Item 1. Business
Overview
PEC Solutions, Inc. was originally incorporated under the laws of the Commonwealth of Virginia as Performance Engineering Corporation (PEC) on June 25, 1985. On January 1, 2000, PEC was reincorporated under the laws of Delaware as PEC Solutions, Inc.
PEC Solutions is a professional services firm providing high-end solutions that help government clients harness the power of the Internet and other advanced technologies to improve mission performance. We specialize in Web-Enabling Government® by providing secure, interoperable technology solutions for clients in law enforcement, intelligence, defense, and civilian agencies within the federal government and at state and local levels. As a total solutions provider, we address the full technology lifecycle, including formulating technology strategies, creating business solutions, performing long-term operational management and continuing enhancement of the solution.
Our clients have included every cabinet-level department of the federal government as well as numerous additional entities at the federal, state and local levels. This group includes a cross-section of civil, law enforcement, intelligence and judicial government organizations. Our largest clients include EDS, the prime contractor for the Navy Marine Corps Intranet ("NMCI") program, the Drug Enforcement Administration, the Immigration and Naturalization Service, the Veterans Benefits Administration, the Internal Revenue Service, the Bureau of Alcohol, Tobacco and Firearms, the Department of Defense and the intelligence community. Since 1996, we have provided more than $296 million of services in the government market and have increased revenues at approximately a 45% compound annual growth rate.
Industry Background
The emergence and adoption of the Internet as a means of gathering, communicating and managing information continues to open up new possibilities for businesses and organizations to dramatically improve productivity and effectiveness. Government has emerged in recent years as one of the leading purchasers of Internet and other advanced technology solutions. With respect to technology services, International Data Corporation estimates that government spending will increase from $12.6 billion in 1999 to $20.8 billion in 2004. Government spending on Internet professional technology services alone is expected to grow at approximately a 39% compound annual growth rate, reaching $3.1 billion in 2004.
Government Reform is Driving Growth in Advanced Technology Spending
We believe that political pressures and budgetary constraints are forcing government agencies at all levels to improve their processes and services and to operate more like commercial enterprises. Organizations throughout the federal, state and local governments are investing heavily in information technology to improve effectiveness, enhance productivity and extend new services in order to deliver increasingly responsive and cost-effective public services. We believe that Internet technologies provide an ideal solution to meet government's needs.
Recent changes in federal government contract procurement and compliance regulations have streamlined the government's buying practices, resulting in a more commercial approach to the procurement and management of technologies and services. As a result, procurement lead times have decreased and government buyers now have greater flexibility to purchase services on the basis of distinguishing corporate capabilities and successful past performance. Federal government entities now are able to award contracts based on factors other than price alone, if they judge that the government would receive a greater value. In addition, the General Services Administration's extension of basic
government-wide contract vehicles for procuring technology components and services, the GSA Schedules, makes purchasing technology services easier and faster. Federal government buyers can now order services directly from pre-approved providers instead of using a time-consuming bid solicitation process. We believe that these changes have improved our ability to successfully pursue business in the government market. There are currently no proposed changes to government procurement regulations that we believe will materially affect our business in the immediate future.
Government's Need to Outsource Technology Programs
Government organizations rely heavily on outside contractors to provide skilled resources to accomplish technology programs. We believe that this reliance will continue to intensify due to political and budgetary pressures in many government agencies and due to the difficulties government faces in recruiting and retaining highly skilled technology professionals in a competitive labor market. In concert with its transition to more commercial practices, government is increasingly outsourcing technology programs as a means of simplifying the implementation and management of the technology, so that government workers can focus on their mission.
Technology Services Providers in the Government Sector
Engagements in the government market can be broadly classified into four categories based on the type of services provided. Many companies provide a mix of services across these categories.
First, at the low end, providing information technology staff augmentation at low hourly rates typically involves placing staff in client facilities. These engagements typically exhibit low operating margins and slow growth.
Second, large-scale systems integration and outsourcing engagements typically involve assuming responsibility for acquiring, assembling and operating large inventories of equipment and software. Major portions of these engagements involve reselling commodity technologies at highly competitive fixed unit prices. These engagements typically exhibit moderate growth, but low operating margins.
Third, large-scale systems development engagements involve providing full-service solutions that combine hardware, software development, system engineering and operations. These engagements typically exhibit moderate growth and operating margins.
Fourth, at the high end, engagements involving high-value management consulting and development and integration of complex systems in core mission areas use specialized or emerging technologies such as the Internet and advanced security. These engagements typically exhibit strong growth and operating margins.
Efforts to Improve Homeland Security and Mount Counter-Terrorism Programs will Stimulate Government Technology Spending
We believe that the events of September 11, 2001 will result in escalating priorities relating to the needs of the nation's law enforcement infrastructure, and in the broader areas of national and homeland defense. The President's proposed budget for GFY 2003 (which begins in October 2002) reflects one of the largest increases in Federal information technology spending in history, more than doubling last year's growth rate. Much of the proposed spending will focus on homeland security and electronic government. We believe that high-end technology solutions providers, with strong legacy practices and client bases in the agencies and government verticals relating to law enforcement, intelligence and defense, could experience strong increases in demand as the Federal market moves forward.
Challenges in the Government Technology Services Sector
Technology services providers face a unique combination of challenges when providing services to the government. These include:
•substantial government investments in legacy systems that are not readily adaptable to evolving technologies;
•extremely large volumes of data collected and retained in government databases;
•large and widely dispersed workforces, often consisting of tens of thousands of knowledge workers located in hundreds of sites throughout the United States and the world;
•heightened security concerns due to the need to protect individual privacy and extraordinarily sensitive information; and
•complex management needs that require a combination of strategic planning capabilities, government domain expertise, public sector procurement savvy and cutting-edge technology skills.
