liquidity is affected by many factors, some of which are based on normal ongoing operations of our business and others that are related to uncertainties in the markets in which we compete and other global economic factors. We have historically financed, and intend to continue to finance, our capital and working capital requirements, including debt service and internal growth, through a combination of cash flows from our operations and borrowings under our senior secured credit facilities. Our primary uses of cash are cost of sales, operating expenses, debt service, income taxes and capital expenditures.
The term loans under our first and second lien credit facilities will mature and become payable in November 2017 unless we refinance at least 65% of our outstanding senior notes and satisfy certain other conditions prior to that time. However, if we refinance at least 65% of our outstanding senior notes and satisfy certain other conditions prior to the requisite deadline, the maturity of the term loans under our first and second lien credit facilities will be extended by approximately three and a half years. We intend to refinance at least 65% of our outstanding senior notes and satisfy the conditions necessary for the extension of the maturity dates of the term loans under our first and second lien credit facilities. On December 12, 2016, we entered into a commitment letter (the “Commitment Letter”) with UBS, AG, Stamford Branch and UBS Securities LLC (collectively, “UBS”), pursuant to which UBS has committed (subject to certain customary conditions) to provide and arrange a bridge loan facility of $245 million to refinance 100% of our existing senior notes (if we are otherwise unable to refinance our senior notes with certain other financing) and 100% of our second lien credit facility (see more information under the caption “Debt Obligations” below).
On September 17, 2015, we purchased the outstanding stock of ASC Signal for a payment of approximately $50.7 million in cash consideration, net of $2.2 million cash acquired, including a post-closing adjustment based on a determination of ASC Signal’s closing net working capital of $0.4 million paid in the first quarter of fiscal year 2016. We funded this acquisition with cash from operations and borrowings in an aggregate principal amount of $28.0 million under a new second lien term loan facility. See “Debt Obligations” under the caption “Contractual Obligations” below for more information.
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Our Radant Technologies Division, formed in October 2013 from our acquisition of Radant, has achieved certain agreed-upon financial targets over the two years following the date of the acquisition. As a result, on December 16, 2015, we paid the previous owners of Radant $10.0 million in settlement of a contingent consideration earnout arrangement in connection with such acquisition.
Assuming we are successful in refinancing our senior notes prior to November, 2017, we believe that cash flows from operations and availability under our revolving credit facility included in our first lien credit facility will be sufficient to fund our working capital needs, capital expenditures and other business requirements for at least the next 12 months.
Our ability to make payments to fund working capital, capital expenditures, debt service, strategic acquisitions, joint ventures and investments will depend on our ability to generate cash in the future, which is subject to general economic, financial, competitive, regulatory and other factors that are beyond our control. Future indebtedness may impose various restrictions and covenants on us which could limit our ability to respond to market conditions, to provide for unanticipated capital investments or to take advantage of business opportunities.
Cash and Working Capital
The following summarizes our cash and cash equivalents and working capital (in millions):
We invest cash balances in excess of operating requirements in overnight U.S. Government securities and money market accounts. In addition to the above cash and cash equivalents, we have restricted cash of $1.6 million as of September 30, 2016, consisting primarily of bank guarantees from customer advance payments to our international subsidiaries and cash collateral for certain performance bonds. The bank guarantees will become unrestricted cash when performance under the sales contract is complete. The cash collateral for the performance bonds will become unrestricted cash when the performance bonds expire.
We are highly leveraged. As of September 30, 2016, excluding approximately $4.5 million of outstanding letters of credit, our total indebtedness was $545.3 million before the total unamortized debt discount of $2.6 million and debt issuance costs of $8.2 million. We also had an additional $25.5 million available for borrowing under our revolving credit facility as of September 30, 2016. Our liquidity requirements are significant, primarily due to debt service requirements. For fiscal year 2016, our interest expense exclusive of debt issuance costs and discount amortization was $34.4 million, and our cash interest paid was $34.6 million. With the additional borrowings under a new second term loan facility we entered into on September 17, 2015 to partially fund the ASC Signal acquisition, our interest expense in fiscal year 2016 increased compared to the prior year .
As of September 30, 2016, we were in compliance with the covenants under the agreements governing our existing senior secured credit facilities and the indentures governing our senior notes.
Free Cash Flow and Adjusted Free Cash Flow
Our free cash flow and adjusted free cash flow were $20.2 million and $29.1 million, respectively, for fiscal year 2016. Free cash flow represents net cash provided by operating activities minus capital expenditures. Adjusted free cash flow represents free cash flow further adjusted to exclude certain acquisition-related and non-ordinary course professional costs, Veritas Capital management fees and the estimated tax benefit from these expenses. While these items may be recurring in nature, our management team believes that excluding such inflows and outflows from the presentation provides investors with an important supplemental metric by which to evaluate our operating financial performance and liquidity.
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We believe that GAAP-based financial information for leveraged businesses, such as our business, should be supplemented by free cash flow and adjusted free cash flow so that investors better understand our operating performance in connection with their analysis of our business. Other companies may define free cash flow and adjusted free cash flow differently and, as a result, our measures may not be directly comparable to free cash flow and adjusted free cash flow of other companies. Because free cash flow and adjusted free cash flow do not include certain material costs necessary to operate our business, when analyzing our business, these non-GAAP measures should be considered in addition to, and not as a substitute for, net cash provided by operating activities or statements of cash flows data prepared in accordance with GAAP.
The following table reconciles free cash flow and adjusted free cash flow, non-GAAP financial measures, from a GAAP financial measure (in millions):
Historical Operating, Investing and Financing Activities
In summary, our cash flows were as follows (in millions):
Operating Activities
During the periods presented above, we funded our operating activities through cash generated internally. Cash provided by operating activities is net income adjusted for certain non-cash items and changes to working capital items.
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Net cash provided by operating activities of $26.1 million in fiscal year 2016 was attributable to net income of $5.7 million and depreciation, amortization and other non-cash charges of $31.2 million, partially offset by net cash used in working capital of $10.8 million. The primary uses of cash for working capital during fiscal year 2016 were an increase in inventories in anticipation of fulfilling certain customer orders and a decrease in accrued expenses. The decrease in accrued expenses reflects the operating portion of the settlement of a contingent consideration earnout arrangement associated with the Radant acquisition, revenue recognition during fiscal year 2016 for which customer advances assumed from ASC Signal acquisition were applied, and payments made for previously accrued acquisition expenses related to ASC Signal. The aforementioned uses of cash for working capital were partially offset by an increase in net income tax payable due to the higher income tax expense for fiscal year 2016.
Net cash provided by operating activities of $20.6 million in fiscal year 2015 was attributable to net income of $4.9 million and depreciation, amortization and other non-cash charges of $26.5 million, partially offset by net cash used in working capital of $10.8 million. The primary uses of cash for working capital during fiscal year 2015 were an increase in accounts receivable due to the timing factors associated with shipments and sales.
Net cash provided by operating activities of $53.6 million in fiscal year 2014 was attributable to net income of $9.1 million; depreciation, amortization and other non-cash charges of $39.7 million; and net cash provided by working capital of $4.8 million. The primary working capital sources of cash in fiscal year 2014 were the improved collection of accounts receivable and an increase in accrued expenses due to timing of payroll accruals. The aforementioned working capital sources of cash were significantly offset by a decrease in accounts payable, advance payments from customers, and uncertain tax position reserve. Accounts payable decreased primarily as a result of a timing difference in inventory purchases and the payment of various professional service fees. The decrease in advance payments from customers was primarily due to timing differences in billing and receipt of contract advances. The decrease in reserves for uncertain tax positions was primarily due to the statute of limitation expiration.
Investing Activities
Investing activities for fiscal year 2016 comprised capital expenditures of $5.9 million and an additional payment of $0.4 million made for the purchase of the outstanding stock of ASC Signal. The additional consideration resulted from post-closing adjustment related to ASC Signal’s working capital. The investing outflows were partially offset by $0.3 million cash proceeds received from the sale of available-for-sale securities.
Investing activities for fiscal year 2015 comprised a payment of $50.4 million made for the purchase of the outstanding stock of ASC Signal and capital expenditures of $6.5 million.
Investing activities for fiscal year 2014 comprised a payment of $36.8 million made for the purchase of the outstanding stock of Radant and capital expenditures of $7.7 million.
Financing Activities
Financing activities for fiscal year 2016 comprised the financing portion of the settlement of the contingent consideration associated with the Radant acquisition for $4.3 million, repayment of borrowings under CPII’s first lien term loan facility of $3.1 million and payments of debt issuance costs totaling $0.1 million.
Financing activities for fiscal year 2015 comprised borrowings in the amount of $27.4 million, net of issue discount, under CPII’s new second lien term loan facility, partially offset by repayments of borrowings under CPII’s first lien term loan facility of $3.1 million and payments of debt issuance costs totaling $1.1 million.
Financing activities for fiscal year 2014 comprised a dividend payment of $175.0 million, repayments of borrowings under CPII’s prior and then new first lien term loan facilities of $144.2 million and $1.5 million, respectively, and payments of various costs totaling $14.1 million associated with the April 2014 debt restructuring activities. These financing uses of cash were significantly offset by $309.2 million in net proceeds from borrowings under the first lien term loan facility.
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Contractual Obligations
The following table summarizes our significant contractual obligations as of September 30, 2016 and the effect that such obligations are expected to have on our liquidity and cash flows in future periods (in thousands):
The above table assumes that the respective debt instruments will be outstanding until their scheduled maturity dates and that interest rates in effect on September 30, 2016 remain constant for future periods. The debt obligations in the above table also reflect the prepayment requirement under our senior secured credit facilities, which is calculated based on a percentage of “excess cash flow” as defined in the credit agreement governing our senior secured credit facilities. The excess cash flow mandatory prepayment is applied to scheduled installments of the first lien term loan facility (and allocated to such scheduled installments in direct order to the remaining scheduled installments) until paid in full. The excess cash flow mandatory prepayment is required to be made within five business days of issuing the year-end consolidated financial statements. Based on the results for fiscal year 2016, we determined a prepayment of $10.1 million will be required to be made during the first quarter of fiscal year 2017. Classified accordingly as current in the consolidated balance sheet, this $10.1 million is the only excess cash flow payment reflected in the table above. The remaining balance on our senior secured credit facilities is classified as noncurrent.
The above table also excludes (i) any optional prepayments on our term loan facilities, and (ii) the effect of anticipated refinancing of our senior notes by November 17, 2017 as described above, which would, subject to the satisfaction of certain other conditions, extend the maturity date for the term loan facilities from November 2017 to April 2021. Also excluded from the table above are future cash flows associated with our uncertain tax positions and our ASC Signal division's environmental loss contingency (see the information under the captions “Contingent Income Tax Obligations” and “Environmental Costs,” respectively, below).
The expected timing of payment amounts of the obligations in the above table is estimated based on current
information; the actual timing and amount of payments may be different.
Leases: We are committed to minimum rentals under non-cancelable operating lease agreements, primarily for land and facility space, that expire on various dates through 2050. Certain of our leases provide for escalating lease payments. Assets subject to capital leases as of September 30, 2016 were not material.
Purchase Commitments: As of September 30, 2016, we had known purchase commitments of $46.2 million, which include primarily future purchases for inventory-related items under various purchase arrangements as well as other obligations in the ordinary course of business that we cannot cancel or for which we would be required to pay a termination fee in the event of cancellation.
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Debt Obligations: As of September 30, 2016, our long-term debt consisted of the following (in thousands):
Senior Secured Credit Facilities. In April 2014, we entered into a first lien credit agreement, which provides for (a) a first lien term loan in an aggregate principal amount of $310.0 million and (b) a $30.0 million revolving credit facility. We borrowed the full amount of the first lien term loan facility in connection with our April 2014 debt restructuring. No borrowings have been made to date under the revolving credit facility (other than for approximately $4.5 million of outstanding letters of credit as of September 30, 2016). We may seek commitments for new term loans and revolving loans in an amount not to exceed $75.0 million plus the aggregate amount of certain prepayments outlined in the first lien credit agreement.
On September 17, 2015, we entered into a second lien credit agreement, which provides for a second lien term loan borrowings in an aggregate principal amount of $28.0 million. We borrowed the entire $28.0 million available under the second lien term loan in connection with our acquisition of ASC Signal. We may seek commitments for new term loans in an amount not to exceed $10.0 million plus the aggregate amount of certain prepayments outlined in the second lien credit agreement.
Except as noted below, the first lien term loan and the second lien term loan will mature on November 17, 2017 and the revolving credit facility will mature on August 19, 2017. However, if (a) in the case of the term loans, on or before November 17, 2017, and, in the case of the revolving credit facility, on or before August 19, 2017, CPII has repaid or refinanced no less than 65% of our senior notes outstanding as of the closing date of the first lien term loan, or (b) the first lien leverage ratio as of August 19, 2017 is 2.50:1 or less on a pro forma basis, then the term loans will mature on April 7, 2021 and the revolving credit facility will mature on April 7, 2019.
The revolving credit facility includes borrowing capacity available for letters of credit and for short-term borrowings referred to as the swingline borrowings. Our obligations under the first lien and second lien credit agreements are guaranteed by Parent and CPII’s domestic subsidiaries and are secured by substantially all of the assets of CPII and such guarantors.
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Borrowings under each of the first lien and second lien credit agreements bear interest, at our option, at a rate equal to a margin over either (a) a LIBOR rate or (b) a base rate. LIBOR and the base rate borrowings under each of the term loans are subject to a 1.00% and 2.00% “floor,” respectively.
The first lien credit agreement is subject to amortization requirements. Both the first and second lien credit agreements are subject to prepayment requirements and contain customary representations and warranties, covenants, events of default and other provisions. There are, however, no financial covenants under the second lien credit agreement.
Senior Notes due 2018. In February 2011, we issued an aggregate of $215 million of 8.00% senior notes due 2018. The outstanding notes are our senior unsecured obligations. In April 2014, when the amendments in a supplemental indenture for the senior notes became operative, the interest rate on the senior notes increased from 8.00% to 8.75% per annum. The Parent and each of our existing and future restricted subsidiaries (as defined in the indenture governing the senior notes) guarantee the senior notes on a senior unsecured basis. The indenture governing the senior notes limits, subject to certain exceptions, our and our restricted subsidiaries’ ability to incur additional indebtedness or issue certain preferred stock; pay dividends and make other restricted payments; make certain investments; sell assets; create liens; consolidate, merge or sell all or substantially all of our assets; enter into transactions with affiliates and designate subsidiaries as unrestricted subsidiaries.
Anticipated Refinancing of the Senior Notes and the Second Lien Credit Agreement. On December 12, 2016, we entered into a Commitment Letter with UBS, pursuant to which UBS has committed to provide and arrange the bridge loan financing of $245 million providing the funding necessary for the anticipated refinancing of our senior notes (if we are otherwise unable to refinance our senior notes with certain other financing) and second lien credit facility. This financing commitment is subject to certain customary conditions set forth in the Commitment Letter, including the execution and delivery of documentation, the accuracy of representations, the absence of events of default, the absence of material adverse changes and other customary closing conditions.
See Note 6, “Long-term Debt,” to the accompanying consolidated financial statements for more details on our credit agreements.
Contingent Income Tax Obligations
Uncertain tax positions, including any related interest accrual, represent unrecognized tax benefits related to temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Due to the uncertainty with respect to the timing of future cash flows associated with our unrecognized tax benefits as of September 30, 2016, we are unable to make reasonably reliable estimates of the period of cash settlement with the respective taxing authorities. Therefore, our total unrecognized tax benefits of $2.7 million reported as other long-term liability in our consolidated balance sheet has been excluded from the contractual obligations table above.
See Note 11, “Income Taxes,” to the accompanying consolidated financial statements for more information.
Environmental Costs
ASC Signal's environmental liabilities were estimated to total approximately $1.6 million as of September 30, 2016 for remediation efforts related to volatile organic compounds (“VOC”) and other contamination at ASC Signal's Whitby, Ontario manufacturing facility. We have environmental liability insurance policies which are expected to fully indemnify us from any costs incurred for the remediation efforts. As we believe that the expected remediation costs will be less than the insurance policy limits and due to the uncertainty with respect to the timing of future cash flows associated with the environmental remediation, the environmental loss reserve reported as other long-term liability in our consolidated balance sheet has been excluded from the contractual obligations table above.
The calculation of environmental loss reserve is based on the evaluation of currently available information. Actual costs to be incurred in future periods may vary from the amount of reserve given the uncertainties regarding the status of laws, regulations, enforcement policies, and the impact of potentially responsible parties, technology and information related to affected site.
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Capital Expenditures
Our continuing operations typically do not have large recurring capital expenditure requirements. Capital expenditures are generally made to replace existing assets, increase productivity, facilitate cost reductions or meet regulatory requirements. Total cash capital expenditures for fiscal year 2016 were $5.9 million. In fiscal year 2017, ongoing capital expenditures are expected to be approximately $9.0 to $10.0 million and to be funded by cash flows from operating activities.
Recent Accounting Pronouncements
See Note 2, “Recent Accounting Pronouncements,” to the accompanying consolidated financial statements for information regarding the effect of new accounting pronouncements on our financial statements.
Critical Accounting Policies and Estimates
Our consolidated financial statements are prepared in accordance with GAAP in the U.S., which require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon various factors and information available to us at the time that these estimates, judgments and assumptions are made. These factors and information may include, but are not limited to, history and prior experience, experience of other enterprises in the same industry, new related events, current economic conditions and information from third-party professionals. The estimates, judgments and assumptions we make can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected.
We believe that the following critical accounting policies are the most significant to the presentation of our financial statements and require the most subjective and complex judgments. These matters, and the judgments and uncertainties affecting them, are also essential to understanding our reported and future operating results. See Note 1, “Organization and Summary of Significant Accounting Policies,” to our consolidated financial statements for a more comprehensive discussion of our significant accounting policies.
Revenue recognition
We generally recognize revenue upon shipment of product, following receipt of written purchase orders, when the price is fixed or determinable, title has transferred and collectability is reasonably assured. Revenue recognized under the percentage-of-completion method of accounting is determined on the basis of costs incurred and estimates of costs at completion, which require management estimates of future costs. Changes in estimated costs at completion over time could have a material impact on our operating results.
Revenue arrangements that include multiple deliverables are divided into separate units of accounting if the deliverables meet certain criteria. We allocate the consideration among the separate units of accounting based on their relative selling prices, and consider the applicable revenue recognition criteria separately for each of the separate units of accounting. We apply a selling price hierarchy for determining the selling price of a deliverable in a sale arrangement. The selling price for each deliverable is based on vendor-specific objective evidence (“VSOE”) if available, third-party evidence (“TPE”) if VSOE is not available, or estimated selling price if neither VSOE or TPE is available. The relative selling price method allocates any discount in the arrangement proportionately to each deliverable on the basis of the deliverable’s selling price. The amount of our product revenue is affected by our judgments as to whether an arrangement includes multiple elements and if so, the selling price hierarchy for those elements. Changes to the elements in an arrangement and the measurement of the selling price for those elements could affect the timing of revenue recognition. These conditions are sometimes subjective and actual results could vary from the estimated outcome, requiring future adjustments to revenue.
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Inventory valuation
We assess the valuation of inventory and periodically write down the value for estimated excess and obsolete inventory based upon actual usage and estimates about future demand. The excess balance determined by this analysis becomes the basis for our excess inventory charge. Management personnel play a key role in our excess inventory review process by providing updated sales forecasts, managing product rollovers and working with manufacturing to maximize recovery of excess inventory. If our estimates regarding demand are inaccurate or changes in technology affect demand for certain products in an unforeseen manner, we may incur losses or gains in excess of our established markdown amounts that could be material. Obsolescence is determined based on several factors, including competitiveness of product offerings, product life cycles and market conditions. If actual market conditions are less favorable than those projected by management, additional write-downs may be required. If actual market conditions are more favorable than anticipated, inventory previously written down may be sold, resulting in lower cost of sales and higher income from operations than expected in that period.
Management also reviews the carrying value of inventory for lower of cost or market on an individual product or contract basis. A loss is charged to cost of sales if the estimated product cost or the contract cost at completion is in excess of net realizable value (selling price less estimated cost of disposal). If the actual contract cost at completion is different than originally estimated, then a loss or gain provision adjustment would be recorded that could have a material impact on our operating results.
Recoverability of long-lived assets
We test goodwill and identifiable intangible assets with indefinite useful lives for impairment annually. We amortize intangible assets subject to amortization over their respective estimated useful lives and review them for impairment. We amortize identifiable intangible assets on a straight-line basis over their useful lives of up to 40 years.
We assess the recoverability of the carrying value of goodwill and other intangible assets with indefinite useful lives at least annually or whenever events or changes in circumstances indicate that the carrying amount of any of these assets might exceed their current fair values. Goodwill and indefinite-lived intangible assets are tested for impairment by first evaluating qualitative factors to determine whether it is more likely than not that the fair value of each reporting unit (each of our eight divisions) and indefinite-lived intangible asset is less than the carrying value. Qualitative factors considered in this assessment include industry and market considerations, overall financial performance, and other relevant events and factors affecting the reporting unit. Additionally, as part of this assessment, we may perform a quantitative analysis to support the qualitative factors above by applying sensitivities to assumptions and inputs used in measuring a reporting unit’s fair value. For each reporting unit or indefinite-lived intangible asset in which the impairment assessment concludes that it is not more likely than not that the fair value is less than its carrying value, the currently prescribed quantitative impairment test based on a two-step approach is not performed. Otherwise, the quantitative impairment test is required. With the two-step approach, first, the carrying amount of the reporting unit is compared to the fair value as estimated by the future net discounted cash flows expected to be generated by the reporting unit. To the extent that the carrying value of the reporting unit exceeds the fair value of the reporting unit, a second step is performed, wherein the reporting unit’s assets and liabilities are valued. The implied fair value of goodwill is calculated as the fair value of the reporting unit in excess of the fair value of all non-goodwill assets and liabilities allocated to the reporting unit. To the extent the reporting unit’s carrying value of goodwill exceeds its implied fair value, impairment exists and must be recognized. This process requires the use of discounted cash flow models that utilize certain judgments and estimates, including projections of future revenue and expenses, the discount rate reflecting the risk inherent in future cash flows, the interpretation of current economic indicators and market valuations, and strategic plans with regard to operations. There is inherent uncertainty in these estimates, and changes in these factors over time could result in an impairment charge.