Our Solution
We are a high-end technology solutions provider that addresses the needs and particular challenges of the evolving government market by combining the following key elements in our eGovernment solutions:
Total Solutions Provider Capabilities
As a total solutions provider, we address the full technology lifecycle through our deep technical capabilities and extensive government domain knowledge. We possess a wide range of the specialized skills needed for eGovernment engagements including: strategic technology consulting; program management; system architectural design; network engineering; applications development; and systems integration, deployment and operational support. We relieve our clients of the details of the application and management of technologies so they can focus on their core competencies and mission. Our mission-critical solutions integrate an organization's back-office processes and legacy systems with customized applications, and enhance the interoperability and accessibility of critical enterprise data.
Extensive Government Domain Experience
Our founders, who have worked together for more than 20 years in the government marketplace, have substantial technical and management backgrounds. Our management maintains close working relationships with our clients and an active role in our projects, resulting in consistent contract performance and broad recognition of our managers. Our consulting staff is knowledgeable in the government sector application of technology management policy formulation, acquisition strategy, business process re-engineering and best-value procurement methods.
Deep Technology Expertise
We have expertise in the critical underlying infrastructure technologies necessary to support fully web-based enterprises, including security, intranets, applications development and enterprise management. We have direct experience with the legacy automation architectures found in government agencies, allowing us to craft solutions that take advantage of the substantial investments our clients have in legacy systems. Our employees have experience in emerging technologies and web-enabling tools from vendors such as Microsoft, Netscape, Oracle, Cisco, IBM/Lotus, IBM/Tivoli and Entrust.
Reusable Solution Sets
For portions of our business, we develop reusable solution sets that can be reapplied to requirements commonly encountered in our markets. We develop the software code and components comprising these reusable solution sets based on our government domain expertise. These solutions enable us to give our clients the benefit of our knowledge and experience in addressing complex mission challenges and to develop and implement eGovernment solutions more quickly and efficiently. We focus our efforts on customizing solutions to meet our clients' specific needs and to deliver reliable solutions based on components that have been tested and perfected through repeated use.
The PEC Philosophy-Flexibility and Objectivity
We retain the maximum possible flexibility in the systems and components that we use in our solutions by maintaining both strong established product credentials and substantial hands-on experience with emerging products. We focus on providing strategic and high-end technical service contributions to large programs, while assisting our clients to assemble, contract with and manage the vendors of commodity program elements. By remaining independent of specific vendors, we are able to work with providers that best serve the interests of our clients.
Our Strategy
Our strategy is to continue to grow by capitalizing on our leadership position in the eGovernment solutions market. Our strategies for obtaining this objective include:
Maintaining Our Technology Leadership Position
We will continue to focus on high-end engagements that require specialized knowledge of emerging technologies. We intend to maintain our technology leadership by recruiting employees who will add to our inventory of technology skills and by refining the skills and capabilities of our existing staff through training, certification and hands-on laboratory experimentation. We also intend to work closely with our technology partners to share expertise and innovations and to stay well ahead of competitors in the practical aspects of applying and integrating emerging technologies.
Increasing Federal Government Market Penetration
We intend to capitalize on our long-term relationships with government clients and our reputation within the government market to cross-sell our full range of services to our existing client base and to expand into organizations in the federal government for which we have not already performed services. We intend to pursue these opportunities through a continued active sales and marketing effort and by continuing to promote the success stories stemming from our aggressive application of eGovernment solutions. We also intend to leverage our relationships with our technology providers and their sales resources to obtain new federal government clients.
Enhancing the PEC Solutions Brand and Culture
We are implementing an aggressive program to build the identity and awareness of the PEC Solutions brand in order to improve our visibility in the marketplace and to attract the best and brightest employees. We intend to hire and retain outstanding professionals, provide incentives to achieve corporate goals and maintain a culture that fosters innovation. We will continue to emphasize professional development and training of our employees. We will maintain an active internal communications program to promote a team culture and foster high employee morale. We will also continue to emphasize our corporate technology infrastructure to facilitate the sharing of knowledge among our employees.
Expanding Our Presence in State and Local Government and Selected Commercial Markets
We intend to leverage our domain expertise and deep technology skills for providing services to state and local governments. We also intend to expand our business of web-enabling private sector organizations that operate in highly regulated industries and that have significant interactions with the government agencies with which we work. We believe our existing solution sets, such as case management systems, criminal suspect booking stations, and land and financial records automation, are applicable to projects at the state and local level, as well as at private sector organizations.
Undertaking a Disciplined Acquisition Program
We plan to broaden our capabilities and client base and extend our geographic presence in state and local government markets by acquiring select businesses. Acquired businesses will perform similar technical work for organizations outside our current client base, will support solution sets that are consistent with and extend our web-enabling strategy, or will be located in geographic areas strategic to significant state and local governments and programs.
Our Services
As a provider of eGovernment solutions, we offer a variety of services across the full technology lifecycle. These services include:
Strategy and Design
We help clients develop the operational vision for integrated mission solutions, and formulate the business and execution plans for realizing imaginative, integrated and aggressive technology solutions. We develop sophisticated enterprise architectures-the technology blueprints and systematic guidance that allow enterprises to incrementally develop, migrate to and operate large-scale systems. By re-engineering government processes, we move organizations to an eGovernment environment. We perform economic analyses to weigh the costs of technology investment against the operational benefits expected from such technology implementation. We provide support to organizations that are executing programs to privatize large-scale information systems operations, or are undertaking far-reaching changes in their business models, such as migrating from appropriated to fee-for-service financial models.
Solutions Development and Implementation
We develop, engineer and integrate computer hardware, commercial software, reusable solution sets, custom-built applications and networks to create integrated business solutions for our clients. Our emphasis on Internet technology allows us to combine leading-edge technologies with disciplined and effective system development methodologies. Our methods are designed to ensure that the technology fits with business processes and that users realize process improvement. We distinguish ourselves by addressing the core technical and business challenges in migrating large government enterprises to integrated eGovernment solutions. We build:
•INTEGRATED MISSION APPLICATIONS. We integrate complex back-office business applications and legacy systems with customized mission applications using the information-sharing capabilities of open architectures. We also design, develop and install complex custom application systems that implement knowledge management repositories and tera-byte data warehousing systems allowing government agencies to mine the vast storehouses of records that they collect and maintain.
•LARGE-SCALE INTRANET INFRASTRUCTURES. We deploy and manage complex international network infrastructures: intranets and extranets that deliver the performance,
reliability and flexibility needed to support the diverse needs of web-enabled organizations with thousands of widely dispersed knowledge workers.
•LEADING-EDGE AUTHENTICATION AND ENCRYPTION SECURITY APPLICATIONS. We apply advanced security technologies such as: public key infrastructure to manage data encryption systems; biometric authentication to identify individuals by their physical characteristics; and strong encryption to protect sensitive information in highly decentralized systems against unauthorized access and compromised integrity.
•AUTOMATED ENTERPRISE MANAGEMENT SYSTEMS. We develop and deploy processes and automated tools for our clients to centrally manage and operate complex national networks of workstations and servers at reduced cost.
Ongoing Systems Management and Enhancement
We provide long-term, ongoing support for our solutions including the operation, management and enhancement actions necessary to keep solutions up-to-date with evolving business processes and technologies. We use sophisticated tools to reduce the burden and costs of maintaining large complex intranets, and to enhance whole systems without the need to deploy engineers and field service technicians to the operating locations of an enterprise. We operate highly automated enterprise technology management processes that support integration, configuration management, software distribution and user support, and allow clients to outsource the responsibilities for maintaining their technology infrastructures and applications. The results are reduced operating costs for our clients and improved performance and reliability.
Recent Developments
We recently received funding under our task order subcontract through EDS for work on the Navy Marine Corps Intranet program. The current funded tasks on that program are approximately $28 million through December 31, 2002. The subcontract is for a base period of 5 years and has 3 option years expiring December 31, 2008.
Sales and Marketing
Our marketing efforts are focused on creating awareness of opportunities in eGovernment innovation, establishing PEC Solutions as a leader in this new category and building the PEC brand.
We market and sell our services through multiple channels by using our business development staff, leveraging existing client relationships, capitalizing on our task order contracts, responding to competitive solicitations, attending marketing events and engaging in other public relations activities. We employ marketing research services to identify and track potential contract opportunities. We also cultivate relationships with leading-edge technology vendors, such as Microsoft and IBM, and prime contractors, such as EDS, to identify and obtain project leads consistent with our capabilities.
We employ a team selling approach, whereby our business developers collaborate with our service delivery professionals and management to identify prospects, conduct sales and manage client relationships. Our Director of Strategic Programs initiates and coordinates the activities of our business development staff. We allocate business developers to each of our business units who pursue new clients and programs across their market segments. Each current client is assigned to a relationship manager who is responsible for ensuring client satisfaction and successful project performance, and identifying new business opportunities with the client.
Culture, People and Recruiting
We have developed a corporate culture that promotes excellence in job performance, respect for the ideas and judgment of our colleagues and recognition of the value of the unique skills and capabilities of our professional staff. We seek to attract highly qualified and ambitious staff. We strive to establish an environment in which all employees can make their best personal contribution and have the satisfaction of being part of a unique team. We believe that we have successfully attracted and retained highly skilled employees because of the quality of our work environment, the professional challenge of our assignments, and the financial and career advancement opportunities we make available to our staff.
We occupy state-of-the art facilities that are conducive to highly technical and collaborative work, while providing individual privacy. In our solutions centers, we configure large networks of leading-edge equipment and software, and provide our engineers and developers with advanced tools to evaluate and apply new technologies. We believe that the location, environment and amenities provided by our new Fair Lakes campus facility will contribute to our ability to attract and retain highly skilled employees.
As of December 31, 2001, we had 1,248 personnel. Of our total personnel, 1,114 were consulting and service delivery professionals, and 134 were management and administrative personnel performing corporate marketing, human resources, finance, accounting, legal, internal information systems and administrative functions. None of our personnel is represented by a collective bargaining unit. As of March 29, 2002 comparative numbers were 1,236, 1,097 and 139, respectively.
In addition to standard company benefits, we provide:
•tuition reimbursement for employees pursuing advanced academic degrees;
•professional training programs;
•financial incentives for employees obtaining product competency certifications;
•a bonus program;
•spot cash awards to reward specific employee accomplishments; and
•stock option grants based on job performance.
We invest heavily in technical staff recruiting resources and hiring programs. Each of our business units is staffed with a dedicated recruiter, and we aggressively use a variety of recruiting methods, including advertising, job fairs, open houses and Internet-based career placement services. We also offer substantial awards and recognition to our current employees for referrals, which has been particularly effective in identifying and recruiting talented staff.