At September 30, 2016 and October 2, 2015, the carrying amount of goodwill and other intangible assets with indefinite useful lives was $251.6 million and $250.5 million, respectively. Based on our qualitative assessment performed in the fourth quarter of fiscal year 2016, goodwill and other intangible assets with indefinite useful lives were determined to have fair values that are more likely than not to be greater than the carrying amounts. We will continue to evaluate the need for impairment at least annually in the fourth quarter or in other fiscal quarters if changes in circumstances or available information indicate that impairment may have occurred.
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At September 30, 2016 and October 2, 2015, the carrying amount of property, plant and equipment and finite-lived intangible assets was $285.1 million and $306.8 million, respectively. We review the carrying values of long-lived assets and finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of any of these assets may not be recoverable. We assess the recoverability of property, plant and equipment to be held and used and finite-lived intangible assets by a comparison of the carrying amount of an asset or group of assets to the future net undiscounted cash flows expected to be generated by the asset or group of assets. If such assets are considered impaired, then the impairment recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the assets. This process requires the use of cash flow models that utilize estimates of future revenue and expenses. There is inherent uncertainty in these estimates, and changes in these factors over time could result in an impairment charge.
A prolonged general economic downturn and, specifically, a prolonged downturn in the defense, communications or medical markets, or technological changes, as well as other market factors, could intensify competitive pricing pressure, create an imbalance of industry supply and demand, or otherwise diminish volumes or profits. Such events, combined with changes in interest rates, could adversely affect our estimates of future net cash flows to be generated by our long-lived assets. Consequently, it is possible that our future operating results could be materially and adversely affected by any impairment charges related to the recoverability of our long-lived assets.
Income taxes
Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best assessment of estimated current and future taxes to be paid. We are subject to income taxes in both the United States and a number of foreign jurisdictions. Significant judgments and estimates are required in determining the consolidated income tax expense.
Deferred income taxes arise from temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements, which will result in taxable or deductible amounts in the future. In evaluating our ability to recover our deferred tax assets within the jurisdiction from which they arise, we consider all available positive and negative evidence, including scheduled reversals of deferred tax liabilities, projected future taxable income, tax-planning strategies, and results of recent operations. In projecting future taxable income, we begin with historical results and incorporate assumptions about the amount of future state, federal, and foreign pretax operating income adjusted for items that do not have tax consequences. The assumptions about future taxable income require significant judgment and are consistent with the plans and estimates we are using to manage the underlying businesses.
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We record uncertain tax positions based on a two-step process, whereby (1) we determine whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position, and (2) for those tax positions that meet the more-likely-than-not recognition threshold, we recognize the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority.
We record unrecognized tax benefits as liabilities and adjust these liabilities when our judgment changes as a result of the evaluation of new information not previously available. Because of the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate of the unrecognized tax benefit liabilities. These differences will be reflected as increases or decreases to income tax expense in the period in which new information is available.
Business Combinations
We apply the acquisition method of accounting for business combinations and recognize the assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, intangibles and other asset lives, among other items.
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Our principal identifiable intangible assets acquired generally include developed technology, core technology, tradenames, backlog and customer relationships. Developed technology consists of products that have reached technological feasibility. Core technology represents a combination of processes, inventions and trade secrets related to the design and development of acquired products. Customer relationships represent the underlying relationships and agreements with customers of the acquired company’s installed base. We have generally valued intangible assets based upon the present value of cash flows that the applicable asset is expected to generate. The valuation of tradenames and completed technology is based on the relief-from-royalty method, which uses royalty rates based on both a return-on-asset method and market comparable rate. The valuation of backlog and customer relationships is based on the excess earnings method, which requires us to forecast future expected earnings of the acquired company based on management’s best estimates derived from historical results, and future projected demand of their offerings.
In addition, we estimate the useful lives of our intangible assets based upon the expected period over which we anticipate generating economic benefits from the related intangible asset.
Net tangible assets consist of the fair values of tangible assets less the fair values of assumed liabilities and obligations. Except for deferred revenues, net tangible assets were generally valued by us at the respective carrying amounts recorded by the acquired company, if we believed that their carrying values approximated their fair values at the acquisition date. The values assigned to deferred revenue reflect an amount equivalent to the estimated cost plus an appropriate profit margin to complete the work related to the acquired company’s customer contracts.
In addition, uncertain tax positions and tax related valuation allowances assumed in connection with a business combination are initially estimated as of the acquisition date and we reevaluate these items quarterly with any adjustments to our preliminary estimates being recorded to goodwill provided that we are within the measurement period (up to one year from the acquisition date) and we continue to collect information in order to determine their estimated values. Subsequent to the measurement period or our final determination of the estimated value of uncertain tax positions or tax related valuation allowances, whichever comes first, changes to these uncertain tax positions and tax related valuation allowances will affect our provision for income taxes in our consolidated statements of comprehensive income.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
We do not use market risk sensitive instruments for trading or speculative purposes.
Interest rate risk
Our exposure to market risk for changes in interest rates relates primarily to our long-term debt. As of September 30, 2016, we had (i) fixed-rate senior notes of $211.9 million (net of $1.6 million unamortized original issue discount and $1.5 million debt issuance costs) due in 2018, bearing interest at 8.75% per year, (ii) a variable-rate first lien term loan of $296.0 million (net of $0.5 million unamortized original issue discount and $5.7 million debt issuance costs), and (iii) a variable-rate second lien term loan of $26.5 million (net of 0.5 million unamortized original issue discount and $1.0 million debt issuance costs), which we entered into on September 2015 to partially fund the ASC Signal acquisition.
Both the variable-rate first lien term loan and the variable-rate second lien term loan are subject to changes in the LIBOR rate. As of September 30, 2016, the variable interest rates on the first lien term loan and the second lien term loan were 4.25% and 8.00%, respectively.
We performed a sensitivity analysis to assess the potential loss in future earnings that a 10 basis points increase in the variable portion of interest rates over a one-year period would have on our term loan facilities. The impact was determined based on the hypothetical change from the end of period market rates over a period of one year and would result in no change in future interest expense, as a 10 basis points increase in the current variable interest rate on each of our term loans would not increase the rate above the “LIBOR floor” in the respective credit facilities. Based on the current provisions of our term loans, the LIBOR rate would have to increase to 1% before impacting our future interest expense.
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Foreign currency exchange risk
Although the majority of our revenue and expense activities are transacted in U.S. dollars, we do transact business in foreign countries. Our primary foreign currency cash flows are in Canada and several European countries. In an effort to reduce our foreign currency exposure to Canadian dollar denominated expenses, we enter into Canadian dollar forward contracts to hedge the Canadian dollar denominated costs for our manufacturing operations in Canada. Our Canadian dollar forward contracts are designated as a cash flow hedge and are considered highly effective. At September 30, 2016, the fair value of foreign currency forward contracts comprised a short-term asset of $1.2 million (prepaid and other current assets) and a short-term liability of $0.2 million (accrued expenses). Unrealized gains and losses from foreign exchange forward contracts are included in accumulated other comprehensive income (loss) in the consolidated balance sheets. At September 30, 2016, the unrealized gain, net of tax of $0.2 million, was $0.6 million. We anticipate recognizing the entire unrealized gain or loss in operating earnings within the next five fiscal quarters. Changes in the fair value of foreign currency forward contracts due to changes in time value are excluded from the assessment of effectiveness and are immediately recognized in general and administrative expenses in the consolidated statements of comprehensive income. The time value was not material for all periods presented. If the transaction being hedged fails to occur, or if a portion of any derivative is ineffective, then we promptly recognize the gain or loss on the associated financial instrument in general and administrative expenses in the consolidated statements of comprehensive income. No ineffective amounts were recognized due to anticipated transactions failing to occur for fiscal years 2016, 2015 and 2014.
As of September 30, 2016, we had entered into Canadian dollar forward contracts for approximately $60.0 million (Canadian dollars), or approximately 75% of estimated Canadian dollar denominated expenses for October 2016 through September 2017, at an average rate of approximately 0.75 U.S. dollars to one Canadian dollar. We estimate the impact of a one cent change in the U.S. dollar to Canadian dollar exchange rate (without giving effect to our Canadian dollar forward contracts) to be approximately $0.5 million annually to our net income.
Item 8.
Item 8.
Financial Statements and Supplementary Data
The consolidated financial statements required by this item are hereby incorporated by reference to Part IV of this Annual Report on Form 10-K, and the supplementary data required by this item are included in Note 14, “Selected Quarterly Financial Data,” to the consolidated financial statements.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A.
Controls and Procedures
Evaluation of Disclosure Controls and Procedures
An evaluation was performed under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, our chief executive officer and our chief financial officer have concluded that, as of the end of the period covered by this report, our disclosure controls and procedures are effective.
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Management’s Annual Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes those policies and procedures that:
(i)
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;
(ii)
provide reasonable assurance that the transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of management and/or our board of directors; and
(iii)
provide reasonable assurance regarding the prevention or timely detection of any unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements.
Due to its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate due to changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of our management, including our chief executive officer and our chief financial officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework (2013). Based on its evaluation, our management concluded that our internal control over financial reporting was effective as of September 30, 2016.
Changes in Internal Control over Financial Reporting
There has been no change in our internal control over financial reporting that occurred during the fourth quarter of fiscal year 2016 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting as of September 30, 2016.
Item 9B.
Item 9B.
Other Information
None.
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PART III
Item 10.
Item 10.
Directors, Executive Officers and Corporate Governance
The following table sets forth certain information regarding the board of directors of CPI International, Inc. (“CPII”), the board of directors of CPI International Holding Corp. (“Parent”) and our named executive officers as of December 14, 2016.
O. Joe Caldarelli serves as our chief executive officer and a member of our board of directors. Mr. Caldarelli became chief executive officer and a director of CPII in March 2002. Prior to this, Mr. Caldarelli was a co-chief operating officer of CPII since October 2000 and vice president of CPII since August 1995. Mr. Caldarelli is also the division president of CPII’s Communications & Medical Products Division. Mr. Caldarelli was vice president and general manager for the Communications & Medical Products Division under the Electron Device Business of Varian Associates, Inc. from 1985 until August 1995 and was president and a director of Varian Canada, Inc. from 1992 until August 1995. From 1982 until 1985, Mr. Caldarelli was marketing manager of the Communications & Medical Products Division of Varian Associates and served as its equipment operations manager from 1979 until 1982. Prior to joining Varian Associates, Mr. Caldarelli served as manufacturing engineering manager for Medtronic Canada, Inc. Mr. Caldarelli holds a B.S. degree in mechanical engineering from the University of Toronto. Mr. Caldarelli was chosen to serve on our board of directors because of his extensive industry and CPII experience, his experience in multiple senior management roles, and his prior exposure to mergers and acquisitions and refinancing transactions.
Robert A. Fickett serves as our president, chief operating officer and a member of our board of directors. Mr. Fickett became president and chief operating officer of CPII in March 2002. Prior to this, Mr. Fickett was a co-chief operating officer of CPII since October 2000 and vice president of CPII since April 1998. Mr. Fickett has also been the division president of CPII’s Microwave Power Products Division since April 1998. From January 1996 to April 1998, Mr. Fickett was vice president of operations for CPII’s Microwave Power Products Division. From 1993 until January 1996, he was president and chief executive officer of Altair Technologies, Inc., a contract manufacturer. From 1982 until 1993, Mr. Fickett held a number of positions with Varian Associates, Inc., including engineering manager of the Microwave Power Products Division’s Klystron Engineering Group, to which he was promoted in 1989. Mr. Fickett received a B.S. degree in mechanical engineering from the University of California, Berkeley. Mr. Fickett was chosen to serve on our board of directors because of his extensive industry and CPII experience, his experience in multiple senior management roles, and his experience in engineering and operations.
Joel A. Littman serves as our chief financial officer. Mr. Littman became chief financial officer of CPII in September 2001. Mr. Littman was corporate controller for CPII from November 1996 to September 2001. From September 1989 to November 1996, Mr. Littman served as controller of the Microwave Power Products Division of Varian Associates, Inc. and CPII. Prior to that, Mr. Littman held various finance positions with Varian Associates and TRW Inc. Mr. Littman received a B.A. degree in economics and an M.B.A. degree, both from the University of California at Los Angeles.
John R. Beighley serves as one of CPII’s vice presidents. Mr. Beighley became a vice president of CPII in March 1997. Mr. Beighley currently heads CPII’s worldwide field sales organization. From May 1992 to March 1997, Mr. Beighley was CPII’s Western Hemisphere sales manager responsible for sales in the Americas, the Far East and Australia. From June 1989 to May 1992, Mr. Beighley was CPII’s North American sales manager. From March 1981 to June 1989, Mr. Beighley held a number of product marketing and field sales positions with Varian Associates, Inc. Mr. Beighley received a B.S. degree in marketing from San Francisco State University and an M.B.A. degree from Santa Clara University.
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Andrew E. Tafler serves as one of CPII’s vice presidents. Mr. Tafler became a vice president of CPII in December 2005. Mr. Tafler became division president of CPII’s Satcom Division in May 2004. Mr. Tafler was previously vice president of operations for the Satcom Division from 2000 to 2004. From 1989 to 2000, Mr. Tafler held the business development manager and then the operations manager positions at the Communications & Medical Products Division of the Electron Device Group of Varian Associates, Inc. Mr. Tafler held a number of manufacturing and marketing positions at Varian Associates from 1984 to 1989. Prior to joining Varian Associates, Mr. Tafler served in engineering and management positions with Bell Canada Inc. Mr. Tafler holds a B.A.Sc. degree in electrical engineering from the University of Toronto.
Hugh D. Evans serves as the chairman of our board of directors. Mr. Evans is a managing partner at Veritas Capital Fund Management L.L.C and its affiliates (“Veritas Capital”). Prior to joining Veritas in 2005, Mr. Evans was a partner at Falconhead Capital, a middle market private equity firm. Prior to Falconhead, Mr. Evans was a principal at Stonington Partners. Mr. Evans began his private equity career in 1992 at Merrill Lynch Capital Partners, the predecessor firm of Stonington, which was a wholly owned subsidiary of Merrill Lynch. Mr. Evans is a member of the boards of directors of Truven Health Analytics Inc. and several private companies and was a member of the board of directors of Aeroflex Holding Corp. from August 2007 to September 2014. Mr. Evans holds an A.B. from Harvard University and an M.B.A. from the University of Chicago Graduate School of Business. Mr. Evans was chosen to serve on our board of directors because of his position as a partner of Veritas Capital, his experience on other public and private company boards and his extensive experience in finance and private equity investment.
Benjamin M. Polk joined our board of directors in October 2012. Mr. Polk is a partner at Veritas Capital. Prior to joining Veritas in July 2011, Mr. Polk was a partner with the law firm of Schulte Roth and Zabel LLP from May 2004 to July 2011 and prior to that, a partner with the law firm of Winston & Strawn LLP, where Mr. Polk practiced law with that firm and its predecessor firm, from August 1976 to May 2004. During his legal career Mr. Polk worked with Veritas as its lead outside legal counsel on virtually every major transaction Veritas has been involved in since its founding. Mr. Polk is a member of the board of directors of Monster Beverage Corporation, Truven Health Analytics Inc. and several private companies and was a member of the board of directors of Aeroflex Holding Corp. from November 2012 to September 2014. He holds a B.A. from Hobart College and a J.D. from Cornell Law School. Mr. Polk was chosen to serve on our board of directors because of his extensive experience in finance and private equity investment.
Michael J. Meehan, II joined our board of directors in June of 2011. Mr. Meehan is a senior advisor to several business organizations, including Dimension Capital Management, a wealth management firm. Prior to that, Mr. Meehan was a managing director at Steinberg Asset Management, LLC from 2007 to 2010 and, before that, a senior managing director at Kellogg Capital Markets, LLC from 2005 to 2007. Before joining Kellogg, he was a specialist and a member of Fleet Meehan Specialist, Inc., a member of the New York Stock Exchange, from 2000 to 2005. Prior to that, Mr. Meehan was General Partner of M.J. Meehan & Co. from 1992 through 2000. From 1971 through 1992, he was partner at Salomon Brothers, where he ran their floor operations. Before that, he was a general partner at M.J. Meehan & Co from 1964 through 1970. Mr. Meehan holds a B.A. degree from the University of Pennsylvania. Mr. Meehan was chosen to serve on our board of directors because of his extensive experience in and knowledge of the equity securities markets.
Admiral Leighton W. Smith, Jr. (USN Ret.) joined our board of directors in June of 2011. Admiral Smith was appointed to four-star rank in April 1994, became commander-in-chief, U.S. Naval Forces Europe and commander-in-chief, Allied Forces Southern Europe and concurrently assumed the command of the NATO-led Implementation Force in Bosnia in December 1995. Admiral Smith retired from the U.S. Navy in 1996 after 34 years of service. Admiral Smith has served as a distinguished fellow at the Center for Naval Analysis and as a senior advisor to the Institute for Defense Analysis. Until December 2015, he was also president of Leighton Smith Associates and was engaged in consulting to major defense contractors. Admiral Smith is also a member of the board of Billing Services Group, a provider of clearing, settlement, payment and financial risk management solutions to the telecommunications industry. Prior to 2010, Admiral Smith served as a member of the board of directors of DynCorp International, Inc. Admiral Smith holds a B.A. in Naval Science from the U.S. Naval Academy and a Master’s degree in Personnel Counseling from Troy State University. Admiral Smith was chosen to serve on our board of directors because of his extensive experience in and knowledge of the U.S. Department of Defense, which allows him to bring additional perspective and invaluable insight to our board of directors.
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Committee Composition
Because Parent’s equity securities are owned by CPI International Holding LLC (“Holding LLC”), and are not listed on an exchange or publicly held, the board of directors of Parent has not created separate audit, compensation or nominating committees. The entire board of directors of Parent functions as the compensation and audit committees, and no written charter governs the actions of the board of directors when performing the functions that would generally be performed by those respective committees.
Code of Legal and Ethical Conduct
The Company has adopted a code of legal and ethical conduct that applies to all employees, directors, consultants and agents of the Company and its subsidiaries, including the principal executive officer, principal financial officer, the controller and persons performing similar functions. This code is available on the Company’s website at www.cpii.com under the heading “Company Info,” and the subheading “Code of Legal and Ethical Conduct.” The Company will promptly disclose on the Company’s website any amendments to, and waivers from, the Company’s code of legal and ethical conduct, if and when required.
Audit Committee
The Company’s audit committee consists of the entire board of directors. The Company’s board of directors has not determined if any of the members of the audit committee qualify as an audit committee financial expert as defined in Item 407(d)(5)(ii) and (iii) of Regulation S-K.
Item 11.
Item 11.
Executive Compensation
DIRECTOR COMPENSATION
Director Compensation Table
The table below summarizes the compensation paid to or earned by each person who was a director of the Company during the fiscal year ended September 30, 2016, other than any director who is an executive officer. Mr. Caldarelli and Mr. Fickett are also named executive officers, and information regarding compensation paid to or earned by them is presented below under “Executive Compensation-Summary Compensation Table” and the related explanatory tables and narrative disclosures. Mr. Caldarelli and Mr. Fickett did not receive any additional compensation for their service as directors.
(1)
For a description of the fees earned by the non-employee directors during the fiscal year ended September 30, 2016, see the disclosure below under “Narrative to Director Compensation Table.”
(2)
On June 6, 2011, Mr. Meehan and Admiral Smith were each granted Class B membership interests equal to approximately 0.01% of the aggregate amount of all outstanding Class A and Class B membership interests in Holding LLC upon their appointment to the board for the first time. Pursuant to the terms of the limited liability company operating agreement governing Holding LLC, holders of Class B membership interests are entitled to receive a percentage of all distributions, if any, made by Holding LLC after the holders of Class A membership interests, including affiliates of Veritas Capital, have received a return of their invested capital plus an 8% per annum internal rate of return (compounded quarterly and accruing daily) on their unreturned invested capital. Holders of Class B membership interests are not entitled to any voting rights. The Class B membership interests are non-transferable, and are subject to vesting over a five-year period. Vesting would be accelerated in the event of a change of control.
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All Class B membership interests in Holding LLC granted to Mr. Meehan and Admiral Smith are fully vested as of September 30, 2016.
Narrative to Director Compensation Table
Our independent directors are paid an annual cash retainer of $35,000 plus per meeting fees of $1,500 if in-person and $500 if via teleconference. In addition, we expect to make a one-time grant of Class B membership interests in Holding LLC to an independent director joining the board for the first time, in an amount to be determined by the full board of directors at such time. We may also make additional grants of Class B membership interests in Holding LLC to our independent directors from time to time, as and when determined by the full board. We do not pay any compensation to our non-independent board members in their capacity as such. See “Security Ownership of Certain Beneficial Owners and Management” for additional information regarding the Class B membership interests in Holding LLC.