We have developed an active and effective college recruiting program that draws on management staff and recent college hires from across the company to attract graduating students with strong academic backgrounds in our core disciplines. We currently target colleges and universities in Washington, D.C., Maryland, and Virginia with this program, and perform on-campus recruiting during the spring and fall recruiting seasons at five universities.
Competition
Our current competitors include, and may in the future include, the following:
•information technology services providers and large government contractors such as American Management Systems, Accenture, Booz, Allen & Hamilton, Computer Sciences Corporation, Electronic Data Systems, KPMG, PricewaterhouseCoopers, Science Applications International Corporation and Unisys; and
•Internet professional services providers.
Many of our competitors have long operating histories and strong client relationships, greater financial, technical, marketing and public relations resources, larger client bases and greater brand or name recognition than we have.
We believe that the major competitive factors in our market relate to a company's distinctive technical capabilities, successful past contract performance, reputation for quality and key management and marketing staff. Under best-value procurement methods, price is an important, but secondary, factor in the selection of a technology service provider.
Intellectual Property Rights
Our success is dependent, in part, upon our proprietary processes, components and other intellectual property rights. We do not have any patents or patent applications pending. We rely on a combination of trade secret, nondisclosure and other contractual agreements, and copyright and trademark laws, to protect our proprietary rights. Existing trade secret and copyright laws afford us only limited protection. We enter into confidentiality agreements with our employees and our contractors and limit access to and distribution of our proprietary information. There can be no assurance that the steps we have taken in this regard will be adequate to deter misappropriation of our proprietary information or that we will be able to detect unauthorized use and take appropriate steps to enforce our intellectual property rights.
A portion of our business involves the development of software applications for specific client engagements. Although ownership of client-specific software is generally retained by the client, we retain some rights to the applications, processes and intellectual property developed in connection with client engagements.
Backlog
Our current funded backlog is approximately $63 million dollars. Our contracts typically are funded incrementally, and therefore the funded backlog only represents that portion of the contract value. Funding occurs as work progresses. Our average contract/task performance period runs between six to ten months. Our backlog is typically subject to large variations from quarter to quarter as existing contracts/tasks are renewed or new contracts are awarded. Additionally, all federal government contracts, whether or not funded, may be terminated at the convenience of the government.
Environmental Issues
We have not incurred any costs associated with environmental issues.
Risk Factors
Risk Factors Related to Our Business
Substantially all of our revenues would be threatened if our relationships with agencies of the federal government were harmed
Our largest clients are agencies of the federal government. If the federal government in general, or any significant government agency, uses less of our services or terminates its relationship with us, our revenues could decline substantially, and our business could be seriously harmed. During 2001, contracts with the federal government and contracts with prime contractors of the federal government accounted for approximately 96% of our revenues. During that same period, our ten largest clients, all agencies of the federal government, generated approximately 70% of our revenues, with the top five clients accounting for 56% of our revenues. We believe that federal government contracts are likely to continue to account for a significant portion of our revenues for the foreseeable future. The volume of
work that we perform for a specific client, however, is likely to vary from year to year, and a significant client in one year may not use our services as extensively, or at all, in a subsequent year.
Our government contracts may be terminated prior to their completion, and if we do not replace them, our operating results may be harmed
We derive substantially all of our revenues from government contracts that typically are awarded through competitive processes and span a one year base period and one or more option years. The unexpected termination or nonrenewal of one or more of our significant contracts could result in significant revenue shortfalls. Our clients generally have the right not to exercise the option periods. In addition, our contracts typically contain provisions permitting an agency to terminate the contract on short notice, with or without cause.
Following termination, if the client requires further services of the type provided in the contract, there is frequently a competitive rebidding process. We may not win any particular rebid or be able to successfully bid on new contracts to replace those that have been terminated. Even if we do win the rebid, we may experience revenue shortfalls in periods where we anticipated revenues from the contract rather than its termination and subsequent rebidding. These revenue shortfalls could harm operating results for those periods.
Our lack of long-term contracts with clients and our relatively fixed operating expenses expose us to greater risk of incurring losses
Our clients retain us on an engagement-by-engagement basis, rather than under long-term contracts. We incur costs based on our expectations of future revenues. Our operating expenses are relatively fixed and cannot be reduced on short notice to compensate for unanticipated variations in the number or size of engagements in progress. These factors make it difficult for us to predict our revenues and operating results. If we fail to predict our revenues accurately, it may seriously harm our financial condition and results of operation.
A reduction in or the termination of our services could lead to underutilization of our employees and could harm our operating results
Our employee compensation expenses are relatively fixed. Therefore, if a client defers, modifies or cancels an engagement or chooses not to retain us for additional phases of a project, our operating results will be harmed unless we can rapidly redeploy our employees to other engagements in order to minimize underutilization.
Failing to maintain strong relationships with prime contractors could result in a decline in our revenues
We derived approximately 41% of our revenues during 2001 through our relationships with prime contractors, which, in turn, have contractual relationships with end-clients. One of our prime contractors, EDS (NMCI), accounted for 26% of our revenues during 2001. We expect to continue to depend on these relationships for a material portion of our revenues in the foreseeable future. If any of these prime contractors eliminate or reduce their engagements with us, or have their engagements eliminated or reduced by their end-clients, we will lose a source of revenues, which, if not replaced, will adversely affect our operating results.