EXECUTIVE COMPENSATION
Forward-looking Statements
This section contains “forward-looking statements” (as defined in Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward looking statements include statements that are predictive in nature; that depend upon or refer to future events or conditions; or that include words, such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” or variations or negatives of such words or similar or comparable words or phrases. These statements are only predictions. Forward-looking statements are based on the Company’s current expectations and projections about future events and are subject to risks, uncertainties and assumptions that may cause results to differ materially from those set forth in the forward looking statements. The forward-looking statements may include statements regarding actions to be taken by the Company. The Company undertakes no obligation to publicly update any forward looking statement, whether as a result of new information, future events or otherwise. Forward-looking statements should be evaluated together with the uncertainties that may affect the Company’s business, particularly those mentioned in the cautionary statements in Item 1A “Risk Factors” of this report and in the other periodic reports filed by the Company with the Securities and Exchange Commission (“SEC”).
Compensation Discussion and Analysis
We do not have a separate compensation committee, and the board of directors of Parent is responsible for the oversight of our compensation programs and policies. The board of directors consists of six non-employee directors and two executive officers. The executive officers on the board of directors are excluded from the decision-making process with respect to themselves.
The following narrative discussion of the Company’s compensation policies and practices describes the Company’s policies following the February 2011 merger.
Attracting, retaining and motivating well-qualified executives are essential to the success of any company. The business and product lines of the Company are specialized and require executives with specialized knowledge and unique experience. Accordingly, we have assembled a team of executive officers having deep, specialized knowledge of our particular business and product lines. The goals of our compensation program are to provide significant rewards for successful performance, to encourage stability of our management team and retention of top executives who may have attractive opportunities at other companies and to align the executive officers’ interest with those of our stockholders.
From time to time, the board of directors may utilize the services of independent consultants to perform analyses and to make recommendations to the board of directors relative to executive compensation matters. During fiscal years 2014, 2015 and 2016, the board of directors was not advised by any compensation consultants. The recommendations of the chief executive officer are also solicited by the board of directors with respect to compensation for named executives other than the chief executive officer.
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Elements and Brief Description of Components of Compensation
The elements of our compensation program consist of the following:
Salary
In view of our desire to reward performance and loyalty and to place a significant portion of each executive officer’s compensation at risk, we regard salary as only one component of the compensation of our named executive officers. Our executive officers’ salaries for fiscal year 2016 were approved by our board of directors.
We review the base salaries of our named executive officers annually, after receiving recommendations from our chief executive officer.
Management Incentive Plan
Under our Management Incentive Plan (“MIP”), we set objective financial and performance goals near the beginning of each fiscal year. Each executive officer receives an award under which he will receive a bonus equal to a percentage of his base salary; the applicable percentage depends on whether, and the extent to which, the objective performance goals are achieved for the fiscal year. For each fiscal year, we determine a minimum level of objective performance goals that must be achieved before the executive officers will receive any bonuses under the MIP. The goals and calculations underlying the MIP for fiscal year 2016 are discussed in greater detail under “Management Incentive Plan Awards for Fiscal Year 2016.” The executive officers’ goals under the MIP for fiscal year 2016 were set and approved by our board of directors.
Equity Grants
In 2011, we provided the named executive officers with the opportunity to purchase Class A membership interests in Holding LLC and also issued Class B membership interests to them. The Class B membership interests are subject to vesting. These membership interests will increase in value if the Company’s value increases and are designed to provide a valuable long-term incentive to our named executive officers.
Deferred Compensation
We offer a non-qualified deferred compensation plan for our executive officers and other employees who are part of a select group of highly compensated or management employees. This deferred compensation plan provides participants with an opportunity to defer payments of a specified percentage of their base salary and MIP bonus. In addition, we make employer contributions to the deferred compensation plan based on a formula. Although the employer contributions to the deferred compensation plan for our executive officers are fully vested, they are in relatively small annual amounts compared to the executive officers’ base salaries.
Canadian Defined Benefit Pension Plan for Chief Executive Officer
We provide a defined benefit pension plan governed by Canadian law to our chief executive officer. The purpose of this plan is to provide retirement income to our chief executive officer after he has completed many years of service to us. The plan is a retention device, as our chief executive officer’s benefits under the plan will depend on the number of years of his service to us. The plan is in lieu of our chief executive officer’s participation in our Canadian defined contribution plan (analogous to a 401(k) plan) that is generally available to our Canadian employees. Benefits under this defined benefit pension plan are subject to the same statutory limits that are applicable to broad-based plans in Canada.
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Severance Payments, Change-in-control Payments and Related Tax Gross-ups
The Company is party to employment agreements with its named executive officers. These employment agreements provide that our named executive officers will receive certain severance benefits if we terminate their employment without “cause,” or, in the case of our (a) chief executive officer, (b) chief operating officer and president, and (c) chief financial officer, treasurer and secretary, if they terminate their employment with “good reason” (e.g., because they are demoted). If their termination of employment follows a change in control of the Company, our chief executive officer, chief operating officer and president, and chief financial officer, treasurer and secretary will receive an enhanced level of severance benefits. Furthermore, if a golden parachute excise tax is imposed on our chief executive officer, chief operating officer and president or chief financial officer, treasurer and secretary in connection with his termination of employment following a change in control, the affected executive will receive “gross-up” payments to make him whole for the golden parachute excise tax. However, if a 10% or less reduction in severance would eliminate the golden parachute tax, then the severance will be reduced to eliminate the tax and no reimbursement will be provided. The details of such arrangements are discussed in the section entitled “Narrative Disclosure to Summary Compensation Table, Grants of Plan-based Awards Table, and Grants of Other Equity-based Awards Table-Employment Agreements” below.
The change-in-control provisions contained in the employment agreements of our named executive officers are “double trigger” provisions: i.e., the named executive officer does not receive his change-in-control payments automatically on the occurrence of a change in control, but must either be discharged by the Company (or the applicable subsidiary) without “cause” or (in the case of our chief executive officer, chief operating officer and president, and chief financial officer, treasurer and secretary) terminate his employment with the Company (or the applicable subsidiary) for “good reason” within a stated period after the occurrence of the change in control. Thus, the change-in-control payments are essentially compensation for being fired or forced out of a job in connection with the change in control.
All Other Compensation
All other compensation for our named executive officers includes, among other things, Company contributions under our 401(k) plan, payment of certain legal fees, car allowances and, in the case of our chief executive officer, a tax gross-up on his car allowance.
Risks Associated with the Company’s Compensation Policies and Practices
The Company believes that its compensation policies and practices for all employees, including executive officers, do not create risks that are reasonably likely to have a material adverse effect on the Company.
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COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION
The board of directors, which serves as the compensation committee for the Company, has reviewed the Compensation Discussion and Analysis for fiscal year 2016 and discussed its contents with the Company’s management. Based on such review and discussions, the board of directors recommended that the Compensation Discussion and Analysis be included in the annual report on Form 10-K.
Board of Directors
O. Joe Caldarelli
Hugh D. Evans
Robert A. Fickett
Michael J. Meehan
Benjamin M. Polk
Admiral Leighton W. Smith Jr.
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COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
We do not have a separate compensation committee, and the board of directors of Parent is responsible for the oversight of our compensation programs and policies. The board of directors consists of four non-employee directors and two executive officers, Mr. Caldarelli and Mr. Fickett. The executive officers on the board of directors are excluded from the decision-making process with respect to themselves.
SUMMARY COMPENSATION TABLE
The table below summarizes the total compensation paid to or earned for the fiscal year ended September 30, 2016 by:
•
the chief executive officer;
•
the chief financial officer; and
•
the three other most highly compensated individuals who were serving as executive officers of the Company at the end of the fiscal year.
These individuals are referred to in this proxy as the “named executive officers.”
(a)
For Mr. Caldarelli and Mr. Tafler , salary, non-equity incentive plan compensation and all other compensation amounts are denominated in Canadian dollars. Salary and all other compensation amounts were converted to U.S. dollars using the average exchange rate during fiscal year 2016 of approximately US$0.76 for C$1.00, during fiscal year 2015 of approximately US$0.82 for C$1.00 and during fiscal year 2014 of approximately US$0.93 for C$1.00. Non-equity incentive plan compensation amounts were converted to U.S. dollars for fiscal year 2016 using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00, for fiscal year 2015 using an exchange rate as of October 2, 2015 of approximately US$0.76 for C$1.00 and for fiscal year 2014 using an exchange rate as of October 3, 2014 of approximately US$0.89 for C$1.00.
(b)
Mr. Caldarelli’s base salary has remained constant at C$600,000 since January 7, 2012. Any changes to his base salary as reported on the table were a result of the changing U.S. dollar to Canadian dollar exchange rate.
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(c)
Includes amounts earned under the Company’s MIP for all of the named executive officers and amounts earned under the Company’s sales incentive plan for Mr. Beighley. As noted above, for Mr. Caldarelli and Mr. Tafler, the payments are denominated in Canadian dollars, and the fiscal year 2016 amount was converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00, while the fiscal year 2015 amount was converted to U.S. dollars using an exchange rate as of October 2, 2015 of approximately US$0.76 for C$1.00 and the fiscal year 2014 amount was converted to U.S. dollars using an exchange rate as of October 3, 2014 of approximately US$0.89 for C$1.00.
In addition to the MIP awards, the Board of Directors awarded a discretionary bonus of $65,000 to Mr. Fickett and $35,000 to Mr. Littman for fiscal year 2016.
For fiscal year 2016 and 2015, Mr. Caldarelli, at his discretion, voluntarily reduced the bonus which he was entitled to under the MIP by the entire amount of US$119,315 for fiscal year 2016 and US$95,917 for fiscal year 2015, and the amounts were redistributed in equal amounts to all other plan participants, except CPI officers, division presidents and certain other participants.
(d) Mr. Caldarelli’s pension plan is denominated in Canadian dollars. The aggregate change in the actuarial present value of the pension benefit obligation during fiscal years 2014, 2015 and 2016 consists of the following:
The amounts above were calculated using an exchange rate at the beginning of fiscal year 2014 of approximately US$0.98 for $C$1.00, at the end of 2014 of approximately US$0.89 for C$1.00, at the end of fiscal year 2015 of approximately US$0.76 for C$1.00, at the end of fiscal year 2016 of approximately US$0.76 for C$1.00
(e)
Details regarding the various amounts included in this column are provided in the following table entitled “All Other Compensation Table for Fiscal Year 2016.”
All Other Compensation Table for Fiscal Year 2016
The components of the amounts shown in the “All Other Compensation” column of the “Summary Compensation Table” are displayed in detail in the following table.
(a)
Represents the total cost to the Company for use by the named executive officer of a company car during fiscal year 2016. For Mr. Caldarelli, this includes amounts paid by the Company for lease costs, reimbursement of gas, maintenance costs and car insurance. For Mr. Caldarelli and Mr. Tafler, the amounts were converted to U.S. Dollars using the average exchange rate during fiscal year 2016 of approximately US$0.76 for C$1.00.
(b)
Represents tax gross-ups paid to Mr. Caldarelli related to the use of a company car. The amounts were converted to U.S. Dollars using the average exchange rate during fiscal year 2016 of approximately US$0.76 for C$1.00.
(c)
Represents amount to be contributed by the Company to the non-qualified deferred compensation plan for fiscal year 2016.
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(d)
The Company’s Canadian subsidiary makes contributions to a defined benefit plan (discussed under “Pension Benefits” below). The amounts in this column represent the excess of the amount the Company is obligated to contribute over the governmentally imposed limitation on contributions. The amounts shown are denominated in Canadian Dollars and were converted to U.S. Dollars using the average exchange rate during fiscal year 2016 of approximately US$0.76 for C$1.00.
(e)
Represent C$13,077 contributed by the Company to the defined contribution plan for fiscal year 2016. The amount is denominated in Canadian Dollars and was converted to U.S. Dollars using the average exchange rate during fiscal year 2016 of approximately US$0.76 for C$1.00.
Grants of Plan-based Awards For Fiscal Year 2016
The following table provides information concerning grants of plan-based awards to each of the named executive officers for the fiscal year ended September 30, 2016.
(1)
Amounts represent possible payouts under the Company’s MIP for fiscal year 2016 for all of the named executive officers.
(2)
The amounts in this column represent the actual payouts under the MIP for fiscal year 2016 for all of the named executive officers. The amounts in this column are also included in the “Non-equity Incentive Plan Compensation” column of the “Summary Compensation Table.”
(3)
For Mr. Caldarelli & Mr. Tafler, estimated future payments under non-equity incentive plan awards and actual payouts under non-equity incentive plan awards are denominated in Canadian dollars, which were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
For fiscal year 2016, Mr. Caldarelli, at his discretion, voluntarily reduced the bonus which he was entitled to under the MIP by the entire amount of US$119,315, and this amount was redistributed in equal amounts to all other participants, except CPI officers, division presidents and certain other participants.
Grants of Equity-based Awards For Fiscal Year 2016
There are no equity-based awards granted to named executive officers during fiscal year 2016.
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Narrative Disclosure to Summary Compensation Table, Grants of Plan-based Awards Table, and Grants of Other Equity-based Awards Table
Employment Agreements
Messrs. Caldarelli, Fickett and Littman
Communications & Power Industries Canada Inc. (“CPI Canada”), a subsidiary of the Company, is a party to an employment agreement with Mr. Caldarelli, and CPI, also a subsidiary of the Company, is party to an employment agreement with each of Messrs. Fickett and Littman. The term of each employment agreement commenced on April 27, 2006 and continued for a three-year period thereafter. Each agreement is automatically extended for additional one-year periods thereafter, unless the employer or the executive officer gives notice of non-renewal at least six months prior to the end of the term. No notices of non-renewal have been provided with respect to these agreements.
Each agreement provides for the following initial base salary, subject to upward adjustment by the board of directors of the Company in its sole discretion: Mr. Caldarelli-C$550,000; Mr. Fickett-US$300,000; and Mr. Littman-US$230,000.
Each of these executive officers is eligible to receive an annual cash bonus through participation in the Company’s MIP, as in effect from time to time, and awards under the Company’s equity incentive plans. For fiscal year 2016, the target bonuses for Messrs. Caldarelli, Fickett and Littman under the Company’s MIP were 1.0, 0.75 and 0.60 respectively, times their respective base salaries. Each of these executive officers is eligible to participate in other benefit plans, policies and programs.
If the employment of any of these executive officers is terminated by the employer for cause, is terminated as a result of the death or disability of the executive officer or is terminated by the executive officer other than for good reason, then the employment agreement will terminate immediately, and the executive officer will be entitled to receive only (a) accrued but unpaid salary through the date of termination and vacation pay and other cash compensation or cash entitlements as of the date of termination and (b) in the case of any termination other than by the employer for cause and by the executive officer without good reason, if the executive officer has been employed for at least six months during the fiscal year, a partial bonus for the fiscal year of termination equal to the full bonus payable multiplied by a fraction equal to the fraction of the fiscal year preceding the executive officer’s termination.
If the employment of any of these executive officers is terminated by the employer without cause or by the executive officer for good reason, as applicable, then the executive officer will be entitled to receive severance payments equal to a multiple of the sum of the executive officer’s base salary and the average value of the MIP and other performance bonuses received by the executive officer for the three fiscal years preceding the termination date. The applicable multiples for Messrs. Caldarelli, Fickett and Littman are 2.0, 1.5 and 1.5, respectively. If the termination occurs more than six months after the beginning of a fiscal year, then the executive officer will be eligible to receive a prorated bonus for the year of termination.
In addition, in the case of a termination without cause or a resignation for good reason within the two-year period following a change of control, the severance payments will be equal to a specified multiple of the sum of the executive officer’s base salary and the highest MIP or other performance bonus received by the executive officer during the three fiscal years preceding the termination date. The applicable multiples for Messrs. Caldarelli, Fickett and Littman in this case are 2.5, 2.0 and 2.0, respectively.
In the case of a termination without cause or a resignation for good reason, Messrs. Caldarelli, Fickett and Littman will be eligible to continue receiving certain benefits for 24 months, 18 months and 18 months, respectively, following termination. If the termination occurs within the two-year period following a change of control, the applicable benefit continuation periods for Messrs. Caldarelli, Fickett and Littman will be 30 months, 24 months and 24 months, respectively.
If any compensation payable to an executive officer upon termination is deemed to be “deferred compensation” within the meaning of Section 409A of the Internal Revenue Code, if the stock of the Company (or one of its affiliates) is publicly traded on an established securities market or otherwise and if the executive officer is determined to be a “specified employee” as defined in Section 409A(a)(2)(B)(i) of the Internal Revenue Code, then payment of such compensation will be delayed as required pursuant to Section 409A of the Internal Revenue Code. Such delay will last six months from the date of the executive officer’s termination except in the event of the executive officer’s death.
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As a condition to receiving the benefits and payments described above in connection with a termination by the employer without cause or termination by the executive officer for good reason, the executive officer will be required to execute a release of any claims and potential claims against the employer and its affiliates and directors relating to the executive officer’s employment, and the executive officer and the employer will also enter into reasonable mutual non-disparagement covenants.
Following the termination of employment of any of the executive officers without cause or a resignation for good reason, the executive officer will be subject to a post-termination non-compete covenant and a post-termination covenant not to solicit any of the Company’s current or potential customers. The duration of these covenants will be equal to the duration of the post-termination period during which the Company is obligated to provide benefits as described above. In addition, if their employment is terminated for any reason, Messrs. Caldarelli, Fickett and Littman will be prohibited from soliciting for employment any of the Company’s employees for a 24-month, 18-month and 18-month period, respectively, following termination (or, if longer, the period during which they are subject to the non-compete covenant).
For each of the executive officers, good reason generally means any of the following (i) assignment to the executive officer of any duties inconsistent with the executive officer’s positions with Parent and certain of its affiliates as set forth in the employment agreement (including status, offices, titles and reporting requirements), authorities, duties or responsibilities as contemplated in the employment agreement or any action by Parent or a specified affiliate that results in diminution in such positions, authority, duties or responsibilities; (ii) failure by the employer to comply with the provisions of the employment agreement; (iii) relocation of the office where the executive officer is required to report to a location that is 50 or more miles from the executive officer’s current location; or (iv) notice to the executive officer that the term of the employment agreement will not be extended.
For each of the executive officers, cause generally means any of the following: (a) acts or omissions by the executive officer that constitute intentional material misconduct or a knowing violation of a material policy of the Company or any of its subsidiaries, (b) the executive officer personally receiving a benefit in money, property or services from the Company or any of its subsidiaries or from another person dealing with the Company or any of its subsidiaries, in material violation of applicable law or policy of the Company or any of its subsidiaries, (c) an act of fraud, conversion, misappropriation or embezzlement by the Company or his conviction of, or entering a guilty plea or plea of no contest with respect to a felony or the equivalent thereof (other than DUI) or (d) any deliberate and material misuse or deliberate and material improper disclosure of confidential or proprietary information of the Company or any of its subsidiaries. No act or omission by the executive officer constitutes cause unless the employer has given detailed written notice thereof to the executive officer, and the executive officer has failed to remedy such act or omission within a reasonable time after receiving such notice.
If any payments made by the employer to Mr. Caldarelli, Fickett or Littman would result in the imposition of the golden parachute excise tax under Section 280G of the Internal Revenue Code of 1986, then the employer will reimburse the affected executive officer for the amount of the tax, on a grossed-up basis to cover any taxes on the reimbursement payment. However, if a 10% or less reduction in severance would eliminate the golden parachute tax, then the severance will be reduced to eliminate the tax and no reimbursement will be provided.
Mr. Beighley
CPI has an employment letter, dated June 27, 2000, with Mr. Beighley that provides for an annual base salary of $131,000. The Company’s current practice is for the base salary to be reviewed and adjusted as appropriate. The letter provides that Mr. Beighley is entitled to participate in the Company’s MIP. Mr. Beighley is also entitled to participate in the executive car program, the 401(k) plan and the executive physical program. In addition, Mr. Beighley is entitled to business travel insurance of up to $1 million. Pursuant to the letter, if Mr. Beighley is terminated without cause, he will be entitled to continued payment of his base salary for 12 months, the continuation of employee benefits for 18 months, 100% of the management incentive award that otherwise would have been earned by him, continued use of his company car, and full outplacement services. In order to receive the foregoing severance benefits, Mr. Beighley will be required to execute a general release in favor of the employer. In the event of Mr. Beighley’s death, his heirs or estate will be entitled to receive an amount equal to two times his weekly earnings plus an additional day for every year of completed service.
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Mr. Tafler
CPI Canada is a party to an employment letter agreement, dated June 21, 2004, with Mr. Tafler that provides for an annual base salary of $165,000. The Company's current practice is for the base salary to be reviewed and adjusted as appropriate. The letter provides that Mr. Tafler is entitled to participate in the Company’s MIP. Mr. Tafler is also entitled to participate in the executive car program and the defined contribution plan. If Mr. Tafler is terminated without cause, he will be entitled to continued payment of his base salary for 12 months. If Mr. Tafler is terminated without cause at any time during the two-year period following a change-in-control event, he will be entitled to continued payment of base salary for 12 months, the continuation of employee benefits for the severance period, 100% of the management incentive award that otherwise would have been earned by him, continued use of his company car and full outplacement services. In order to receive the foregoing severance benefits, Mr. Tafler will be required to execute a general release in favor of the employer.
Management Incentive Plan Awards for Fiscal Year 2016
For fiscal year 2016, our board of directors established goals under the MIP based on earnings before interest, taxes, depreciation and amortization, further adjusted to exclude stock-based compensation expense, certain acquisition-related and non-ordinary course professional expenses, Veritas Capital management fees and purchase accounting expenses (“Adjusted EBITDA”), and cash flows from operating activities before taxes, interest and certain acquisition-related and non-ordinary course professional expenses and Veritas Capital management fees, less recurring cash flow from investing activities (“Adjusted Operating Cash Flow”). Minimum and maximum Adjusted EBITDA and Adjusted Operating Cash Flow goals were established at the corporate level and at each division. No bonus is payable with respect to a performance factor if the performance is below the minimum goal. Performance above the maximum level would not result in any increase in bonus.