We must recruit and retain qualified professionals to succeed in our labor-intensive business
Our future success depends in large part on our ability to recruit and retain qualified professionals skilled in complex information technology services and solutions, including encryption and other security systems. Such personnel are in great demand and are likely to remain a limited resource in the
foreseeable future. Competition for qualified professionals is intense. Any inability to recruit and retain a sufficient number of these professionals could hinder the growth of our business.
We may lose money on fixed-price contracts if we miscalculate the resources we need to complete the contract
We derived approximately 13% of our revenues in 2001 from fixed-price contracts. We anticipate a material portion of our future engagements will continue to be contracted at a fixed price. Unlike time and materials contracts, for which we are reimbursed based on our actual expenditures of resources, fixed-price contracts require us to price our contracts by predicting our expenditures in advance. If we miscalculate the resources we need to complete fixed-price engagements, our operating results could be seriously harmed because we are not compensated for the higher costs.
We could lose revenues and clients and expose our company to liability if we fail to meet client expectations
We create, implement and maintain technology solutions that are often critical to our clients' operations. If our technology solutions or other applications have significant defects or errors or fail to meet our clients' expectations, we may:
•lose revenues due to adverse client reaction;
•be required to provide additional remediation services to a client at no charge;
•receive negative publicity, which could damage our reputation and adversely affect our ability to attract or retain clients; and
•suffer claims for substantial damages against us, regardless of our responsibility for the failure.
While many of our contracts limit our liability for damages that may arise from negligent acts, errors, mistakes or omissions in rendering services to our clients, we cannot be sure that these contractual provisions will protect us from liability for damages if we are sued. Furthermore, our general liability insurance coverage may not continue to be available on reasonable terms or in sufficient amounts to cover one or more large claims, or the insurer may disclaim coverage as to any future claim. The successful assertion of any large claim against us could seriously harm our business. Even if not successful, such claims could result in significant legal and other costs and may be a distraction to management.
Security breaches in sensitive government systems could result in the loss of clients and negative publicity
Many of the systems we develop involve managing and protecting information involved in law enforcement and other sensitive government functions. A security breach in one of these systems could cause serious harm to our business, could result in negative publicity and could prevent us from having further access to such critically sensitive systems or other similarly sensitive areas for other governmental clients. Losses that we could incur from such a security breach could exceed the policy limits that we have for "errors and omissions" or product liability insurance.
If we cannot obtain the necessary security clearances, we may not be able to perform classified work for the government and our revenues may suffer
Government contracts require us, and some of our employees, to maintain security clearances. If we lose or are unable to obtain security clearances, the client can terminate the contract or decide not to renew it upon its expiration. As a result, to the extent we cannot obtain the required security clearances for our employees working on a particular engagement, we may not derive the revenue anticipated from the engagement, which, if not replaced with revenue from other engagements, could seriously harm our operating results.
We depend on our senior management team, and the loss of any member may adversely affect our ability to obtain and maintain clients
We believe that our success will depend on the continued employment of our senior management team, including David Karlgaard, our Chief Executive Officer, Paul Rice, our Chief Operating Officer and Alan Harbitter, our Chief Technology Officer. We have key man life insurance policies that cover Messrs. Karlgaard and Rice up to $1 million and Mr. Harbitter up to $500,000. This dependence is particularly important to our business because personal relationships are a critical element of obtaining and maintaining client engagements. If one or more members of our senior management team was unable or unwilling to continue in their present positions, such persons would be difficult to replace and our business could be seriously harmed. Furthermore, clients or other companies seeking to develop in-house capabilities may hire away some of our key employees. Employee defections to clients or competitors would not only result in the loss of key employees but could also result in the loss of a client relationship or a new business opportunity. Any losses of client relationships could seriously harm our business.
We may not be able to successfully identify, manage and integrate future acquisitions, which may harm our operating results
We may use a portion of the proceeds from the initial public offering to acquire companies or businesses that are complementary to ours. However, we have no immediate plans or current agreements to acquire any additional companies or businesses, and we cannot assure you that we will identify appropriate acquisition candidates. If we do identify an appropriate acquisition candidate, we cannot assure you that we would be able to successfully negotiate the terms of an acquisition, finance the acquisition or integrate the acquired business into our existing business. Negotiations of potential acquisitions and the integration of an acquired business could disrupt our business by diverting management away from day-to-day operations. Further, failure to successfully integrate any acquisition may cause significant operating inefficiencies and adversely affect our profitability. Consummating a merger could require us to raise additional funds through additional equity or debt financing. Additional equity financing could result in further dilution of the per share value of your stock. Additional debt financing could force us to accept contractual limitations that could harm our ability to grow.
Audits of our government contracts may result in a reduction in revenues we receive from those contracts or may result in civil or criminal penalties that could harm our reputation
Federal government agencies routinely audit government contracts. These agencies review a contractor's performance on its contract, pricing practices, cost structure and compliance with applicable laws, regulations and standards. An audit could result in a substantial adjustment to our revenues because any costs found to be improperly allocated to a specific contract will not be reimbursed, while improper costs already reimbursed must be refunded. If a government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with federal government agencies. In addition, we could suffer serious reputational harm if allegations of impropriety were made against us.