In addition to the MIP awards, the Board of Directors awarded a discretionary bonus to several members of senior management, including Mr. Fickett $65,000 and Mr. Littman $35,000.
The following table sets forth for fiscal year 2016, the minimum threshold goals (below which no bonuses based on the corresponding factor would be paid) and the maximum goals (above which no bonuses based on the corresponding factor would be paid), for Company Adjusted EBITDA and Adjusted Operating Cash Flow as well as the Company’s actual performance for the year (dollars in millions).
In calculating Adjusted EBITDA for fiscal year 2016, the Company excluded the following items: stock-based compensation expense of $0.6 million, transaction costs related to the evaluation, negotiation, closing and integration of acquisitions and non-ordinary course professional expenses of $2.3 million, Veritas Capital management fees of $2.6 million, and an adjustment for the impact of the revaluation of acquired assets and liabilities of $1.3 million. The base salary used for each executive was: Mr. Caldarelli C$600,000 Canadian, Mr. Littman $357,000, Mr. Fickett $417,000, Mr. Beighley $197,000, and Mr. Tafler C$239,000 Canadian.
The award for Mr. Caldarelli, our chief executive officer, provided that his bonus would be weighted as follows: 40% on Adjusted EBITDA for the Company as a whole, 40% on Adjusted Operating Cash Flow for the Company as a whole, 10% on Adjusted EBITDA for the Communications & Medical Products (“CMP”) Division (of which he is the president) and 10% on Adjusted Operating Cash Flow for the CMP Division. His bonus would be 30% of his base salary (as of the end of the fiscal year) on achievement of the minimum thresholds and 210% of his base salary on achievement of the maximum levels of Adjusted EBITDA and Adjusted Operating Cash Flow, with percentages interpolated for other levels of Adjusted EBITDA and Adjusted Operating Cash Flow.
For fiscal year 2016, the CMP Division’s actual Adjusted EBITDA was below the minimum threshold and the CMP Division's actual Adjusted Operating Cash Flow exceeded the minimum threshold by an amount equal to approximately 19% of the difference between the minimum and the maximum thresholds.
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The award for Mr. Fickett, our chief operating officer and president, provided that his bonus would be weighted as follows: 30% on Adjusted EBITDA for the Company as a whole, 30% on Adjusted Operating Cash Flow for the Company as a whole, 20% on Adjusted EBITDA for the Microwave Power Products (“MPP”) Division (of which he is the president) and 20% on Adjusted Operating Cash Flow for the MPP Division. His bonus would be 22.5% of his base salary (as of the end of the fiscal year) on achievement of the minimum thresholds and 165% of his base salary on achievement of the maximum levels of Adjusted EBITDA and Adjusted Operating Cash Flow, with percentages interpolated for other levels of Adjusted EBITDA and Adjusted Operating Cash Flow.
For fiscal year 2016, the MPP Division’s actual Adjusted EBITDA and actual Adjusted Operating Cash Flow were both below the minimum thresholds.
The award for Mr. Littman, our chief financial officer, treasurer and secretary, provided that his bonus would be weighted as follows: 50% on Adjusted EBITDA for the Company as a whole and 50% on Adjusted Operating Cash Flow for the Company as a whole. His bonus would be 18% of his base salary (as of the end of the fiscal year) on achievement of the minimum thresholds and 120% of his base salary on achievement of the maximum levels of Adjusted EBITDA and Adjusted Operating Cash Flow, with percentages interpolated for other levels of Adjusted EBITDA and Adjusted Operating Cash Flow.
The award for Mr. Beighley, vice president in charge of worldwide field sales, provided that his bonus would be weighted as follows: 40% on Adjusted EBITDA for the Company as a whole, 40% on Adjusted Operating Cash Flow for the Company as a whole and 20% on individual goals. His bonus would be 6.0% of his base salary (as in effect as of the end of the fiscal year) on achievement of the minimum thresholds and 45% of his base salary on achievement of the maximum levels of Adjusted EBITDA or Adjusted Operating Cash Flow, with percentages interpolated for other levels of Adjusted EBITDA or Adjusted Operating Cash Flow.
The award for Mr. Tafler, vice president, provided that his bonus would be weighted as follows: 25% on Adjusted EBITDA for the Company as a whole, 25% on Adjusted Operating Cash Flow for the Company as a whole, 25% on Adjusted EBITDA for the Satcom Division (of which he is the president) and 25% on Adjusted Operating Cash Flow for the Satcom Division. His bonus would be 15.0% of his base salary (as in effect as of the end of the fiscal year) on achievement of the minimum thresholds and 112.5% of his base salary on achievement of the maximum levels of Adjusted EBITDA and Adjusted Operating Cash Flow, with percentages interpolated for other levels of Adjusted EBITDA and Adjusted Operating Cash Flow.
For fiscal year 2016, the Satcom Division’s actual Adjusted EBITDA exceeded the maximum threshold, and the Satcom Division’s Adjusted Operating Cash Flow exceeded the minimum threshold by an amount equal to approximately 90% of the difference between the minimum and maximum thresholds.
The MIP provided that total aggregate bonus payments under the MIP for fiscal year 2016 would not exceed 8% of Adjusted EBITDA. For fiscal year 2016, the bonuses actually paid under the MIP did not approach this limit.
Except in the case of scheduled retirement, death or disability or as otherwise provided in an employee’s employment agreement, to be eligible for a bonus award, an executive officer must be on the payroll in good standing at the end of the fiscal year and at the time of payment. Payments are expected to be distributed on January 6, 2017 for U.S. executive officers, and no later than the end of January 2017 for Canadian executive officers. In the event of scheduled retirement, death or disability, a pro rata payment will be made to the executive officer or the executive officer’s estate.
Sales Incentive Plan Awards for Fiscal Year 2016
The award for Mr. Beighley under the Sales Incentive Plan provided that his bonus would be weighted as follows: 80% on worldwide field orders, 6.7% for days sales outstanding for Europe, 6.7% for advanced payments received, 3.3% for receivables past due for Europe and 3.3% for receivables past due for the U.S. and the rest of the world. His bonus would be 6.5% of his base salary (as in effect as of the beginning of the fiscal year) on achievement of the minimum thresholds and 47.5% of his base salary on achievement of the maximum levels, with percentages interpolated for other levels of achievement.
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The following table sets forth for fiscal year 2015, the minimum threshold goals (below which no bonuses based on the corresponding factor would be paid) and the maximum goals (above which no bonuses based on the corresponding factor would be paid), and the actual performance for Mr. Beighley:
Outstanding Equity Awards at September 30, 2016
There are no unvested equity awards outstanding as of September 30, 2016.
Class B Membership Interest Vested for Fiscal Year 2016
(1)
Represents Class B membership interests in Holding LLC that vested on April 27, 2016.
(2)
The market values of Class B membership interests that were vested at September 30, 2016 were determined by management using an income approach based on a cash flow methodology, the ownership percentage in Holding LLC, the preference of the Class A membership interests, and a discount for lack of liquidity.
Pension Benefits
(1)
Amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
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Narrative Disclosure to Pension Benefits Table
In December 2002, CPI Canada adopted a defined benefit pension plan for its chief executive officer, O. Joe Caldarelli. CPI Canada, Mr. Caldarelli’s employer, is the administrator of the plan. The amount of annual pension payable to Mr. Caldarelli at age 65, which is the normal retirement age as defined in the plan, is equal to: (i) 2% of the average of Mr. Caldarelli’s highest average indexed earnings for each year of pensionable service before December 31, 1990 plus (ii) the aggregate of 2% of Mr. Caldarelli’s indexed earnings for each year of pensionable service on or after January 1, 1991. In effect, under current Canadian regulations, as of the end of December 2016, the annual pension amount would be limited to C$2,890 per year of pensionable service. As used above and defined in the plan, “earnings” refers to salary, commissions, bonus and profit sharing; “pensionable service” (subject to exceptions for certain temporary absences) refers to the number of years and completed months of continuous service in Canada with the employer and all pensionable service recognized under The Retirement Plan of Communications & Power Industries Canada Inc. (the predecessor plan), “indexed earnings” means, for any given calendar year, the earnings adjusted to the date of calculation (which is the earliest date of retirement, termination of employment, date of death or termination of the plan) to reflect increases after the year in the average weekly wages and salaries of the Industrial Aggregate as published by Statistics Canada, and “highest average indexed earnings” means the average of the highest three years of indexed earnings preceding any date of calculation. Amounts payable to Mr. Caldarelli under the plan cannot exceed the maximum pension limits under the Canadian Income Tax Act. Under current Canadian regulations, Mr. Caldarelli would have been entitled to a maximum pension of C$109,201 per year if he had retired at the end of December 2016.
The pension paid under the plan will be increased annually on January 1 of each year, beginning the January 1 after the date of commencement of payment of the pension, based on the average rate of increase in the Canada all-items Consumer Price Index as published by Statistics Canada, during the previous calendar year (or part of the year) in respect of which payments were made, less 1%. If the annual pension benefit payable at normal retirement age is less than 2% of the yearly maximum pensionable earnings, as defined in the plan, for the calendar year in which Mr. Caldarelli retires, dies or his employment terminates, then a lump sum of the commuted value (as described in the plan) will be paid instead.
Pension payments will generally begin on the date that Mr. Caldarelli actually retires and will be paid in equal monthly installments of one-twelfth of the annual amount. If Mr. Caldarelli does not have a spouse at the time that the pension commences to be paid, then the pension payments will cease with the last payment due before his death or after 180 monthly payments have been made, whichever is later. If Mr. Caldarelli were to die before said 180 monthly payments had been made, then the commuted value (as described in the plan) of the remaining payments would be paid to his beneficiary, in one lump sum. If Mr. Caldarelli has a spouse at the time that the pension commences to be paid, then pension payments will be made throughout Mr. Caldarelli’s lifetime for a minimum of 60 monthly payments, with the provision that after his death, or after 60 monthly payments have been made (whichever is later), pension payments will continue to his spouse throughout his spouse’s lifetime at the rate of 66.67% of his pension. If he were to die before the minimum of 60 monthly payments had been made, then such payments will continue in full to the surviving spouse until the balance of the 60 monthly payments has been made and will then be reduced to 66.67%. If his spouse were also to die before the minimum of 60 monthly payments had been made, then the commuted value (as described in the plan) of the remaining payments would be paid to Mr. Caldarelli’s estate, in one lump sum. Notwithstanding the foregoing, Mr. Caldarelli’s spouse is entitled to waive her entitlement to receive payment of the pension under the plan, and in such event, Mr. Caldarelli will be deemed to not have a spouse for purposes of the plan at the time that the pension commences. Because Mr. Caldarelli is married, he has the option of electing a reduced amount of pension payment during his lifetime, with the provision that after his death, payment will continue as follows during the lifetime of his spouse if his spouse is then living: (i) in full without a guaranteed period or with a guaranteed period from commencement date of the pension of 60, 120 or 180 monthly payments or (ii) reduced to 66.67% with a guaranteed period from the commencement of the pension of 120 or 180 monthly payments.
Under the plan, Mr. Caldarelli is permitted to retire early, on the first of any month within 10 years of his normal retirement date, and Mr. Caldarelli is therefore currently eligible for early retirement under the plan. The amount payable at early retirement is the lesser of (i) the actuarial equivalent (determined on the basis of mortality tables, rates of interest and rules adopted from time to time by the employer for this purpose on recommendation of the actuary) of the pension accrued to the date of early retirement and otherwise payable from the normal retirement date and (ii) the pension accrued to the date of early retirement and otherwise payable from the normal retirement date, reduced by the early retirement reduction factor prescribed by Income Tax Regulation 8503(3)(c) under the Canadian Income Tax Act.
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Under the plan, if Mr. Caldarelli remains in service after his normal retirement age, he may delay receipt of his pension to the earlier of (i) the first day of the month coinciding with or following his actual retirement date and (ii) the first day of the month before the calendar year of his 69th birthday. The amount of pension payable at late retirement will be the sum of (a) the actuarial equivalent (determined as described above) of the pension accrued to his normal retirement date plus (b) the pension accrued (as calculated pursuant to the first paragraph) to the date of late retirement for each year, or part of a year, of pensionable service after his normal retirement date.
Upon termination of employment prior to normal retirement age, Mr. Caldarelli will receive a deferred pension payable from the normal retirement age in the normal form described in the plan. The amount of deferred pension will equal the amount of pension otherwise accrued under the plan to the date of termination. In addition, upon termination of employment (or wind-up of the plan), he is entitled to receive an early retirement pension, as described above. If Mr. Caldarelli dies while employed prior to commencement of the deferred pension payments to which he would have been entitled had his employment terminated immediately before his death, his surviving spouse may elect a lump sum payment equal to the commuted value (as described in the plan) of the deferred pension or an immediate or deferred pension payable in equal monthly installments, the present value of which does not exceed the present value of the deferred pension, payable throughout the spouse’s lifetime without a guaranteed period or with a guaranteed period not in excess of 180 monthly payments.
The plan may be amended or discontinued by the employer, and in such event, the benefits provided prior to the date of amendment will not be adversely affected. Replacement of the plan by another plan will be considered an amendment. If the plan is discontinued, the assets will be allocated to provide the pensions and benefits according to the plan.
The employer will pay into the plan in monthly installments within 30 days after the month for which contributions are payable, the amounts deemed to be employer-eligible contributions. An employer-eligible contribution is a contribution made by the employer to the plan that is a prescribed contribution or complies with prescribed conditions per applicable legislation and is made pursuant to the recommendation of the actuary. The employer is required to establish a pension fund into which all contributions will be deposited. The pension fund is not part of the revenue or assets of the employer. Accordingly, payments to be made under the plan will be made from the balance in the pension fund and from the general assets of the employer.
The method of valuation for determining the present value of the accumulated benefit is based on the following assumptions:
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Non-qualified Deferred Compensation
(1)
Amounts reported in this column are also included in the “Summary Compensation Table” in the “All Other Compensation” column.
(2)
Amounts reported in this column are not considered as “above market or preferential earnings” under SEC Rules and are therefore not included in the “Summary Compensation Table.”
Narrative Disclosure to Non-qualified Deferred Compensation Table
The Company adopted the Communications & Power Industries, Inc. Non-qualified Deferred Compensation Plan (the “Original Plan”) in 1995, and in 2004 adopted the First Amendment and Restatement of the Communications & Power Industries, Inc. Non-qualified Deferred Compensation Plan (the “Restated Deferred Compensation Plan”). The Restated Deferred Compensation Plan provides for the deferral of income on a pre-tax basis for a select group of the Company’s management and highly compensated employees and is administered by the board of directors of the Company. Participation in the Restated Deferred Compensation Plan is limited to employees who are (i) a select group of management or highly compensated employees, as defined by the Employee Retirement Income Security Act of 1974 (ERISA), and (ii) designated as such by the plan administrator. The Restated Deferred Compensation Plan first applied to elections made by participating employees to defer compensation earned or vested after December 31, 2004. The provisions of the Original Plan will remain in effect for deferrals of compensation that was earned and vested before January 1, 2005.
Under the Restated Deferred Compensation Plan, generally, a participating employee may elect in December of each year to defer up to 100% of his or her salary and MIP bonus for the next calendar year (subject to reduction to facilitate compliance with applicable withholding requirements). The Company makes contributions during each calendar year for the benefit of each participant equal to the sum of (1) 4.75% of the participant’s base salary paid in such calendar year in excess of the Social Security taxable wage base in effect for such year, up to and including the dollar limit set forth in Section 401(a)(17) of the Internal Revenue Code, plus (2) 9.5% of the participant’s base salary paid in such calendar year in excess of the dollar limit in Section 401(a)(17) of the Internal Revenue Code.
A participant’s account will be credited with such participant’s deferred compensation, the Company’s contributions for such participant and any investment earnings, gains, losses or changes in value (from time to time, as provided in the Restated Deferred Compensation Plan). The administrator will keep a sub-account within the account of each person who was a participant before the effective date of the Restated Deferred Compensation Plan to reflect (i) the portion of the account attributable to deferred compensation amounts and Company contributions that were earned and vested before January 1, 2005 (which will continue to be governed by the provisions of the Original Plan) and (ii) the portion of the account attributable to deferred compensation amounts and Company contributions that were earned or vested after December 31, 2004 (which will be governed by the provisions of the Restated Deferred Compensation Plan). A participating employee is at all times fully vested in his or her account balance.
Investment elections may be made from the various investment alternatives selected by a participant from those made available by the Company from time to time. A participant may elect to have his or her account deemed invested in up to 10 investment alternatives, provided that an investment alternative must be applied to at least 10% of the total balance in the account and must be in a whole percentage amount. Notwithstanding the foregoing, the Company may invest contributions in investments other than the investments selected by the participant; however the participant’s return will be based on the results of his or her investment election (reduced for expenses as provided in the Restated Deferred Compensation Plan).
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In the event of a participant’s disability or termination of employment for any reason, including retirement or death, the Company will pay the participant a termination benefit equal to the balance of the participant’s account in one lump sum within 2.5 months after the disability or termination of employment, provided that if stock of the Company is publicly traded on an established securities market (or otherwise), no payment will be made to a key employee (as defined in Section 416(i) of the Internal Revenue Code without regard to paragraph 5 of such section) of the Company or one of its affiliates within six months after such person’s separation from service (or the date of death, if earlier). In the event of a participant’s death before payment of the benefits pursuant to the preceding sentence, a death benefit equal to the balance in the participant’s account will be paid to the participant’s beneficiary in one lump sum within 2.5 months after the participant’s death. If the plan administrator, upon written request of a participant, determines in its sole discretion that the participant has suffered an unforeseeable financial emergency (as described in the Restated Deferred Compensation Plan), then the Company will pay the participant an amount necessary to meet the emergency in accordance with the provisions and subject to the limitations of the Restated Deferred Compensation Plan.
The board of directors may terminate, amend or modify the Restated Deferred Compensation Plan, subject to certain limitations set forth in the Restated Deferred Compensation Plan and applicable law. If the Restated Deferred Compensation Plan is terminated, (a) the portion of the participant’s account attributable to deferred compensation and Company contributions that were earned and vested before January 1, 2005 will be distributed in one lump sum and (b) the portion of the participant’s account attributable to deterred compensation and Company contributions that are earned or vested after December 31, 2004 will be distributed as and when such portion of the account would have been distributed if the plan had not terminated. The Restated Deferred Compensation Plan is intended to comply with the provisions of Internal Revenue Code Section 409A as enacted by the American Jobs Creation Act of 2004.
As with all non-qualified deferred compensation plans, a participating employee’s rights against the Company to receive the deferred amounts are limited to the rights of an unsecured general creditor. The Company’s obligation to pay benefits under the Original Plan and the Restated Deferred Compensation Plan is not backed by any security interest in the Company’s assets to assure payment of the deferred amounts.
Potential Payments upon Termination or Change in Control
Agreements Providing for Payments upon Termination or Change in Control
Employment Agreements
The employment agreements with Messrs. Caldarelli, Fickett, Littman, Beighley, and Tafler could require the Company (or the applicable subsidiary) to make certain payments to those executive officers in connection with certain terminations of their employment, including in connection with a termination following a change of control of the Company. These agreements are described above under “Narrative Disclosure to Summary Compensation Table, Grants of Plan-based Awards Table and Grants of Other Equity-based Awards Table-Employment Agreements.”
Class B Membership Interests
The Class B membership interests granted to the named executive officers are subject to vesting over a five-year period. Upon the occurrence of a change of control, all unvested Class B membership interests will immediately become vested.
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Calculation of Potential Payments upon Termination or Change in Control
The following table presents the Company’s estimate of the benefits payable to the named executive officers under the agreements described above in connection with certain terminations of their employment with the Company or its subsidiaries, including those in connection with a change in control. In calculating the amount of any potential payments to the named executive officers, the Company has assumed that the applicable triggering event (i.e., termination of employment) occurred on September 30, 2016.
(1)
The Company believes that the Section 280G tax gross-up amounts should not apply to Mr. Caldarelli or Mr. Tafler, as they typically receive little or no U.S.-source income from the Company.
(2)
Mr. Beighley and Mr. Tafler are not entitled to receive the benefits described in this table in the event of a voluntary termination of employment (whether or not for good reason).
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(3)
Excludes any payments to be received upon termination of employment in connection with the non-qualified deferred compensation plan described above under “Narrative Disclosure to Non-qualified Deferred Compensation Table” and the pension plan described above under “-Narrative Disclosure to Pension Benefits Table.”
(4)
The amounts shown represent two years, 1.5 years, 1.5 years, one year and one year, respectively, of Mr. Caldarelli’s, Mr. Fickett’s, Mr. Littman’s, Mr. Beighley’s and Mr. Tafler’s annual base salary (as applicable) as in effect on September 30, 2016. For Mr. Caldarelli and Mr. Tafler, salary amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(5)
The amounts shown represent (i) the amount of the MIP awards that would have been payable to Mr. Caldarelli, Mr. Littman and Mr. Fickett, as applicable, for fiscal year 2016 plus (ii) the average value of the amount paid under the Company’s MIP for fiscal years 2014, 2015 and 2016 (A) to Mr. Caldarelli, multiplied by two, (B) to Mr. Fickett multiplied by 1.5 and (C) to Mr. Littman multiplied by 1.5. For Mr. Caldarelli, his amount is denominated in Canadian dollars and was converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(6)
The amounts shown represent the aggregate value of the continuation of certain employee benefits for two years, 1.5 years, 1.5 years, 1.5 years and one year, respectively, for Mr. Caldarelli, Mr. Fickett, Mr. Littman, Mr. Beighley and Mr. Tafler. For purposes of the calculation of these amounts, expected costs have not been adjusted for any actuarial assumptions related to mortality, likelihood that the executive will find other employment or discount rates for determining present value. For Mr. Caldarelli and Mr. Tafler, amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(7)
The amounts shown represent the amounts of the MIP award that would have been payable to Mr. Beighley and Mr. Tafler for fiscal year 2016.
(8)
The amounts shown assume full outplacement services for a 12-month period with a firm providing transition support for executives.
(9)
The amounts shown represent 2.5 years, two years, two years, one year and one year, respectively, of Mr. Caldarelli’s, Mr. Fickett’s, Mr. Littman’s, Mr. Beighley’s and Mr. Tafler’s annual base salary (as applicable) as in effect on September 30, 2016. For Mr. Caldarelli and Mr. Tafler, amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(10)
The amounts shown represent (i) the amount of the MIP awards that would have been payable to Mr. Caldarelli, Mr. Littman and Mr. Fickett, as applicable, for fiscal year 2016 plus (ii) the highest amount paid under the Company’s MIP during fiscal years 2014, 2015 and 2016 (A) to Mr. Caldarelli, multiplied by 2.5, (B) to Mr. Fickett multiplied by two and (C) to Mr. Littman multiplied by two. For Mr. Caldarelli, amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(11)
The amounts shown represent the aggregate value of the continuation of certain employee benefits for 2.5 years, two years, two years, 1.5 years and one year, respectively, for Mr. Caldarelli, Mr. Fickett, Mr. Littman, Mr. Beighley and Mr. Tafler. For purposes of the calculation of these amounts, expected costs have not been adjusted for any actuarial assumptions related to mortality, likelihood that the executive will find other employment or discount rates for determining present value. For Mr. Caldarelli and Mr. Tafler, amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(12)
The calculation of the potential 280G tax gross-up amounts reflect the reimbursement that we are required to pay to Mr. Fickett and Mr. Littman due to (i) excise taxes that are imposed upon the executive as a result of a change in control, (ii) income and excise taxes imposed upon the executive as a result of our reimbursement of the excise tax amount and (iii) additional income and excise taxes that are imposed upon the executive as a result of our reimbursement of the executive for any excise or income taxes. The calculation of the potential 280G gross-up amounts are based upon a 280G excise tax rate of 20% on payments that exceed the “base amount” as defined in the income tax regulations under Internal Revenue Code Section 280G, a 39.6% federal income tax rate, a 2.35% Medicare tax rate and a 12.3% state income tax rate. For purposes of the 280G calculation, it is assumed that no amounts will be discounted as attributable to reasonable compensation and no value will be attributed to the executive executing a non-competition agreement.
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(13)
The amounts shown represent the amount of the MIP awards that would have been payable to Messrs. Caldarelli, Littman, Fickett, Beighley and Tafler, as applicable, for fiscal year 2016. For Mr. Caldarelli and Mr. Tafler, amounts are denominated in Canadian dollars and were converted to U.S. dollars using an exchange rate as of September 30, 2016 of approximately US$0.76 for C$1.00.
(14) The amount shown represents the special death benefit Mr. Beighley would receive in the event of his death, as described in his employment letter.
Item 12.
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Holding LLC owns all of the outstanding common stock of Parent, which in turn owns all of the outstanding common stock of CPII. The Veritas Fund and its affiliates and certain members of our management beneficially own shares of our common stock indirectly through their holdings in Holding LLC.
The following table sets forth information with respect to the beneficial ownership of the Class A and Class B membership interests in Holding LLC as of December 14, 2016 of: (1) each person or entity who beneficially owns 5% or more of the outstanding equity of Holding LLC; (2) each member of CPII’s board of directors, the board of directors of the Parent and the board of managers of the Holding LLC; (3) each of our named executive officers and directors; and (4) all of our directors and executive officers as a group.
Beneficial ownership is determined in accordance with the rules of the SEC. To our knowledge, each of the holders of Class A membership interests in Holding LLC listed below has sole voting and investment power as to the interests owned unless otherwise noted.
(1)
Except as otherwise indicated, addresses are c/o CPI International, Inc. 811 Hansen Way, Palo Alto, California 94303-1110.
(2)
Percentages do not reflect the impact of dilution due to the issuance of Class B membership interests.
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(3)
Certain directors and members of our management were granted Class B membership interests in Holding LLC. Pursuant to the terms of the amended and restated limited liability company agreement governing Holding LLC, holders of Class B membership interests are entitled to receive a percentage of all distributions, if any, made by Holding LLC after the holders of the Class A membership interests, including Veritas Capital, have received a return of their invested capital plus an 8% per annum internal rate of return (compounded quarterly and accruing daily) on their unreturned invested capital. Holders of Class B membership interests are not entitled to any voting rights. The aggregate amount of outstanding Class B membership interests shall not exceed 7.5% of the aggregate amount of all outstanding Class A and Class B membership interests. The Class B membership interests will be non-transferable and will vest ratably over five years, beginning on the first anniversary of the grant date. Following consummation of the Merger, we granted Class B membership interests to members of our management and our independent directors in an aggregate amount equal to approximately 5.51% of the aggregate amount of all outstanding Class A and Class B membership interests. 98% of these Class B membership interests are currently vested.
(4)
The address for The Veritas Capital Fund IV, L.P., The Veritas Capital Fund III, L.P., CICPI Holdings LLC, and Messrs. Evans and Polk is c/o Veritas Capital Fund Management, L.L.C. 9 West 57th Street, 29th Floor, New York, New York 10019.
(5)
Pursuant to the amended and restated limited liability company agreement governing Holding LLC, The Veritas Capital Fund IV, L.P. controls the appointment of the board of managers of Holding LLC.
(6)
Messrs. Evans and Polk, who are members of the board of managers of Holding LLC, control (i) Veritas Capital Partners IV, L.L.C., which is the general partner of The Veritas Capital Fund IV, L.P., (ii) Veritas Capital Partners III, L.L.C., which is the general partner of The Veritas Capital Fund III, L.P., and (iii) Veritas Capital Fund Management, L.L.C., which is the non-member manager of CICPI Holdings LLC and, as such, may be deemed beneficial owners of the Class A membership interests owned by each of The Veritas Capital Fund IV, L.P., The Veritas Capital Fund III, L.P. and CICPI Holdings LLC. Messrs. Evans and Polk disclaim this beneficial ownership except to the extent of their pecuniary interest in such entities.
(7)
Includes Class A membership interests held by The Veritas Capital Fund IV, L.P., The Veritas Capital Fund III, L.P. and CICPI Holdings LLC, beneficial ownership of which may be deemed to be held by Messrs. Evans and Polk. See footnote 6 above. Messrs. Evans and Polk disclaim this beneficial ownership except to the extent of their pecuniary interest in such entities, if any.
Item 13.
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Arrangements With Veritas
Advisory Agreement
In connection with the Merger, on February 11, 2011 we entered into an advisory agreement with Veritas Capital Fund Management, L.L.C. (“Veritas Management”), a Delaware limited liability company and an affiliate of Veritas Capital, pursuant to which Veritas Management will provide us with certain management, advisory and consulting services including, without limitation, business and organizational strategy, financial and advisory services. The initial term of the advisory agreement will end December 31, 2023 and the agreement will renew automatically for additional one-year terms thereafter unless Veritas Management or we terminate the advisory agreement. Pursuant to such agreement, we will pay Veritas Management an annual fee equal to the greater of $1 million and 3.0% of our Adjusted EBITDA, a portion of which is payable in advance annually beginning on the date of the Merger, and we will reimburse certain out-of-pocket expenses of Veritas Management. For fiscal year 2016, we incurred Veritas Management advisory fee expense (also referred to as “Veritas Capital management fees” in other sections of this Annual Report) of $2.6 million, of which $1.0 million was paid in fiscal year 2016 and $1.6 million remained in “accrued liabilities” in the accompanying consolidated balance sheet as of September 30, 2016.
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If Parent or any of its subsidiaries (including us) is involved in any transaction (including, without limitation, any acquisition, merger, disposition, debt or equity financing, recapitalization, structural reorganization or similar transaction), we will pay a transaction fee to Veritas Management equal to the greater of $0.5 million or 2% of transaction value. We may terminate the advisory agreement immediately prior to a change of control or an initial public offering, upon payment of an amount equal to all accrued fees and expenses plus the present value of all annual fees that would have been payable under the advisory agreement through December 31, 2023.
No other related person has any interest in the advisory agreement.
Review and Approval of Transactions with Related Persons
Any material transaction involving our directors, nominees for director, executive officers and their immediate family members and us or any of our affiliates is reviewed and approved by our Chief Executive Officer, following consultation with the board of directors, who determine whether the transaction is in our best interest. The policies and procedures for related-party transactions are not in writing, but the proceedings are documented in the minutes of the board of directors.
Director Independence
We are not a listed issuer whose securities are listed on a national securities exchange or in an inter-dealer quotation system which has requirements that a majority of the board of directors be independent. However, if we were a listed issuer whose securities were traded on the NYSE and subject to such requirements, we would be entitled to rely on the controlled company exception contained in Section 303A of the NYSE Listed Company Manual for exception from the independence requirements related to the majority of our board of directors. Pursuant to Section 303A of the NYSE Listed Company Manual, a company of which more than 50% of the voting power is held by an individual, a group or another company is exempt from the requirements that its board of directors consist of a majority of independent directors.
Other
See “Executive Compensation-Compensation Discussion and Analysis-Overview” for a description of arrangements with directors, executive officers and other senior management employees.
Item 14.
Item 14.
Principal Accounting Fees and Services
FEES PAID TO INDEPENDENT PUBLIC ACCOUNTANTS
The following table sets forth the aggregate fees billed and expected to be billed to the Company by KPMG LLP for professional services during fiscal years 2016 and 2015, as well as out-of-pocket costs incurred in connection with these services (in thousands):
Audit Fees
For fiscal years 2016 and 2015, the audit fees consist of fees for professional services rendered for the audit of the Company’s financial statements and reviews of the interim financial statements included in quarterly reports.
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Pre-Approval Policies
The Company does not have a separate Audit Committee. The Parent’s board of directors has the responsibility assigned to the Audit Committee. The Parent’s board of directors has determined not to adopt any blanket pre-approval policies. Instead, the Parent’s board of directors determined that it will, through designated individuals, specifically pre-approve the provision by KPMG LLP of all services.
All of the services provided by KPMG LLP described in the preceding paragraphs were approved by the Parent’s board of directors.
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PART IV
Item 15.
Item 15.
Exhibits, Financial Statement Schedules
(a)
(1) Financial Statements
The following consolidated financial statements and schedules are filed as a part of this report:
•
Report of Independent Registered Public Accounting Firm
•
Consolidated Balance Sheets
•
Consolidated Statements of Comprehensive Income
•
Consolidated Statements of Stockholders’ Equity
•
Consolidated Statements of Cash Flows
•
Notes to Consolidated Financial Statements
(2)
Consolidated Financial Statement Schedules
All schedules are omitted because they are not applicable, or because the required information is included in the consolidated financial statements or notes thereto.
(3)
The Exhibit Index beginning on page 140 of this annual report is hereby incorporated by reference herein.
(b)
Exhibits
See Item 15(a)(3) above.
(c)
Financial Statement Schedules:
See Item 15(a)(2) above.
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Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholder
CPI International Holding Corp.:
We have audited the accompanying consolidated balance sheets of CPI International Holding Corp. and subsidiaries (the Company) as of September 30, 2016 and October 2, 2015, and the related consolidated statements of comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended September 30, 2016. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CPI International Holding Corp. and subsidiaries as of September 30, 2016 and October 2, 2015, and the results of their operations and their cash flows for each of the years in the three-year period ended September 30, 2016, in conformity with U.S. generally accepted accounting principles.
/s/ KPMG LLP
Santa Clara, California
December 14, 2016
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(All tabular amounts in thousands)
1.
Organization and Summary of Significant Accounting Policies
Organization and Basis of Presentation: CPI International Holding LLC (“Holding LLC”) owns all of the outstanding common stock of CPI International Holding Corp., headquartered in Palo Alto, California (“Parent”), the parent company of CPI International, Inc. (“CPII”). CPII, in turn, owns all of the outstanding equity interests of Communications & Power Industries LLC (“CPI”) and Communications & Power Industries Canada Inc. (“CPI Canada”), CPII’s main operating subsidiaries. The Veritas Capital Fund IV, L.P., The Veritas Capital Fund III, L.P. and their affiliates, including CICPI Holdings LLC (collectively, “Veritas Capital”) and certain members of CPII’s management beneficially own shares of Parent’s common stock indirectly through their holdings in Holding LLC. Holding LLC, Parent and CPII are holding companies with no material assets or operations other than their respective direct or indirect equity interests in CPI and CPI Canada and activities related thereto.
As used herein, unless the context indicates or otherwise requires, the term “Company” refers to Parent and its consolidated subsidiaries and, where the context so requires, its direct and indirect parent companies.
The Company develops, manufactures and globally distributes components and subsystems used in the generation, amplification, transmission and reception of microwave signals for a wide variety of systems including radar, electronic warfare and communications (satellite and point-to-point) systems for military and commercial applications, specialty products for medical diagnostic imaging and the treatment of cancer, as well as microwave and radio frequency (“RF”) energy generating products for various industrial and scientific pursuits. The Company has two reportable segments: RF products and satcom equipment.
The accompanying consolidated financial statements represent the consolidated results and financial position of the Company. The Company’s fiscal year is the 52- or 53-week period that ends on the Friday nearest September 30. Fiscal years 2016 and 2015 comprised the 52-week periods ended September 30, 2016, and October 2, 2015, respectively, and fiscal year 2014 comprised the 53-week period ended October 3, 2014.
Certain prior year amounts within the consolidated balance sheets have been reclassified to conform to the current year presentation. Specifically, debt issuance costs and current deferred tax assets and current deferred tax liabilities have been reclassified due to recent accounting standard updates. See Note 2, “Recent Accounting Pronouncements” for additional information on these updates.
The consolidated financial statements include those of the Company and its subsidiaries. Significant intercompany balances, transactions, and stockholdings have been eliminated in consolidation.
Risks and Uncertainties: The Company operates in a dynamic industry and, accordingly, its liquidity can be affected by a variety of factors, some of which are based on normal ongoing operations of its business and others that are related to uncertainties in the markets in which the Company competes and other global economic factors. The Company has historically financed, and intends to continue to finance, its capital and working capital requirements, including debt service and internal growth, through a combination of cash flows from its operations and borrowings under its senior secured credit facilities. The Company's primary uses of cash are cost of sales, operating expenses, debt service, income taxes and capital expenditures.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The term loans under the Company's first and second lien credit facilities will mature and become payable in November 2017 unless the Company refinances at least 65% of its outstanding senior notes and satisfies certain other conditions prior to that time. However, if the Company refinances at least 65% of its outstanding senior notes and satisfies certain other conditions prior to the requisite deadline, the maturity of the term loans under the first and second lien credit facilities will be extended by approximately three and a half years. The Company intends to refinance at least 65% of its outstanding senior notes and satisfy the conditions necessary for the extension of the maturity dates of the term loans under its first and second lien credit facilities. On December 12, 2016, the Company entered into a commitment letter (the “Commitment Letter”) with UBS, AG, Stamford Branch and UBS Securities LLC (collectively, “UBS”), pursuant to which UBS has committed (subject to certain customary conditions) to provide and arrange a bridge loan facility to refinance 100% of the Company's existing senior notes (if the Company is otherwise unable to refinance its senior notes with certain other financing) and 100% of the Company's second lien credit facility. Assuming the Company is successful in refinancing its senior notes prior to November 2017, the Company believes that cash flows from operations and availability under its revolving credit facility, included in its senior secured credit facilities, will be sufficient to fund the Company's working capital needs, capital expenditures and other business requirements for at least the next 12 months. See Note 15, “Subsequent Event,” for additional information.
Foreign Currency Translation: The functional currency of the Company’s foreign subsidiaries is the U.S. dollar. Gains or losses resulting from the translation into U.S. dollars of amounts denominated in foreign currencies are included in the determination of net income or loss. Foreign currency translation gains and losses are generally reported on a net basis in the general and administrative expense in the consolidated statements of comprehensive income, except for translation gains or losses on income tax-related assets and liabilities, which are reported in income tax expense in the consolidated statements of comprehensive income.
Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of sales and costs and expenses during the reporting period. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition; inventory valuation; recoverability and valuation of recorded amounts of long-lived assets and identifiable intangible assets, including goodwill; recognition and measurement of current and deferred income tax assets and liabilities; and business combinations. The Company bases its estimates on various factors and information, which may include, but are not limited to, history and prior experience, experience of other enterprises in the same industry, new related events, current economic conditions and information from third-party professionals that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Revenue Recognition: Sales are recognized when persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. The Company’s products are generally subject to warranties, and the Company provides for the estimated future costs of repair, replacement or customer accommodation in cost of sales.
Revenue arrangements that include multiple deliverables are divided into separate units of accounting if the deliverables meet certain criteria. The Company allocates the consideration among the separate units of accounting based on their relative selling prices, and considers the applicable revenue recognition criteria separately for each of the separate units of accounting. The Company applies a selling price hierarchy for determining the selling price of a deliverable in a sale arrangement. The selling price for each deliverable is based on vendor-specific objective evidence (“VSOE”) if available, third-party evidence (“TPE”) if VSOE is not available, or best estimate of selling price (“BESP”) if neither VSOE or TPE is available. BESP’s are determined using management’s best estimate of the established selling prices of each deliverable, including list prices, and predominant selling prices observed in similar arrangements with the same customers.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The Company has commercial and U.S. Government fixed-price contracts that are accounted for under the accounting guidance for construction-type and production-type contracts. These contracts have represented not more than 3.0% of the Company’s sales during fiscal years 2016, 2015 and 2014, and are for contracts that generally are greater than six months in duration and that include a significant amount of product development. The Company uses the percentage-of-completion method when reasonably dependable estimates of the extent of progress toward completion, contract revenues and contract costs can be made. The portion of revenue earned or the amount of gross profit earned for a period is determined by measuring the extent of progress toward completion using total cost incurred to date and estimated costs at contract completion. In circumstances when reasonable and reliable cost estimates for a project cannot be made, the completed-contract method is used whereas no revenue is recognized until the project is complete.
Sales under cost-reimbursement contracts, which are primarily for research and development, are recorded as costs are incurred and include estimated earned fees in the proportion that costs incurred to date bear to total estimated costs. The fees under certain commercial and U.S. Government contracts may be increased or decreased in accordance with cost or performance incentive provisions that measure actual performance against established targets or other criteria. Such incentive fee awards or penalties are included in revenue at the time the amounts can be reasonably determined.
Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority.
Cash and Cash Equivalents: The Company considers all highly liquid short-term investments with original maturities of three months or less at the date of purchase that are readily convertible to known amounts of cash to be cash equivalents.
Restricted Cash: Restricted cash consists primarily of bank guarantees from customer advance payments to the Company’s international subsidiaries and cash collateral for certain performance bonds. The bank guarantees become unrestricted cash when performance under the sales or supply contract is complete. The cash collateral for the performance bonds becomes unrestricted cash when the performance bonds expire.
Inventories: Inventories are stated at the lower of cost (average cost) or market value (net realizable value). Each of the Company’s divisions uses either an actual cost, a standard cost or a moving weighted-average cost methodology based on the most appropriate methodology for that division’s operations in determining the cost basis for its inventories. In each case, the methodology used by the respective division approximates a first-in, first-out basis. Inventory costs include direct labor, direct material and overhead costs. Overhead costs include indirect manufacturing costs such as production management salaries and related expenses and an allocation of facility costs, which are allocated among cost of sales and materials, work-in-process and finished goods inventory. Inventories also include costs and earnings in excess of progress billings for contracts using the percentage-of-completion method of accounting. Progress billings in excess of costs and earnings for contracts using the percentage-of-completion method of accounting are reported in Advance Payments from Customers.
The Company assesses the valuation of inventory and periodically writes down the value for estimated excess and obsolete inventory based upon actual usage and estimates about future demand. The excess balance determined by this analysis becomes the basis for the Company’s excess inventory charge. Obsolescence is determined based on several factors, including competitiveness of product offerings, product life cycles and market conditions.
Management also reviews the carrying value of inventory for lower of cost or market on an individual product or contract basis. A loss is charged to cost of sales when known if estimated product or contract cost at completion is in excess of net realizable value (selling price less estimated cost of disposal). If actual product or contract cost at completion is different than originally estimated, then a loss or gain provision adjustment is recorded that would have an impact on the Company’s operating results.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Property, Plant and Equipment: Property, plant and equipment are stated at cost. Major improvements are capitalized, while maintenance and repairs are expensed as incurred. Plant and equipment are depreciated over their estimated useful lives using the straight-line method. Building, land improvements and process equipment are depreciated generally over 25, 20 and 12 years, respectively. Machinery and equipment are depreciated generally over seven to 12 years. Office furniture and equipment are depreciated generally over five to 10 years. Leasehold improvements are amortized using the straight-line method over their estimated useful lives, or the remaining term of the lease, whichever is shorter.
Goodwill and Other Intangible Assets: The Company accounts for business combinations using the purchase method of accounting in which identifiable intangible assets acquired are recognized and reported apart from goodwill.
The values assigned to acquired identifiable intangible assets are generally determined based on varying income approaches, depending on the nature of the identified intangible. The relief-from-royalty method of the income approach, generally used for completed and core technology and tradenames, determines fair value using estimated royalty rates that would be otherwise required to pay for the use of such intangibles to third parties. The excess earnings method of the income approach, generally used for customer relationships and backlog, determines fair market value using estimates and judgments regarding the expectations of future after-tax cash flows from those assets over their lives, including the probability of expected future contract renewals and sales, all of which are discounted to their present value. The results under the income approach are then compared to available market approaches, to ensure reasonableness.