We may be liable for penalties under a variety of procurement rules and regulations, and changes in government regulations could slow our growth or reduce our profitability
We must comply with and are affected by federal government regulations relating to the formation, administration and performance of government contracts. These regulations affect how we do business with our clients and may impose added costs on our business. Any failure to comply with applicable laws and regulations could result in contract termination, price or fee reductions or suspension or
debarment from contracting with the federal government. Further, the federal government may reform its procurement practices or adopt new contracting methods relating to the GSA schedule or other government-wide contract vehicles. If we are unable to successfully adapt to those changes, our business could be seriously harmed.
Our failure to adequately protect our confidential information and proprietary rights may harm our competitive position
While our employees execute confidentiality agreements, we cannot guarantee that this will be adequate to deter misappropriation of our confidential information. In addition, we may not be able to detect unauthorized use of our intellectual property in order to take appropriate steps to enforce our rights. If third parties infringe or misappropriate our copyrights, trademarks or other proprietary information, our competitive position could be seriously harmed. In addition, other parties may assert infringement claims against us or claim that we have violated their intellectual property rights. Such claims, even if not true, could result in significant legal and other costs and may be a distraction to management
Risks Factors Related to the eGovernment Solutions Market
Competition could result in price reductions, reduced profitability and loss of market share
Competition in the market for eGovernment solutions is intense. If we are unable to differentiate our services from those of our competitors, our revenue growth and operating margins may decline. Many of our competitors are larger and have greater financial, technical, marketing and public relations resources, larger client bases and greater brand or name recognition than us. Our larger competitors may be able to provide clients with additional benefits, including reduced prices. We may be unable to meet those prices, which may cause us to lose business and market share. Alternatively, we could decide to meet the lower prices, which could harm our profitability. If we fail to compete successfully, our business could be seriously harmed.
Our current competitors include, and may in the future include, the following:
•information technology services providers and large government contractors such as American Management Systems, Accenture, Booz-Allen & Hamilton, Computer Sciences Corporation, Electronic Data Systems, KPMG, PricewaterhouseCoopers, Science Applications International Corporation and Unisys; and
•Internet professional services providers.
Current and potential competitors also have established or may establish cooperative relationships among themselves or with third parties to increase their ability to address client needs. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share. In addition, some of our competitors may develop services that are superior to, or have greater market acceptance than, the services that we offer.
Our business will be harmed if government agencies are unwilling to replace or supplement expensive legacy systems
Government agencies have spent substantial resources over an extended period of time to develop computer systems and to train their personnel to use them. These agencies may be reluctant to abandon or supplement these legacy systems with Internet and other advanced technology systems because of the cost of developing them or the additional cost of re-training their personnel. Such reluctance would make it more difficult to acquire new engagements which would harm our business prospects.
Our growth will be harmed if a viable market for egovernment services is not sustained
We cannot be certain that a viable government market for Internet and other advanced technology services will be sustainable. If this market is not sustained and we are unable to refocus our services on the private sector market or other in-demand technologies, our growth would be negatively affected. Although government agencies have recently increased focus on and funding for technology initiatives, we cannot be certain that these initiatives will continue in the future. Budget cutbacks or political changes could result in a change of focus or reductions in funding for technology initiatives, which, in turn, could seriously harm our revenues.
Risks Related to the Ownership of Our Common Stock
Our quarterly revenues and operating results could be volatile and may cause our stock price to fluctuate
Our quarterly revenues and operating results may fluctuate significantly in the future. In particular, if the Federal government does not adopt a budget for its fiscal year beginning on October 1, Federal agencies may be forced to suspend our contracts due to a lack of funding. Consequently, we may realize lower revenues in the quarter ending December 31. Further, the rate at which the Federal government procures technology may be negatively affected following changes in Presidential administrations and in senior government officials. As a result, our operating results could be volatile and difficult to predict and period-to-period comparisons of our operating results may not be a good indication of our future performance.
A significant portion of our operating expenses, such as personnel and facilities costs, are fixed in the short term. Therefore, any failure to generate revenues according to our expectations in a particular quarter could result in reduced income in the quarter. In addition, our quarterly operating results may not meet the expectations of securities analysts or investors, which in turn may have an adverse effect on the market price of our common stock.
Our officers and directors beneficially own 56.0% of our stock and could control matters submitted to stockholders for their approval
Our directors and executive officers beneficially own, in the aggregate, 56.0% of our outstanding common stock. As a result, these stockholders will be able to exercise control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. This concentration of ownership may also have the effect of delaying or preventing a change in control of PEC Solutions.
We have various mechanisms in place that may prevent a change in control that stockholders may consider favorable
Our certificate of incorporation and bylaws may discourage, delay or prevent a change in control of PEC Solutions that stockholders may consider favorable. Our certificate of incorporation and bylaws:
•authorize the issuance of blank check capital stock that could be issued by our board of directors to thwart a takeover attempt;
•classify the board of directors into staggered, three-year terms, which may lengthen the time required to gain control of our board of directors;
•prohibit cumulative voting in the election of directors, which would otherwise allow holders of less than a majority of the stock to elect some directors;
•require super-majority voting to effect amendments to provisions of our bylaws concerning the number of directors;
•limit who may call special meetings of stockholders;
•prohibit stockholder action by written consent, requiring all actions to be taken at a meeting of the stockholders;
•establish advance notice requirements for nominating candidates for election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings; and
•require that vacancies on the board of directors, including newly-created directorships, be filled only by a majority vote of directors then in office.
In addition, Section 203 of the Delaware General Corporation Law may discourage, delay or prevent a change in control by prohibiting PEC Solutions from engaging in a business combination with an interested stockholder for a period of three years after the person becomes an interested stockholder.
Item 2.