Impairment of goodwill and identifiable intangible assets with indefinite useful lives is assessed at least annually in the fourth quarter, or whenever events or changes in circumstances suggest an impairment indicator exists. Goodwill and indefinite-lived intangible assets are tested for impairment by first evaluating qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit or an indefinite-lived intangible asset is less than the carrying value. Qualitative factors considered in this assessment include industry and market considerations, overall financial performance, and other relevant events and factors affecting the reporting unit. Additionally, as part of this assessment, a quantitative analysis is performed to support the qualitative factors above by applying sensitivities to assumptions and inputs used in measuring a reporting unit’s fair value. For each reporting unit or indefinite-lived intangible asset in which the impairment assessment concludes that it is more likely than not that the fair value is less than its carrying value, the currently prescribed quantitative impairment test based on a two-step approach is performed. If the fair value is less than the carrying amount, the implied fair value of a reporting unit's goodwill or an indefinite-lived intangible asset is compared with the carrying amount of that goodwill or indefinite-lived intangible asset. If the carrying amount exceeds the implied fair value, an impairment loss is recognized in an amount equal to that excess. The Company’s annual assessment resulted in no impairment of goodwill in fiscal years 2016, 2015 and 2014.
Intangible assets subject to amortization are amortized over their respective estimated useful lives and reviewed for impairment. Identifiable intangible assets are amortized on a straight-line basis over their useful lives of up to 40 years.
Long-Lived Assets: Long-lived assets, including property, equipment and leasehold improvements and finite-lived intangible assets, are evaluated for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset or asset group may not be recoverable. An impairment loss would be recognized when the sum of the undiscounted future net cash flows expected to result from the use of the asset or asset group and its eventual disposition is less than its carrying amount. Such impairment loss would be measured as the difference between the carrying amount of the asset or asset group and its fair value.
There were no triggering events identified that would indicate a need to review for impairment of long-lived assets during fiscal years 2016, 2015 and 2014.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Debt Issuance Costs: Costs incurred related to the issuance of the Company’s long-term debt and other credit facilities are capitalized and amortized over the estimated time the obligations are expected to be outstanding using the effective interest method. Debt issuance costs are amortized over the expected life of the respective debt of approximately five years for the revolving credit facility, six to seven years for the term loan facilities and seven years for the senior notes. Effective in the first quarter of fiscal year 2016, the Company has presented unamortized debt issuance costs as a direct deduction from long-term debt in the consolidated balance sheets in compliance with a recent accounting standard update further described in Note 2, “Recent Accounting Pronouncements.”
Product Warranty: The Company’s products typically carry warranty periods of one to three years or warranties over a predetermined product usage life. The Company estimates the costs that may be incurred under its warranty plans and records a liability in the amount of such estimated costs at the time revenue is recognized. The determination of product warranty reserves requires the Company to make estimates of product return rates and expected cost to repair or replace the products under warranty. The Company assesses the adequacy of its preexisting warranty liabilities and adjusts the balance based on actual experience and changes in future expectations.
Business Risks and Credit Concentrations: Defense-related applications, such as certain radar, electronic countermeasures and military communications applications, constitute a significant portion of the Company’s sales. Companies engaged in supplying defense-related equipment and services to government agencies are subject to certain business risks unique to that industry. Sales to the government may be affected by changes in procurement policies, budget considerations, changing concepts of national defense, political developments in the U.S. or abroad and other factors.
An entity is more vulnerable to concentrations of credit risk if it is exposed to risk of loss greater than it would have had if it mitigated its risk through diversification of customers. Such risks of loss manifest themselves differently, depending on the nature of the concentration, and vary in significance. Concentrations of credit risk in the Company's accounts receivable resulting from sales to the Company's one customer that accounted for 10% or more of its consolidated sales in fiscal years 2016, 2015 and 2014 are discussed in Note 13, “Segments, Geographic and Customer Information.”
Research and Development: Company-sponsored research and development costs related to both present and future products are expensed as incurred in operating expenses in the consolidated statement of comprehensive income. Customer-sponsored research and development represents development costs incurred on customer sales contracts to develop new or improved products. Customer-sponsored research and development costs are charged to cost of sales to match revenue recognized. Total expenditures incurred by the Company on research and development are summarized as follows:
Advertising Expenses: Costs related to advertising are recognized in selling and marketing expenses as incurred. Advertising expenses were not material in any of the periods presented.
Income Taxes: The Company accounts for income taxes under the asset and liability method, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Under this method, deferred tax assets and liabilities are determined on the basis of the differences between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in income in the period that includes the enactment date.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The Company recognizes deferred tax assets to the extent that the Company believes that these assets are more likely than not to be realized. In making such a determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax-planning strategies, and results of recent operations. If the Company determines that its deferred tax assets would be realized in the future in excess of their net recorded amount, the Company would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes.
The Company records uncertain tax positions based on the two-step process, whereby (1) the Company determines whether it is more likely than not that the tax positions will be sustained on the basis of the technical merits of the position, and (2) for those tax positions that are not more-likely-than-not to be sustained based solely on their technical merits, the Company recognizes the largest amount of tax benefit that is more than 50 percent likely to be realized upon ultimate settlement with the related tax authority.
Income tax-related interest expense or income, foreign exchange gains and losses and penalties are reported as components of the provision for income taxes in the consolidated statements of comprehensive income.
Effective in the first quarter of fiscal year 2016, the Company has classified deferred tax assets and liabilities as noncurrent in the consolidated balance sheets in compliance with a recent accounting standard update further described in Note 2, “Recent Accounting Pronouncements.”
Comprehensive Income: Comprehensive income is defined as a change in equity of a company during a period from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net income and comprehensive income for the Company arises from unrealized gains and losses, net of tax, on cash flow hedge contracts, and unrealized actuarial gains and losses and prior service costs and credits, net of tax, for pension liability.
2.
Recent Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update that provides a single model for revenue arising from contracts with customers. This accounting standard update, which will supersede current revenue recognition guidance, requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of goods or services. In July 2015, the FASB approved a one-year deferral of the effective date of this accounting standard update. This accounting standard update is now effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period. This accounting standard update will be effective for the Company beginning in the first quarter of fiscal year 2019. The guidance permits companies to either apply the requirements retrospectively to all prior periods presented, or apply the requirements in the year of adoption, through a cumulative adjustment. The Company is currently evaluating the impact the adoption will have on its consolidated results of operations, financial position or cash flows and related disclosures. The Company has not yet selected a transition method, nor has it determined the effect of the standard on its ongoing financial reporting.
In April 2015, the FASB issued an accounting standard update that requires debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This accounting standard update requires retrospective adoption and is effective for annual reporting periods beginning after December 15, 2015, including interim periods within that reporting period. Early adoption is permitted. The Company early adopted this accounting standard update beginning in the first quarter of fiscal year 2016. The new accounting standard update reduced other long-term assets and long-term debt on the Company’s consolidated balance sheet as of October 2, 2015 by $11.1 million, representing the unamortized balance of deferred debt issuance costs at that date. The new accounting standard update had no impact on the Company’s consolidated results of operations or cash flows.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
In September 2015, the FASB issued an accounting standard update that replaces the requirement that an acquirer in a business combination account for measurement period adjustments retrospectively with a requirement that an acquirer recognize such adjustments in the reporting period in which the adjustment amounts are determined. This accounting standard update requires that the acquirer record, in the same period’s financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. For public business entities, this accounting standard update is effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years. The guidance is to be applied prospectively to adjustments to provisional amounts that occur after the effective date of the guidance, with earlier application permitted for financial statements that have not been issued. The Company early adopted this accounting standard update in the first quarter of fiscal year 2016. See Note 3, “Business Combinations,” for details on the measurement period adjustments made during the fiscal year 2016 related to the Company's acquisition of ASC Signal Holdings Corporation and their corresponding impact on the Company’s financial statements.
In November 2015, the FASB issued an accounting standard update that requires deferred tax liabilities and assets be classified as noncurrent in the balance sheet. The existing requirement that deferred tax liabilities and assets of a tax-paying component of an entity be offset and presented as a single amount is not affected by the amendments in this accounting standard update. The Company early adopted this accounting standard update retrospectively in the first quarter of fiscal year 2016. The new accounting standard update reduced current assets by $8.5 million, increased other long-term assets and reduced current liabilities by $0.1 million each, and reduced noncurrent deferred tax liabilities by $8.3 million on the Company’s consolidated balance sheet as of October 2, 2015. The new accounting standard update had no impact on the Company’s consolidated results of operations or cash flows.
In February 2016, the FASB issued an accounting standard update which requires lessees to record most leases on their balance sheets. Lessees initially recognize a lease liability (measured at the present value of the lease payments over the lease term) and a right-of-use (“ROU”) asset (measured at the lease liability amount, adjusted for lease prepayments, lease incentives received and the lessee’s initial direct costs). Lessees can make an accounting policy election to not recognize ROU assets and lease liabilities for leases with a lease term of 12 months or less as long as the leases do not include options to purchase the underlying assets that the lessee is reasonably certain to exercise. This accounting standard update is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early adoption is permitted with the recognition and measurement of leases at the beginning of the earliest period presented in the financial statements using a modified retrospective approach. This accounting standard update will be effective for the Company beginning in the first quarter of fiscal year 2020. The Company is currently evaluating the impact the adoption may have on its consolidated results of operations, financial position or cash flows and related disclosures.
In August 2016, the FASB issued an accounting standard update that provides new guidance to reduce the diversity in practice in how certain transactions are classified in the statement of cash flows. The guidance adds or clarifies guidance on the classification of certain cash receipts and payments in the statement of cash flows. This accounting standard update is effective for annual and interim periods beginning after December 15, 2017. This accounting standard update will be effective for the Company beginning in the second quarter of fiscal year 2018.The Company does not expect that the adoption of this accounting standard update will have a material effect on its consolidated statements of cash flows.
3.
Business Combinations
All of the Company’s business combinations constitute transactions in which the Company obtains control of one or more “businesses” or a “business combination” and, accordingly, are accounted for under the acquisition method of accounting in which Parent or the Company is deemed to be the accounting acquirer. Under this method of accounting, all assets acquired and liabilities assumed are recorded at their respective fair values at the date of the completion of each transaction. Determining the fair value of assets acquired and liabilities assumed requires management’s judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to future cash inflows and outflows, discount rates, intangibles and other asset lives, among other items.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (an exit price). Market participants are assumed to be buyers and sellers in the principal (most advantageous) market for the asset or liability. Additionally, fair value measurements for an asset assume the highest and best use of that asset by market participants. As a result, the Company may have been required to value the acquired assets at fair value measures that do not reflect its intended use of those assets. Use of different estimates and judgments could yield different results. Any excess of the purchase price over the fair value of the net assets acquired is recognized as goodwill.
ASC Signal
On September 17, 2015, the Company acquired all of the issued and outstanding equity securities of ASC Signal Holdings Corporation (“ASC Signal”), a Delaware corporation, for a payment of approximately $50.7 million in cash consideration, net of $2.2 million cash acquired, including a post-closing adjustment based on a determination of ASC Signal’s closing net working capital of $0.4 million paid in the first quarter of fiscal year 2016. ASC Signal designs and builds advanced satellite communications, radar and high-frequency antennas and controllers used in commercial and government satellite communications, terrestrial communications, imagery and data transmission, and radar and intelligence applications. ASC Signal’s product portfolio includes satcom antenna systems with UHF (“ultra high frequency”) to V-band capabilities; radar antennas in S-band and L-band for air traffic control radar applications and in S-band and C-band for weather radar applications; and high-frequency and specialty antennas in a wide frequency range for a variety of applications. The results of ASC Signal’s operations were included in the Company’s satcom equipment segment and the Company’s consolidated results of operations beginning on the date of the acquisition.
The following table sets forth the final allocation of the total purchase price, including the measurement period adjustments, as of September 30, 2016 to the assets acquired and the liabilities assumed and the resulting goodwill:
The other long-term asset and other long-term liability represent an environmental indemnification receivable and an environmental loss reserve, respectively, for environmental remediation efforts at ASC Signal's Whitby, Ontario, Canada manufacturing facility. See Note 9, “Commitments and Contingencies,” for more information.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The measurement period adjustments shown in the table above reflect (i) an increase of $0.6 million to the fair value of assumed product warranty, (ii) a reduction of $0.1 million in sales tax benefit, (iii) an increase of $0.3 million to the fair value of property, plant and equipment, (iv) a decrease of $1.1 million to the fair value of customer relationship, (v) a decrease of $0.2 million to the fair value of backlog, (vi) a decrease of $0.5 million to long-term deferred tax liabilities and (vii) a decrease of $0.7 million to each of long-term environmental indemnification receivable and long-term environmental loss reserve, along with their effect on goodwill. In addition, deferred tax assets of $1.2 million were netted against deferred tax liabilities. These measurement period adjustments were among those expected to be made to the preliminary purchase price allocation based on awaited information obtained in the measurement period and are properly reflected in the Company’s consolidated balance sheet as of September 30, 2016.
As mentioned in Note 2, “Recent Accounting Pronouncements,” the Company has recently adopted an accounting standard update that requires the acquirer in a business combination to record the effect on earnings of measurement period adjustments in the same period the adjustments are identified. As a result, the Company recorded cumulative catch-up pre-tax adjustments of an immaterial amount to each of the depreciation of property, plant and equipment and the amortization of acquisition-related intangible assets in the Company’s consolidated statements of comprehensive income for fiscal year 2016.
The fair value assigned to identifiable intangible assets acquired was determined using variations of the income approach. Under these methods, fair value was estimated based upon the present value of cash flows that the applicable asset is expected to generate. The valuation of tradenames and completed technology was based on the relief-from-royalty method, and backlog and customer relationship was valued using the excess earnings method. The royalty rates used in the relief-from-royalty method were based on both a return-on-asset method and market comparable rates. The excess earnings method required for the Company to forecast future expected earnings of ASC Signal based on management’s best estimates derived from historical results, and future projected demand of their offerings. The Company believes that these identifiable intangible assets have no residual value after their estimated economic useful lives. The fair value of the identifiable intangible assets and their weighted-average useful lives are as follows:
All of the above identifiable intangible assets are definite-lived and are amortized over their estimated useful lives.
Goodwill resulting from the ASC Signal acquisition is largely attributable to future growth opportunities within the Company’s communications and radar markets and is not deductible for income tax purposes.
In connection with the ASC Signal acquisition, the Company incurred various direct costs totaling $1.2 million and $2.2 million included in general and administrative in the consolidated statements of comprehensive income for fiscal years 2016 and 2015, respectively. These costs, which the Company expensed as incurred, consist primarily of professional fees payable to financial and legal advisors and an accrual for retention bonuses for ASC Signal's senior management.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The following unaudited pro forma results of operations are presented as though the ASC Signal acquisition had occurred as of the beginning of the fiscal year 2014 or September 28, 2013, after giving effect to purchase accounting adjustments relating to depreciation and amortization of the revalued assets and debt incurred by the Company to partially fund the acquisition. The pro forma results of operations exclude the impact of certain charges that have resulted from or were in connection with the acquisition, including (i) the utilization of the net increase in the cost basis of inventory of $0.9 million, and (ii) amortization of backlog of $2.1 million for fiscal year 2016. All other pro forma adjustments reflected in the supplemental pro forma results of operations are individually immaterial to each period presented. The pro forma results of operations are not necessarily indicative of the combined results that would have occurred had the acquisition been consummated as of the earliest period presented, nor are they necessarily indicative of future operating results.
Radant Technologies
On October 1, 2013, the Company purchased all of the outstanding stock of Radant Technologies, Inc. (“Radant”), a Massachusetts corporation, for a payment of approximately $36.8 million in cash consideration, net of $0.6 million cash acquired. The Company was obligated to make a maximum of $10.0 million in potential additional payments if certain financial targets were achieved by Radant over the two years following the acquisition. Radant achieved the agreed-upon financial targets, which gave rise to the maximum earn-out payment in December 2015. See Note 5, “Financial Instruments,” for additional information.
4.
Supplemental Financial Information
Accounts Receivable: Accounts receivable are stated net of allowances for doubtful accounts as follows:
The following table sets forth the changes in allowance for doubtful accounts during the periods presented:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Inventories: The following table provides details of inventories:
Reserve for loss contracts: The following table summarizes the activity related to reserves for loss contracts during the periods presented:
At the end of each period presented above, reserve for loss contracts was reported in the consolidated balance sheet in the following accounts:
Property, Plant and Equipment, Net: The following table provides details of property, plant and equipment, net:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Intangible Assets: The following tables present the details of the Company’s total intangible assets:
The amortization of intangible assets is recorded as amortization of acquisition-related intangible assets, except for leasehold interest, which is included in cost of sales in the consolidated statements of comprehensive income. The amortization of intangible assets amounted to $14.7 million, $11.3 million and $11.5 million for fiscal years 2016, 2015 and 2014, respectively.
The estimated future amortization expense of intangible assets, excluding the Company’s unamortized tradenames, is as follows:
- 103 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Goodwill: The following table sets forth goodwill by reportable segment:
Accrued Expenses: The following table provides details of accrued expenses:
Product Warranty: The following table summarizes the activity related to product warranty:
- 104 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
5.
Financial Instruments
Fair value is the price that would be received upon sale of an asset or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value is calculated based on assumptions that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities includes consideration of non-performance risk, including the Company’s own credit risk.
The Company uses a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The three levels of the fair value hierarchy are described as follows:
The Company transfers assets or liabilities from one level to another when the methodology to obtain the fair value changes such that there are more or fewer unobservable inputs as of the end of the reporting period.
The Company’s non-financial assets (including goodwill, intangible assets, inventories and long-lived assets) and liabilities are measured at fair value on a non-recurring basis; that is, the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances, such as when they are deemed to be impaired. The fair values of these non-financial assets and liabilities are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables and discounted cash flow projections. During all periods presented, no fair value adjustments or material fair value measurements were required for the Company’s non-financial assets or liabilities other than the initial recognition of assets and liabilities in connection with business combinations. The estimated fair values of tangible and intangible assets and liabilities recorded in connection with business combinations are based on Level 3 inputs. See Note 3, “Business Combinations” for more information.
The Company measures certain financial assets and liabilities at fair value on a recurring basis, including cash equivalents, available-for-sale securities, derivative instruments and contingent consideration. As of September 30, 2016 and October 2, 2015, financial assets utilizing Level 1 inputs included cash equivalents, such as money market, fixed deposits and overnight U.S. Government securities, and available-for-sale securities, such as mutual funds. Financial assets and liabilities utilizing Level 2 inputs included foreign currency derivatives. As of October 2, 2015, the financial liability utilizing Level 3 inputs included the contingent consideration arising from the acquisition of Radant.
- 105 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The following tables set forth financial instruments carried at fair value within the hierarchy:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Investments Other Than Derivatives
In general and where applicable, the Company uses quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to the Company’s Level 1 investments, such as money market, fixed deposits, U.S. Government securities and mutual funds.
If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then the Company would use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. These investments would be included in Level 2.
Derivatives
The Company executes foreign exchange forward contracts to purchase Canadian dollars in the retail market with its relationship banks. To determine the most appropriate value, the Company uses an in-exchange valuation premise which considers the assumptions that market participants would use in pricing the derivatives. The Company has elected to use the income approach and uses observable (Level 2) market expectations at the measurement date and standard valuation techniques to convert future amounts to a single present amount. Level 2 inputs for derivative valuations are midmarket quoted prices for similar assets or liabilities in active markets and inputs other than quoted prices that are observable for the asset or liability.
Key inputs for currency derivatives are spot rates, forward rates, interest rates and credit derivative rates. The spot rate for the Canadian dollar is the same spot rate used for all balance sheet translations at the measurement date. Forward premiums/discounts and interest rates are interpolated from commonly quoted intervals. Once valued, each forward is identified as either an asset or liability. Assets are further discounted using counterparty annual credit default rates, and liabilities are valued using the Company’s credit as reflected in the spread paid over LIBOR on the term loan under the Company’s first lien credit agreement.
See Note 8, “Derivative Instruments and Hedging Activities,” for further information regarding the Company’s derivative instruments.
Contingent Consideration
In connection with, and as part of the Company’s acquisition of Radant, the Company was obligated to pay a maximum of $10.0 million in contingent consideration if certain financial targets were achieved by Radant over the two years following the acquisition. The fair value of the contingent consideration was based on a probability-weighted calculation whereby the Company assigned estimated probabilities to achieving the earn-out targets and then discounted the total contingent consideration to net present value using Level 3 inputs. Key assumptions included a discount rate of 14%, which the Company believed to reflect market participant assumptions, and a probability-adjusted level of Radant’s earnings before net interest expense, provision for income taxes and depreciation and amortization (“EBITDA”) in aggregate for the two years following the acquisition. Radant achieved the set financial targets, which gave rise to the earn-out payment of $10.0 million in December 2015.
The following table summarizes the activity related to contingent consideration during the periods presented:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The change in fair value of the contingent consideration since the date of the Radant acquisition was primarily due to the passage of time and subsequent adjustments in the probability assumptions regarding Radant’s EBITDA. Other assumptions used for determining the estimated fair value of the contingent consideration did not change significantly from those used at the acquisition date.
Other Financial Instruments
The Company’s other financial instruments include cash, restricted cash, accounts receivable, accounts payable, accrued expenses and long-term debt. Except for long-term debt, the carrying value of these financial instruments approximates fair values because of their relatively short maturity.
The estimated carrying and fair values of the Company’s long-term debt are as follows:
The fair value of the Second Lien Term Loan, into which the Company entered in September 2015, was estimated using inputs that are not observable (Level 3) as there are no quoted prices in active markets for this term loan. The fair value of the Second Lien Term Loan approximates its carrying value at September 30, 2016 as interest payments on this term loan are based on LIBOR rates that are reset monthly, and the Company believes that its credit risk has not changed materially since the date the term loan was executed.
- 108 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
6.
Long-term Debt
The Company’s long-term debt comprises the following as of the dates presented:
Senior Secured Credit Facilities
In April 2014, CPII entered into a First Lien Credit Agreement, which provides for (a) a term loan in an aggregate principal amount of $310.0 million (“First Lien Term Loan”) and (b) a $30.0 million revolving credit facility (“Revolver”), with sub-limits for letters of credit and swingline loans. On the closing date of the First Lien Credit Agreement, CPII borrowed the entire $310.0 million available under the First Lien Term Loan. No borrowings have been made to date under the Revolver (other than for approximately $4.5 million of outstanding letters of credit as of September 30, 2016).
On September 17, 2015, CPII entered into a Second Lien Credit Agreement, which provides for term loan borrowings in an aggregate principal amount of $28.0 million (“Second Lien Term Loan”). On the closing date of the Second Lien Term Loan, CPII borrowed the entire $28.0 million available under the Second Lien Term Loan. Proceeds of $27.4 million, after netting $0.6 million of issue discount, were principally used to fund a portion of the Company’s acquisition of ASC Signal.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Under the First Lien Credit Agreement, upon satisfaction of certain specified conditions, including pro forma compliance with a total leverage ratio, CPII may seek commitments for new term loans and revolving loans, not to exceed the sum of (i) $75.0 million, plus (ii) the aggregate amount of all prepayments of the First Lien Term Loan and permanent commitment reductions of the Revolver made prior to or simultaneously with the incurrence of new incremental commitments, plus (iii) such additional amounts to the extent CPII maintains a first lien leverage ratio of 3.50:1 or less on a pro forma basis after giving effect to such incremental commitments (the “First Lien Incremental Cap”). In addition, instead of incremental commitments of term loans or revolving loans under the First Lien Credit Agreement, CPII may utilize the First Lien Incremental Cap plus additional amounts at any time by issuing or incurring incremental equivalent debt, outside of the First Lien Credit Agreement, which may be in the form of secured or unsecured debt securities or loans, in each case upon satisfaction of certain specified conditions, including maintaining certain leverage ratios.
Under the Second Lien Credit Agreement, upon satisfaction of certain specified conditions, CPII may seek commitments for new term loans, not to exceed the sum of (i) $10.0 million, plus (ii) the aggregate amount of all prepayments of the Second Lien Term Loan made prior to or simultaneously with the incurrence of new incremental commitments (the “Second Lien Incremental Cap”). In addition, instead of incremental commitments of term loans under the Second Lien Credit Agreement, CPII may utilize the Second Lien Incremental Cap plus additional amounts at any time by issuing or incurring incremental equivalent debt, outside of the Second Lien Credit Agreement, which may be in the form of junior secured or unsecured debt securities or loans, in each case upon satisfaction of certain specified conditions, including maintaining certain leverage ratios.
The First Lien Credit Agreement and the Second Lien Credit Agreement (collectively, “Senior Credit Facilities”) are guaranteed by Parent and CPII’s domestic subsidiaries and are secured by substantially all of the assets of CPII and such guarantors.
Except as noted below, the First Lien Term Loan and the Second Lien Term Loan (collectively, “Term Loans”) will mature on November 17, 2017 and the Revolver will mature on August 19, 2017. However, if (a) in the case of the Term Loans, on or before November 17, 2017, and, in the case of the Revolver, on or before August 19, 2017, CPII has repaid or refinanced no less than 65% of the Senior Notes due 2018 (“Senior Notes”) outstanding as of the closing date of the First Lien Term Loan, or (b) the first lien leverage ratio as of August 19, 2017 is 2.50:1 or less on a pro forma basis (“Maturity Extension Condition”), then the Term Loans will mature on April 7, 2021 and the Revolver will mature on April 7, 2019.
Borrowings under the First Lien Credit Agreement bear interest at a rate equal to, at CPII’s option, the LIBOR or the base rate (“ABR”) plus the applicable margin. LIBOR and ABR borrowings under the First Lien Term Loan are subject to a 1.00% and 2.00% “floor,” respectively. The ABR under the First Lien Credit Agreement is the greatest of (a) the base rate established by the administrative agent, (b) the federal funds rate plus 0.50% and (c) adjusted LIBOR for a one-month interest period plus 1.00%. For the First Lien Term Loan, the applicable margin will be 3.25% per annum for LIBOR borrowings and 2.25% per annum for ABR borrowings. The applicable margins under the Revolver vary depending on CPII’s total leverage ratio, as defined in the First Lien Credit Agreement and range from 3.25% to 3.00% for LIBOR borrowings and from 2.25% to 2.00% for ABR borrowings.
Borrowings under the Second Lien Credit Agreement bear interest at a rate equal to, at CPII’s option, the LIBOR or the ABR plus the applicable margin. LIBOR and ABR borrowings under the Second Lien Term Loan are subject to a 1.00% and 2.00% “floor,” respectively. The ABR under the Second Lien Credit Agreement is the greatest of (a) a rate equal to the rate last quoted by The Wall Street Journal as the “Prime Rate” in the United States or, if The Wall Street Journal ceases to quote such rate, the highest per annum interest rate published by the Federal Reserve Board as the “bank prime loan” rate or, if such rate is no longer quoted therein, any similar rate quoted therein (as determined by the administrative agent) or any similar release by the Federal Reserve Board (as determined by administrative agent), (b) the federal funds rate plus 0.50% and (c) adjusted LIBOR for a one-month interest period plus 1.00%. For the Second Lien Term Loan, the applicable margin will be 7.00% per annum for LIBOR borrowings and 6.00% per annum for ABR borrowings. However, upon satisfaction of the Maturity Extension Condition, the applicable margin shall be increased by an amount equal to 150% of the difference in the coupon rate of the Senior Notes after the exchange and the coupon rate of the Senior Notes prior to the exchange, to the extent such difference is positive.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
In addition to customary fronting and administrative fees under the First Lien Credit Agreement, CPII will pay letter of credit participation fees equal to the LIBOR margin per annum applicable to the Revolver on the average daily amount of the letter of credit exposure, and a commitment fee on the average daily unused commitments under the Revolver. The commitment fee with respect to the unused portion of the Revolver varies depending on CPII’s total leverage ratio, as defined in the First Lien Credit Agreement, and will range from 0.375% to 0.500% per annum. Upon the satisfaction of the Maturity Extension Condition, CPII will pay to the lenders under the Second Lien Credit Agreement, a fee equal to 2.00% of the aggregate principal amount of the Second Lien Term Loans.
The First Lien Term Loan is payable in equal quarterly installments in annual amounts equal to 1.00% of the original principal amount of the First Lien Term Loan, with the remainder due on the First Lien Term Loan maturity date. The Second Lien Term Loan is due and payable on its scheduled maturity date.
Subject to the intercreditor agreement governing the First Lien Credit Agreement and the Second Lien Credit Agreement (the “Intercreditor Agreement”), CPII is required to prepay its outstanding loans under the Senior Credit Facilities, subject to certain exceptions and limitations, with net cash proceeds received from certain events, including, without limitation:
•
proceeds received from certain asset sales by Parent or any of its restricted subsidiaries subject to reinvestment rights,
•
proceeds received from certain issuances of debt or certain disqualified capital stock by Parent or any of its restricted subsidiaries, and
•
proceeds paid to Parent or any of its restricted subsidiaries from casualty and condemnation events in excess of amounts applied to replace, restore or reinvest in any properties for which proceeds were paid within a specified period.
Under the First Lien Credit Agreement, for each fiscal year, beginning with fiscal year 2015, CPII will also be required to make prepayments within five business days after the date on which the financial statements with respect to that fiscal year are delivered, based on a calculation of excess cash flow, as defined in the First Lien Credit Agreement, less optional prepayments and, in the case of the Revolver, corresponding reductions in commitment, made during such fiscal year. Based on the results for fiscal year 2016, CPII determined a prepayment of $10.1 million is required to be made on the First Lien Term Loan during the first quarter of fiscal year 2017. This excess cash flow prepayment is presented accordingly as a current liability in the consolidated balance sheet as of September 30, 2016. No other contractual principal payment is due on the First Lien Term Loan until its scheduled maturity date.
A prepayment premium of 1.00% of the aggregate principal amount of First Lien Term Loans which are prepaid pursuant to a repricing transaction, as defined in the First Lien Credit Agreement, on or prior to the date that is six months following the closing date of the First Lien Credit Agreement applies to any such prepayment of the First Lien Term Loans. CPII can make optional prepayments on the outstanding loans under the First Lien Credit Agreement at any time without premium or penalty, except for customary “breakage” costs with respect to LIBOR loans. A prepayment premium of 2.00% of the aggregate principal amount of Second Lien Term Loans which are prepaid on or prior to the date that is eighteen months following the closing date of the Second Lien Credit Agreement applies to any such prepayment of the Second Lien Term Loans. Following the date that is eighteen months after the closing date of the Second Lien Credit Agreement, subject to the Intercreditor Agreement, CPII can make optional prepayments on the outstanding Second Lien Term Loans at any time without premium or penalty, except for customary “breakage” costs with respect to LIBOR loans. No such optional prepayments were made during fiscal years 2016 and 2015.
The Senior Credit Facilities contain a number of covenants that, among other things, restrict, subject to certain exceptions, the ability of Parent and its restricted subsidiaries, including CPII, to:
•
sell assets;
•
engage in mergers or acquisitions;
•
pay dividends or distributions or repurchase their capital stock;
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
•
incur additional indebtedness or issue equity interests;
•
make investments and loans;
•
create liens or further negative pledges on assets;
•
engage in certain transactions with affiliates;
•
enter into sale and leaseback transactions;
•
amend documents relating to the Senior Notes to accelerate the dates principal payments are due thereon or make prepayments relating to subordinated indebtedness, the Senior Notes or permitted incremental debt outside of the Senior Credit Facilities; and
•
amend or waive provisions of charter documents in a manner materially adverse to the lenders.
Under the First Lien Credit Agreement, if on the last day of any period of four consecutive fiscal quarters, the aggregate principal amount of revolving loans, swingline loans and/or letters of credit (excluding letters of credit which have been cash collateralized) that are issued and/or outstanding is greater than 30% of the commitments under the Revolver, Parent and its restricted subsidiaries must comply with a maximum total leverage ratio, calculated on a consolidated basis for Parent and its restricted subsidiaries. There are no financial covenants under the Second Lien Credit Agreement.
Subject in certain cases to applicable notice provisions and grace periods, events of default under the Senior Credit Facilities include, among other things: failure to make payments when due; breaches of representations and warranties in the documents governing the Senior Credit Facilities; non-compliance by Parent, and/or the restricted subsidiaries with certain covenants; failure by Parent and/or the restricted subsidiaries to pay certain other indebtedness or to observe any other covenants or agreements that would allow acceleration of such indebtedness; events of bankruptcy or insolvency of CPII, Parent and/or CPII’s material subsidiaries; certain uninsured and unstayed judgments against CPII, Parent and/or CPII’s material subsidiaries; impairment of the security interests in the collateral or the guarantees under the Senior Credit Facilities; and a change in control, as defined in the Senior Credit Facilities. If an event of default occurs and is continuing under the Senior Credit Facilities, the entire outstanding balance may become immediately due and payable.
The refinancing in April 2014 of CPII’s prior senior credit facilities with the First Lien Credit Agreement was accounted for as a debt extinguishment in connection with which the Company recorded an expense of $3.8 million included in loss on debt restructuring in the consolidated statement of comprehensive income for fiscal year 2014. This expense primarily represents the write offs of deferred debt issuance costs and unamortized debt discount associated with the previously existing credit facilities.
Senior Notes due 2018
In February 2011, CPII issued an aggregate of $215 million of the Senior Notes originally bearing interest at the rate of 8.0% per year. The outstanding Senior Notes are CPII’s senior unsecured obligations. Parent and each of CPII’s existing and future restricted subsidiaries (as defined in the indenture governing the Senior Notes) guarantee the Senior Notes on a senior unsecured basis. Interest is payable in cash on a bi-annual basis. The indenture governing the Senior Notes limits, subject to certain exceptions, CPII and its restricted subsidiaries’ ability to incur additional indebtedness or issue certain preferred stock; pay dividends and make other restricted payments; make certain investments; sell assets; create liens; consolidate, merge or sell all or substantially all of CPII’s assets; enter into transactions with affiliates and designate subsidiaries as unrestricted subsidiaries.
Second Supplemental Indenture. In connection with the refinancing of its senior credit facilities in April 2014, CPII entered into a second supplemental indenture dated as of March 12, 2014, which amended the indenture governing the Senior Notes to:
•
increase the interest rate on the Senior Notes from 8.00% to 8.75% per annum;
•
increase the premium for any optional redemption of the Senior Notes to prices set forth in the table below;
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
•
increase the aggregate amount of indebtedness under CPII’s First Lien Credit Agreement that constitutes “Permitted Indebtedness” for purposes of the Limitations on Additional Indebtedness covenant from $230.0 million to $365.0 million; and
•
modify the Restricted Payments covenant in order to allow CPII to pay a one-time dividend of up to $175.0 million to the Company in fiscal year 2014.
In consideration for these amendments, in April 2014, CPII made an aggregate cash payment of $5.4 million (the “Consent Payment”) to those holders of such Senior Notes who had validly delivered a duly executed consent prior to the applicable expiration date of CPII’s consent solicitation and who had not revoked the consent in accordance with the procedure described in the consent solicitation statement. Upon payment of the Consent Payment, the amendments in the second supplemental indenture for the Senior Notes became operative.
The amendment of the indenture governing the Senior Notes as provided for in the second supplemental indenture was accounted for as debt modification, which resulted in the Company’s recording the Consent Payment mentioned above of $5.4 million as a debt discount netted against the balance of the Senior Notes on the consolidated balance sheet. Debt discount is amortized and recognized as interest expense under the effective interest method over the remaining term of the Senior Notes. Also, the Company recorded an expense of $3.4 million included in loss on debt restructuring in the consolidated statement of comprehensive income for fiscal year 2014 for incurred fees and costs associated with this debt modification.
At any time, or from time to time, on or after February 15, 2016, CPII, at its option, may redeem the Senior Notes, in whole or in part, at the redemption prices (expressed as percentages of principal amount) set forth below, together with accrued and unpaid interest thereon, if any, to the redemption date, if redeemed during the 12-month period beginning February 15 of the years indicated:
Upon a change of control, CPII may be required to purchase all or any part of the Senior Notes for a cash price equal to 101% of the principal amount, plus accrued and unpaid interest thereon, if any, to the date of purchase.
Debt Maturities: As of September 30, 2016, maturities on long-term debt were as follows:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The above table assumes that the respective debt instruments will be outstanding until their scheduled maturity dates, and that interest rates in effect on September 30, 2016 remain constant for future periods. The debt obligations in the above table also reflect the required “excess cash flow” prepayment under the Company's Senior Credit Facilities of $10.1 million payable in the first quarter of fiscal year 2017. The above table also excludes any optional prepayments on the Term Loans and the effect of the Company’s contractual right to repay or refinance the Senior Notes by November 17, 2017, which would extend the maturity date for the Term Loans from November 2017 to April 2021.
Covenants
As of September 30, 2016, the Company was in compliance with the covenants under the agreements governing CPII’s First Lien Credit Agreement, Second Lien Credit Agreement and the indentures governing the Senior Notes.
Anticipated Refinancing
See Note 15, “Subsequent Event,” for the Commitment Letter which CPII entered into on December 12, 2016 with respect to the anticipated refinancing of the Senior Notes and the Second Lien Credit Agreement.
7.
Employee Benefit Plans
Retirement Plans: The Company provides a qualified 401(k) investment plan covering substantially all of its domestic employees and a pension contribution plan covering substantially all of its Canadian employees. The Company also has a Non-Qualified Deferred Compensation Plan (the “Non-Qualified Plan”) that allows a select group of management and highly compensated employees to defer a portion of their compensation. The Non-Qualified Plan liability recorded by the Company as other long-term liability in the consolidated balance sheets amounted to approximately $1.8 million as of each of September 30, 2016 and October 2, 2015. For all of the Company’s current retirement plans, all participant contributions and Company matching contributions are 100% vested. Total CPI contributions to these retirement plans were $4.5 million for fiscal year 2016 and $4.1 million for each of fiscal years 2015 and 2014.
Defined Benefit Pension Plan: The Company maintains a defined benefit pension plan for its Chief Executive Officer (“CEO”). The plan’s benefits are based on the CEO’s compensation earnings and are limited by statutory requirements of the Canadian Income Tax Act. All costs of the plan are borne by the Company.
At each of September 30, 2016 and October 2, 2015, the Company recorded a liability of $0.2 million, which approximates the excess of the projected benefit obligation over plan assets of $1.4 million and $1.2 million, respectively. Additionally, the Company recorded an unrealized loss as of September 30, 2016 and an unrealized gain as of October 2, 2015 of immaterial amounts to accumulated other comprehensive income (loss) in the consolidated balance sheets.
The Company’s defined benefit pension plan is managed by an insurance company consistent with regulations or market practice in Canada, where the plan assets are invested. Net pension expense, recorded in general and administrative in the consolidated statements of comprehensive income, was $27,000, $30,000 and $36,000 for fiscal years 2016, 2015 and 2014, respectively. Contributions to the plan are not expected to be significant to the financial position of the Company.
8.
Derivative Instruments and Hedging Activities
Foreign Exchange Forward Contracts: Although the majority of the Company’s revenue and expense activities are transacted in U.S. dollars, the Company does transact business in foreign countries. The Company’s primary foreign currency cash flows are in Canada and several European countries. In an effort to reduce its foreign currency exposure to Canadian dollar-denominated expenses, the Company enters into Canadian dollar forward contracts to hedge the Canadian dollar-denominated costs for its manufacturing operation in Canada. The Company does not engage in currency speculation.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The Company’s Canadian dollar forward contracts in effect as of September 30, 2016 have durations of five to 20 months. These contracts are designated as a cash flow hedge and are considered highly effective. Unrealized gains and losses from foreign exchange forward contracts are included in accumulated other comprehensive income (loss) in the consolidated balance sheets. At September 30, 2016, the unrealized gain, net of tax of $0.2 million, was $0.6 million. At October 2, 2015, the unrealized loss, net of tax of $0.7 million, was $2.0 million. The Company anticipates recognizing the entire unrealized gain or loss in operating earnings within the next five fiscal quarters. Changes in the fair value of foreign currency forward contracts due to changes in time value are excluded from the assessment of effectiveness and are immediately recognized in general and administrative expenses in the consolidated statements of comprehensive income. The time value was not material for all periods presented. If the transaction being hedged fails to occur, or if a portion of any derivative is ineffective, then the Company immediately recognizes the gain or loss on the associated financial instrument in general and administrative expenses in the consolidated statements of comprehensive income. No ineffective amounts were recognized due to hedge ineffectiveness in the fiscal years 2016, 2015 and 2014.
As of September 30, 2016, the Company had entered into Canadian dollar forward contracts for nominal values of approximately $60.0 million (Canadian dollars), or approximately 75% of estimated Canadian dollar denominated expenses for October 2016 through September 2017, at an average rate of approximately 0.75 U.S. dollars to one Canadian dollar.
The following table summarizes the aggregate fair value of all derivative instruments designated as cash flow hedges as of September 30, 2016 and October 2, 2015:
As of September 30, 2016 and October 2, 2015, the Company had no derivative instruments that were classified as non-hedging instruments. The Company’s derivatives are reported on a gross basis. The Company has no master netting arrangements with its derivative counterparties that would allow for net settlement.
The following tables summarize the effect of derivative instruments on the consolidated statements of comprehensive income for the periods of fiscal years 2016, 2015 and 2014 presented:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
As a result of the use of derivative instruments, the Company is exposed to the risk that counterparties to derivative contracts will fail to meet their contractual obligations. The Company does not hold collateral or other security from its counterparties supporting its derivative instruments. To mitigate the counterparty credit risk, the Company has a policy of only entering into contracts with carefully selected major financial institutions based upon their credit ratings and other factors. The Company regularly reviews its credit exposure balances as well as the creditworthiness of its counterparties.
When the Company’s derivatives are in a net asset position, the Company is exposed to credit loss from nonperformance by the counterparty. If the counterparty fails to perform, credit risk with such counterparty is equal to the extent of the fair value gain in the derivative.
9.
Commitments and Contingencies
Leases: The Company is committed to minimum rentals under non-cancelable operating lease agreements, primarily for land and facility space, that expire on various dates through 2050. Certain of the leases provide for escalating lease payments. Future minimum lease payments for all non-cancelable operating lease agreements at September 30, 2016 were as follows:
Real estate taxes, insurance, and maintenance are also obligations of the Company. Rental expense under non-cancelable operating leases amounted to $4.0 million, $3.4 million and $4.0 million for fiscal years 2016, 2015 and 2014, respectively. Assets subject to capital leases at September 30, 2016 and October 2, 2015 were not material.
Guarantees: The Company has restricted cash of $1.6 million and $1.7 million as of September 30, 2016 and October 2, 2015, respectively, consisting primarily of bank guarantees from customer advance payments to the Company’s international subsidiaries and cash collateral for certain performance bonds.
Indemnification: As permitted under Delaware law, the Company has agreements whereby the Company indemnifies its officers, directors and certain employees for certain events or occurrences while the, officer, director or employee is, or was serving, at the Company’s request in such capacity. The term of the indemnification period is for the officer’s, director’s and employee’s lifetime. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has Director and Officer insurance policies that limit its exposure and may enable it to recover a portion of any future amounts paid.
The Company has entered into other standard indemnification agreements in its ordinary course of business. Pursuant to these agreements, the Company agrees to indemnify, defend, hold harmless and to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally the Company’s business partners or customers, in connection with any patent, copyright or other intellectual property infringement claim by any third-party with respect to the Company’s products. The term of these indemnification agreements is generally perpetual after execution of the agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. Management believes that the likelihood of loss under these agreements is remote.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Employment Agreements: The Company has entered into employment agreements with certain members of the executive management, which include provisions for the continued payment of salary, benefits and a pro-rata portion of an annual bonus for periods ranging from 12 months to 30 months upon certain terminations of employment.