Item 2. Properties
The Company's operations occupy approximately 305,000 square feet of space located in Alexandria, Arlington, Norfolk and Fairfax, Virginia, Baltimore, Maryland, Denver, Colorado and San Diego and Vacaville, California, San Antonio, Texas, Trevose, Pennsylvania and Honolulu, Hawaii. We also have employees working at client sites throughout the United States. The large majority of the space is office space, all of which is leased. For lease commitment information, reference is made to Note 13 to the accompanying consolidated financial statements. Existing facilities are considered to be generally suitable and adequate for the Company's present needs. We have entered into a new lease for an additional facility in our corporate complex in Fairfax, Virginia which will come on line in December 2002 and will replace existing space in Fairfax, Virginia and will provide additional space for some of the anticipated growth. We have a 48% equity interest in the company that owns the new building under this lease. Based on contracts, it may be necessary in the future to lease additional office space in other cities located in the United States.
Item 3.
Item 3. Legal Proceedings
None
Item 4.
Item 4. Submission of Matters To a Vote of Security Holders
None
PART II
Item 5.
Item 5. Market for the Company's Common Equity and Related Stockholder Matters
At March 13, 2002, we had approximately 13,300 holders of record of our common stock. We had 26,181,302 Common Shares outstanding on the Nasdaq National Market. The Company began trading on the Nasdaq National Market on April 20, 2000. The following high and low sale prices indicated for
our Common Stock are as reported on the Nasdaq National Market during each of the quarters indicated.
In April 2000, we commenced and completed a firm commitment underwritten initial public offering of 3,000,000 shares of our common stock at a price of $9.50 per share. The shares were registered with the Securities and Exchange Commission pursuant to a registration statement on Form S-1 (No. 333-95331), which was declared effective on April 19, 2000. The public offering was underwritten by a syndicate of underwriters led by Donaldson, Lufkin & Jenrette Securities Corporation; Chase Securities Inc. Legg Mason Wood Walker, Incorporated; and DLJdirect Inc. as their representatives. After deducting underwriting discounts and commissions of approximately $2 million and expenses of approximately $0.9 million, we received net proceeds of $25.6 million.
The primary purposes of this offering was to create a public market for our common stock, to improve the incentive mechanism for our professionals through stock options, to obtain additional equity capital and to facilitate future access to public markets. We expect to use the net proceeds from this offering for general corporate purposes, including working capital. We may also use a portion of the net proceeds to acquire businesses that are complementary to ours.
On August 28, 2000, we acquired all of the outstanding capital stock of Viking Technology, Inc. ("Viking") for $2 million cash plus the assumption of debt in a business combination accounted for as a purchase. Viking is a provider of integrated software and advanced technology solutions for state and local law enforcement, fire and emergency medical service agencies. On November 20, 2001, we acquired all of the outstanding capital stock of Troy Systems, Inc. ("Troy") for $15.3 million cash plus common stock valued at $3.0 million (103,065 shares). Troy derives revenue from system development, networking, engineering, integration services, and information systems security and its primary customer is the federal government.
Management will have broad discretion in the allocation of the net proceeds from the sale of common stock. We have no current plans, agreements or commitments for, and are not currently engaged in any negotiations with respect to, any other acquisition transaction. Pending their use, the proceeds of this offering have been invested in investment grade, interest-bearing securities.
The Company declared dividends in the amount of $413,149 for 1999, which were paid in 2000, but did not declare any dividends for 2000 and 2001. The Company expects to retain future earnings, if any, for use in the operation and expansion of the business and does not anticipate paying any further cash dividends in the foreseeable future.
Recent Sales of Unregistered Securities
During the three months ended December 31, 2001, we sold an aggregate of 116,494 shares of common stock at purchase prices ranging from $1.0975 to $7.50 per share, for an aggregate consideration of $310,912 upon exercise of stock options granted under our stock option agreement and
our nonqualified stock option plan. For the year ended December 31, 2001, we sold an aggregate of 551,244 shares of common stock at purchase prices ranging from $0.78 to $7.50 per share, for an aggregate consideration of $1,292,111 upon exercise of stock options granted under our stock option agreement and our nonqualified stock option plan. For the year ended December 31, 2001, we sold an aggregate of 125,725 shares of common stock at purchase prices ranging from $6.27 to $8.93 per share through our employee stock purchase plan, for an aggregate consideration of $878,420.
On January 4, 2002, the company sold an aggregate of 35,132 of common stock at purchase prices of $14.08 and $18.05 per share, for an aggregate consideration of $515,081 under our employee stock purchase plan.
The above securities were offered and sold by us in reliance upon exemptions from registration pursuant to Section 4(2) of the Securities Act of 1933 as transactions not involving any public offering or Rule 701 promulgated under the Securities Act of 1933.
Item 6.
Item 6. Selected Financial Data
The selected consolidated financial data of the company for the years ended December 31, 2001, 2000, 1999, 1998 and 1997 have been derived from the company's audited consolidated financial statements. This information should be read in conjunction with the consolidated financial statements and the related notes thereto appearing elsewhere in this Annual Report on Form 10-K. Certain reclassifications have been made to the prior period financial statements to conform to the presentation used in the December 31, 2001 consolidated financial statements.