Contingencies: From time to time, the Company may be subject to claims that arise in the ordinary course of business. In the opinion of management, all such matters involve amounts that would not have a material adverse effect on the Company’s consolidated results of operations, financial position or cash flows if unfavorably resolved.
In 2010, the Company’s new subsidiary, ASC Signal, became aware of volatile organic compounds (“VOC”) and other contamination in the soil and groundwater at the Whitby, Ontario industrial site. The Company believes that the contamination originated from the neighboring property, which reportedly is used for crystal manufacturing, and secondarily from the operational practices of the prior operators of ASC Signal. The Company has addressed these conditions through the implementation of a remediation plan. ASC Signal holds a pair of pollution insurance policies and the insurer is indemnifying ASC Signal for the remediation costs. The Company expects that the total remediation costs will be less than the insurance policy limits. In addition, ASC Signal has filed a civil action against the neighbor and certain other parties to recover consequential damages resulting from the contamination. The Company has been informed that one of the defendants in this lawsuit has filed for bankruptcy.
The Company believes that the remaining cost to remediate the contamination at the Whitby site will be in the range of approximately Canadian $2.1 million to $4.1 million (or U.S. $1.6 million to $3.1 million based on an exchange rate of 0.76 U.S. dollars to one Canadian dollar) as of September 30, 2016. The Company, as a result, had a loss reserve accrual balance as of September 30, 2016 of U.S. $1.6 million, which represents the low end of the range of loss estimates because of the uncertainty of the loss estimate amounts. The minimum amount in the range is not necessarily the amount of loss that will be ultimately determined, and it is not likely that the ultimate loss will be less than the minimum amount. As mentioned above, ASC Signal has environmental liability insurance policies which are expected to provide complete indemnification from any costs incurred for the remediation efforts. The expected indemnification gave effect to an environmental indemnification asset also acquired by the Company with the ASC Signal acquisition. The accompanying consolidated balance sheet as of September 30, 2016 reflects the current balances of the environmental indemnification asset of $1.6 million and the environmental loss reserve of $1.6 million in other long-term assets and other long-term liabilities, respectively. The calculation of environmental loss reserves is based on the evaluation of currently available information. Actual costs to be incurred in future periods may vary from the amount of reserve given the uncertainties regarding the status of laws, regulations, enforcement policies, and the impact of potentially responsible parties, technology and information related to the affected site.
All legal costs are expensed as incurred.
10.
Related-Party Transactions
A former major stockholder of the predecessor of the Company's Radant Technologies Division now serves as the Director of Business Development of that division (the “Radant Director of Business Development”). In connection with, and as part of the consideration for, the Radant acquisition, the Company was obligated to make $10.0 million in additional payments to the former stockholders of Radant including the Radant Director of Business Development and certain of his relatives for Radant’s having achieved certain agreed-upon financial targets over the two years following the acquisition. The Company, as a result, made the earn-out payment in full in December 2015. Also in connection with the acquisition, the Company entered into a lease agreement for a property in Stow, Massachusetts, that contains a manufacturing plant and office facilities owned by a company controlled by the Radant Director of Business Development. The Company paid and recorded a rent expense of $0.4 million for such lease for each of fiscal years 2016, 2015 and 2014.
- 117 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The Company is party to an advisory agreement with Veritas Capital Fund Management, L.L.C. (“Veritas Management”), a Delaware limited liability company and an affiliate of Veritas Capital, pursuant to which Veritas Management provides the Company with certain management, advisory and consulting services including, without limitation, business and organizational strategy, financial and advisory services. The initial term of the advisory agreement will end December 31, 2023, and the agreement will renew automatically for additional one-year terms thereafter unless Veritas Management or the Company terminates the advisory agreement. Pursuant to such agreement, the Company pays Veritas Management an annual fee equal to the greater of $1.0 million or 3.0% of the Company’s Adjusted EBITDA (EBITDA further adjusted to exclude stock-based compensation expenses, refinancing expenses, certain acquisition-related and non-ordinary course professional expenses, the Veritas Management annual advisory fee and purchase accounting expenses), a portion of which is payable in advance annually, and the Company reimburses certain out-of-pocket expenses of Veritas Management. For fiscal years 2016, 2015 and 2014, the Company incurred Veritas Management advisory fee expense of $2.6 million, $2.4 million and $2.7 million, respectively, recorded in general and administrative expenses in the consolidated statements of comprehensive income. As of September 30, 2016, $1.6 million of the Veritas Management advisory fee remained unpaid.
Under the Veritas Management advisory agreement, if Parent or any of its subsidiaries (including the Company) is involved in any transaction (including, without limitation, any acquisition, merger, disposition, debt or equity financing, recapitalization, structural reorganization or similar transaction), the Company is obligated to pay a transaction fee to Veritas Management equal to the greater of $0.5 million or 2.0% of transaction value. The Company may terminate the advisory agreement immediately prior to a change of control or an initial public offering, upon payment of an amount equal to all accrued fees and expenses plus the present value of all annual fees that would have been payable under the advisory agreement through December 31, 2023. In connection with entering into Second Lien Credit Agreement and the acquisition of ASC Signal in September 2015, the Company incurred a $1.0 million transaction fee, which was paid to Veritas Management in the first quarter of fiscal year 2016. The total transaction fee incurred in fiscal year 2015 comprised (1) $0.4 million attributed to the Second Lien Credit Agreement as part of its capitalized debt issuance costs, and (2) $0.6 million attributed to the ASC Signal acquisition as part of acquisition costs included in general and administrative expense on the accompanying consolidated statements of comprehensive income for fiscal year 2015. In connection with April 2014 debt refinancing, the Company paid $4.0 million in transaction fees to Veritas Management during fiscal year 2014. The total transaction fee paid in fiscal year 2014 comprised (1) $2.5 million attributed to the First Lien Credit Agreement as part of its capitalized debt issuance costs, and (2) $1.5 million attributed to the Senior Notes as part of their expensed debt modification costs included in loss on debt restructuring on the accompanying consolidated statements of comprehensive income for fiscal year 2014. Veritas Management waived any transaction fees due for acquisitions made by the Company during fiscal year 2014.
No other related person has any interest in the advisory agreement.
One of the vendors of the of the Company's ASC Signal Division is owned by the father of ASC Signal's Vice President of Products. The vendor is also a customer of ASC Signal. Purchases from and sales to this vendor were $2.0 million and $0.1 million, respectively, for fiscal year 2016. From the date of ASC Signal acquisition of September 17, 2015 through the end of fiscal year 2015, the Company’s total purchases from and sales to this vendor were not material. The Company had $0.1 million and $0.2 million outstanding payables to this vendor as of September 30, 2016 and October 2, 2015, respectively, and $0.1 million and zero outstanding receivables from this vendor as of the same dates, respectively.
Certain members of management of the Company have been granted Class B membership interests in Holding LLC. See Note 12, “Stockholders’ Equity,” for more details.
- 118 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
11.
Income Taxes
The components of income before income taxes are summarized as follows:
Income tax expense is summarized as follows:
The differences between the effective income tax rate and the federal statutory income tax rate were as follows:
- 119 -
CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
In fiscal year 2016, the tax rate in excess of the federal statutory rate was primarily due to an increase in the valuation allowance on foreign tax credits generated and the Company's inability to benefit from foreign tax credits on foreign earnings, and state taxes, partially offset by the domestic manufacturing deduction. In fiscal year 2015, the tax rate in excess of the federal statutory rate was primarily due to an increase in the valuation allowance on foreign tax credits and nondeductible acquisition earn-out expense, partially offset by the domestic manufacturing deduction and tax benefits from closure of a California tax audit and a change in state apportionment. The negative state tax rate for fiscal year 2015 is primarily due to the impact of a change in state apportionment on deferred tax accounts. In fiscal year 2014, the tax rate in excess of the federal statutory rate was primarily due to a change in the Company's ability to use foreign tax credits and nondeductible acquisition earn-out expense, partially offset by tax benefits from the expiration of the statute of limitations on uncertain tax positions and a provision to tax return true-up.
Deferred income taxes reflect the net tax effects of temporary differences between the basis of assets and liabilities for financial reporting and income tax purposes. The significant components of the Company’s deferred tax assets (liabilities) were as follows:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The breakdown of long-term deferred tax assets and liabilities were as follows:
Realization of the Company’s net deferred tax assets is based upon the weight of available evidence, including such factors as earnings history and expected future taxable income. As of September 30, 2016, the Company believes that sufficient positive evidence exists from historical operations and projections of taxable income in future years to conclude that it is more likely than not that the Company will realize its deferred tax assets except for federal foreign tax credit carryforwards. Utilization of federal foreign tax credit carryforwards requires income of a certain character to be recognized within a ten year carryforward period. The Company does not expect there will be sufficient future income of this character to fully utilize federal foreign tax credit carryforwards; therefore, a valuation allowance was recorded. As of September 30, 2016, the Company had federal foreign tax credit carryforwards of $6.8 million. If not utilized, federal foreign tax credit carryforwards begin to expire in 2021.
In connection with the ASC Signal acquisition, the Company acquired federal net operating loss (“NOL”) carryforwards of approximately $10.9 million and state NOL’s of approximately $3.9 million which the Company believes will not expire before utilization. At September 30, 2016, the Company had federal NOL carryforwards of approximately $7.6 million and state NOL’s of approximately $6.2 million. If not utilized, federal NOL carryforwards begin to expire in 2028 and state NOL carryforwards begin to expire in 2023.
The Company provides U.S. income taxes on earnings of foreign subsidiaries unless the subsidiaries earnings are considered indefinitely reinvested outside of the United States. The Company has approximately $9.4 million of undistributed earnings in its Canadian operations that were indefinitely reinvested in business acquisitions; the unrecognized deferred tax liability on such amount is approximately $4.0 million.
As of September 30, 2016 and October 2, 2015, unrecognized tax benefits of $0.5 million and $0.9 million, respectively, are reported as other long-term liabilities in the consolidated balance sheets. Unrecognized tax benefits as of September 30, 2016 would affect the effective tax rate if recognized. The amount of accrued income tax related interest and penalties and the amount charged to income tax expense for fiscal year 2016 and 2015 is not significant.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
A reconciliation of the beginning and ending balances of the total gross unrecognized tax benefits, excluding accrued interest and penalties, is as follows:
The Company believes that it is reasonably possible that, in the next 12 months, the amount of unrecognized tax related to the resolution of federal, state and foreign matters could be reduced by $0.6 million as audits close, statutes expire and tax payments are made.
The Company files a U.S. federal income tax return and state income tax returns in California, Massachusetts and several other U.S. states. The Company also files income tax returns in Canada and other foreign jurisdictions. With the exception of Canada and California, the Company is no longer subject to examination by the various taxing authorities for fiscal years prior to 2013. The Company is no longer subject to examination by taxing authorities in Canada and California for fiscal years prior to 2008.
Based on the outcome of tax examinations of the Company and the result of the expiration of statutes of limitations for specific jurisdictions, it is reasonably possible that the related unrecognized tax benefits could change from those recorded in the statement of financial position. The Company has provided for amounts of anticipated tax audit adjustments in various jurisdictions based on its reasonable estimate of additional taxes and interest as required by the more likely than not standard under the accounting guidance for uncertainty in income taxes.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
12.
Stockholders’ Equity
Special Dividend
In April 2014, the Company’s board of directors officially declared, and the Company paid a special cash dividend in an aggregate amount of $175.0 million to Holding LLC, the Company’s sole stockholder of record as of the close of business April 2, 2014. The special dividend was recorded as a reduction to additional paid-in capital.
Equity-based Compensation
In April 2011, December 2011 and June 2015, certain members of management and independent directors of the Company were granted Class B membership interests in Holding LLC. Pursuant to the terms of the limited liability company operating agreement governing Holding LLC, holders of Class B membership interests are entitled to receive a percentage of all distributions, if any, made by Holding LLC after the holders of Class A membership interests, including Veritas Capital, have received a return of their invested capital plus an 8% per annum internal rate of return (compounded quarterly and accruing daily) on their unreturned invested capital. Holders of Class B membership interests are not entitled to any voting rights. The Class B membership interests are subject to a five-year vesting schedule, except vesting will be accelerated in the event of a change of control. Class B membership interests are granted with no exercise price and no expiration date. Grants of Class B membership interests are limited in the aggregate to 7.50% of the net profits interests in Holding LLC.
A summary of activity for grants, forfeitures and the outstanding balance of Class B membership interests in Holding LLC follow:
As of September 30, 2016, 100% of Class B membership interests for the majority of current holders were vested.
The fair value at date of grant of Class B membership interests was determined by management using an income approach based on a cash flow methodology, the ownership percentage in Holding LLC, the preference of the Class A membership interests, and a 25% marketability discount. The discount is estimated based on an option pricing model for an Asian put option known as the Finnerty model, and the weighted average assumptions are risk free rate of 0.65%, expected volatility of 75%, restricted period of two years, and no dividend yield.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The Company records equity-based compensation expense based on the grant-date fair value on a straight-line basis over the vesting period of the awards. The following table summarizes equity-based compensation expense for the periods presented, which was allocated as follows:
The unamortized amount of equity-based compensation was $0.1 million at September 30, 2016, and is scheduled to be charged to expense as follows:
Accumulated Other Comprehensive Income (Loss)
The following table provides the components of accumulated other comprehensive income (loss) in the consolidated balance sheets:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
The following table provides changes in accumulated other comprehensive income (loss), net of tax, reported in the Company’s consolidated balance sheets for fiscal years 2016 and 2015 (amounts in parentheses indicate debits):
The following table provides the gross amounts reclassified from accumulated other comprehensive income or loss and the corresponding amounts of taxes for fiscal years 2016 and 2015 (amounts in parentheses indicate debits):
See Note 8, “Derivatives Instruments and Hedging Activities,” for additional disclosures about reclassifications out of accumulated other comprehensive income and their corresponding effects on the respective line items in the consolidated statements of comprehensive income.
13.
Segments, Geographic and Customer Information
The Company’s reportable segments, RF products and satcom equipment, are differentiated based on their underlying profitability and economic performance. The divisions or reporting units forming each segment have been aggregated based on the similarity of their economic characteristics as measured by EBITDA, and the similarity of their products and services, production processes, types of customers and distribution methods, and the nature of their regulatory environments. The Company’s analysis of the similarity of economic characteristics was based on both a historical and anticipated future analysis of performance. Segment information reported below is consistent with the manner in which it is reviewed and evaluated by the Company’s chief operating decision maker (“CODM”), its chief executive officer, and is based on the nature of the Company’s operations and products offered to customers.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Made up of five divisions, the RF products reportable segment develops, manufactures and distributes high-power/high-frequency microwave and RF signal components and structures. These products are used in the communications, radar, electronic warfare, industrial, medical and scientific markets depending on the specific power and frequency requirements of the end-user and the physical operating conditions of the environment in which the RF products will be located. These products are distributed through the Company’s direct sales force, independent sales representatives and distributors.
The satcom equipment segment consists of two divisions, including the ASC Signal division, which the Company acquired in September 2015. The satcom equipment segment manufactures and supplies high-power amplifiers primarily for communication with satellites, and satellite communications, radar and high-frequency antennas and controllers. These products are used for satellite communication uplinks, terrestrial communications, imagery and data transmission, and radar and intelligence applications. This segment also provides spares, service and other post-sales support. Its products are distributed through the Company’s direct sales force and independent sales representatives.
Amounts not reported as RF products or satcom equipment are reported as “other.” Other includes the activities of the Company’s Malibu Division and unallocated corporate expenses, such as business combination-related expenses, share-based compensation expense and certain other charges and credits that the Company’s management has determined are non-operational, non-cash items or not directly attributable to the Company’s operating divisions. The Malibu Division is a designer, manufacturer and integrator of advanced antenna systems for radar, radar simulators and telemetry systems, as well as for data links used in ground, airborne, unmanned aerial vehicles (“UAVs”) and shipboard systems.
Sales and marketing, and certain administration expenses, are allocated to the divisions and are included in the results reported. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Intersegment product transfers are recorded at cost.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
Summarized financial information concerning the Company’s reportable segments is shown in the following tables:
EBITDA represents earnings before net interest expense, provision for income taxes and depreciation and amortization. The Company believes that EBITDA is useful to assess its ability to generate cash from operations sufficient to pay taxes, to service debt and to undertake capital expenditures.
For the reasons listed below, the Company believes that U.S. GAAP-based financial information for leveraged businesses like its own should be supplemented by EBITDA so that investors better understand its financial performance in connection with their analysis of the Company’s business:
•
EBITDA is a component of the measures used by the Company’s board of directors and management team to evaluate the Company’s operating performance;
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
•
the Company’s first lien senior credit facility contains covenants that require the Company to maintain a total leverage ratio in certain circumstances that contains EBITDA as a component, and the Company’s management team uses EBITDA to monitor compliance with these covenants;
•
EBITDA is a component of the measures used by the Company’s management team to make day-to-day operating decisions;
•
EBITDA facilitates comparisons between the Company’s operating results and those of competitors with different capital structures and, therefore, is a component of the measures used by the management to facilitate internal comparisons to competitors’ results and the Company’s industry in general; and
•
the payment of management bonuses is contingent upon, among other things, the satisfaction by the Company of certain targets that contain EBITDA as a component.
EBITDA is not a presentation made in accordance with U.S. GAAP and has important limitations as an analytical tool. EBITDA should not be considered as an alternative to comprehensive income, net income, operating income or any other performance measures derived in accordance with U.S. GAAP as a measure of operating performance or operating cash flows as a measure of liquidity. The Company’s use of the term EBITDA varies from others in the Company’s industry. The Company’s presentation of EBITDA should not be construed to imply that the Company’s future results will be unaffected by the items added back or excluded in the calculation of EBITDA.
Operating income by the Company’s reportable segments was as follows:
The following table reconciles net income to EBITDA:
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
With the exception of goodwill, the Company does not identify or allocate assets by operating segment, nor does its CODM evaluate operating segments using discrete asset information.
Net property, plant and equipment by geographic area were as follows:
Goodwill by geographic area was as follows:
The Company attributes sales from external customers to individual countries based on product shipment destination. Sales by geographic area were as follows for external customers:
There were no individual foreign countries with sales greater than 10% of total sales for the periods presented.
The United States Government, including its agencies, is the only customer that accounted for 10% or more of the Company’s consolidated sales in fiscal years 2016, 2015 and 2014. Direct sales to the U.S. Government and its agencies were $86.0 million, $83.5 million and $81.6 million, for fiscal years 2016, 2015 and 2014, respectively. Accounts receivable from this customer represented 8% and 7% of consolidated accounts receivable as of September 30, 2016 and October 2, 2015, respectively.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
14.
Selected Quarterly Financial Data (Unaudited)
In management’s opinion, the unaudited data has been prepared on the same basis as the audited information and includes all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the data for the periods presented. The Company’s results of operations have varied and may continue to fluctuate significantly from quarter to quarter. The results of operations in any period should not be considered indicative of the results to be expected from any future period.
15.
Subsequent Event
On December 12, 2016, CPII entered into the Commitment Letter with UBS with respect to its existing Senior Notes. Pursuant to the Commitment Letter, which expires on April 12, 2016, UBS has committed to provide and arrange a bridge loan financing of $245.0 million (the “Bridge Facility”) providing the funding necessary for the anticipated refinancing of the Senior Notes (if the Company is otherwise unable to refinance its Senior Notes with certain other financing) and the Second Lien Credit Agreement. The financing commitment is subject to certain customary conditions set forth in the Commitment Letter, including the execution and delivery of documentation, the accuracy of representations, the absence of events of default, the absence of material adverse changes and other customary closing conditions. Successful refinancing of the Senior Notes through the Bridge Facility, or otherwise, will extend the maturity date for the First Lien Term Loan and, if not refinanced, the Second Lien Term Loan from November 2017 to April 2021.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
16.
Supplemental Guarantors Condensed Consolidating Financial Information
The tables that follow reflect the supplemental guarantor financial information associated with CPII’s Senior Notes issued on February 11, 2011. The Senior Notes are guaranteed by Parent and, subject to certain exceptions, each of Parent’s existing and future domestic restricted subsidiaries (other than CPII) on a senior unsecured basis. Separate financial statements of the guarantors are not presented because (i) the guarantors are wholly owned and have fully and unconditionally guaranteed the Senior Notes on a joint and several basis and (ii) CPII’s management has determined that such separate financial statements are not material to investors. Instead, presented below are the consolidating financial statements of: (a) the guarantor subsidiaries, (b) the non-guarantor subsidiaries, (c) the consolidating elimination entries, and (d) the consolidated totals. The accompanying consolidating financial information should be read in connection with the consolidated financial statements of the Company.
Investments in subsidiaries are accounted for based on the equity method. The principal elimination entries eliminate investments in subsidiaries, intercompany balances, intercompany transactions and intercompany sales.
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING BALANCE SHEET
As of September 30, 2016
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING BALANCE SHEET
As of October 2, 2015
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING STATEMENT OF COMPREHENSIVE INCOME
For the Year Ended September 30, 2016
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING STATEMENT OF COMPREHENSIVE INCOME
For the Year Ended October 2, 2015
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING STATEMENT OF COMPREHENSIVE INCOME
For the Year Ended October 3, 2014
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
For the Year Ended September 30, 2016
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
For the Year Ended October 2, 2015
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CPI INTERNATIONAL HOLDING CORP.
and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(All tabular dollar amounts in thousands)
CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
For the Year Ended October 3, 2014
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated:
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EXHIBIT INDEX
- 140 -
- 141 -
- 142 -
- 143 -