(a)Gross profit represents revenues less direct costs, which consist primarily of project personnel salaries and benefits and direct expenses incurred to complete projects.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
This Management's Discussion and Analysis of Financial Condition and Results of Operation section includes "forward-looking statements," within the meaning of the Federal Private Securities Litigation Reform Act of 1995. While forward-looking statements sometimes are presented with numerical specificity, they are based on various assumptions made by management regarding future circumstances over many of which we have little or no control. Forward-looking statements may be identified by words including "anticipate," "believe," "estimate," "expect" and similar expressions. We caution readers that forward-looking statements, including without limitation, those relating to future business prospects, revenues, working capital, liquidity, and income, are subject to certain risks and uncertainties that would cause actual results to differ materially from those indicated in the forward-looking statements. Factors that could cause actual results to differ from forward-looking statements include the concentration of our revenues from the U.S. Government and its agencies and departments (the "Government"), risks involved in contracting with the Government, difficulties we may have in attracting, retaining and managing professional and administrative staff, fluctuations in quarterly results, risks related to acquisitions, risks related to competition and our ability to continue to win and perform efficiently on Government contracts, and other risks and factors identified from time to time in the reports we file with the U.S. Securities and Exchange Commission (SEC), including those identified under the caption "Risk Factors" in our registration statement on Form S-3, (SEC File No. 333-62042.) Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected.
Overview
PEC Solutions is a professional services firm specializing in high-end solutions that help government organizations capitalize on the internet and other advanced technologies. We migrate paper-intensive procedures to web-enabled processes using eGovernment solutions and that help our clients enhance their productivity and improve the services they offer to the public. As a total solutions provider, we address the full technology lifecycle, including formulating technology strategies, creating business solutions, performing long-term operational management and continuing enhancement of the solution.
As part of our growth strategy, we have completed our acquisitions of Viking Technology, Inc. ("Viking") on August 28, 2000 and Troy Systems, Inc. ("Troy") on November 20, 2001. These business combinations were accounted for as purchases. See "Acquisitions".
We derive substantially all of our revenues from fees for consulting services. We generate these fees from contracts with various payment arrangements, including time and materials contracts, fixed-price contracts and cost-reimbursable contracts. During 2001, revenues from these contract types were approximately 71%, 13% and 16%, respectively, of total revenues. We expect this approximate mix of business to continue in 2002. We typically issue invoices monthly to manage outstanding accounts receivable balances. We recognize revenues on time and materials contracts as the services are provided. We recognize revenues on fixed-price contracts using the percentage of completion method as services are performed over the life of the contract, based on the costs we incur in relation to the total estimated costs. We recognize and make provisions for any anticipated contract losses at the time we know and can estimate them. Fixed-price contracts are attractive to clients, and while subject to increased risks, provide opportunities for increased margins. We recognize revenue on cost-reimbursable contracts as services are provided. These revenues are equal to the costs incurred in providing these services plus a proportionate amount of the fee earned. We have historically recovered all of our costs on cost-reimbursable contracts, which means we have lower risk and our margins are lower on these contracts.
Our historical revenue growth is attributable to various factors, including an increase in the size and number of projects for existing and new clients. Existing clients from the previous fiscal year generated approximately 71% of our revenues in 2001, approximately 92% of our revenues in 2000 and approximately 96% of our revenues in 1999. We expect business from existing clients to return to the 90% range in 2002. We have also expanded our geographic presence by opening offices in Norfolk, Virginia, San Diego, California and Honolulu, Hawaii. We manage our client development efforts through each of our strategic service groups, each having specific client responsibility and focus. As of December 31, 2001, we had 1,248 personnel and on March 29, 2002 we had 1,236 personnel.
In 2001, we derived approximately 41% of our revenue through relationships with prime contractors, who contract directly with the end-client and subcontract with us. We expect this percentage to remain approximately the same in 2002. With the exception of the EDS (NMCI) subcontract, in most of these engagements we retain full responsibility for the end-client relationship and direct and manage the activities of our contract staff.
During 2001 we had two customers that each accounted for more than 10% of our total revenue. EDS (NMCI) accounted for 26% of the revenue and the Special Projects Division of the Drug Enforcement Agency accounted for 11%. We expect these percentages to decrease in 2002 as other parts of the business continue to grow.
Our most significant expense is direct costs, which consist primarily of project personnel salaries and benefits, and direct expenses incurred to complete projects. Our direct costs as a percentage of revenues are also related to the utilization rate of our consulting employees. We manage utilization by frequently monitoring project requirements and timetables. The number of consulting employees assigned to a project will vary according to the size, complexity, duration and demands of the project.
General and administrative expenses consist primarily of costs associated with our executive management, finance and administrative groups, human resources, unassigned consulting employees, employee training, occupancy costs, depreciation and amortization, travel and all other branch and corporate costs.
Sales and marketing expenses include the costs of sales and marketing personnel and costs associated with marketing and bidding on future projects.
Other income consists primarily of interest income earned on our cash, cash equivalents and marketable securities.
Acquisitions
On August 28, 2000, the Company acquired all of the outstanding capital stock of Viking for $2 million cash plus the assumption of debt in a business combination accounted for as a purchase. Viking is a provider of integrated software and advanced technology solutions to state and local law enforcement, fire, and emergency medical service agencies. The excess of purchase price over the fair value of the net assets was approximately $3.6 million. At the time of the acquisition, Viking had 20 personnel.
On November 20, 2001, the Company acquired all of the outstanding common shares of Troy for $15.3 million of cash and common stock valued at $3.0 million in a business combination accounted for as a purchase. Troy derives revenue from system development, networking, engineering, integration services, and information systems security and its primary customer is the federal government. The excess of purchase price over the fair value of the net assets was approximately $9.9 million. At the time of the acquisition, Troy had 354 personnel.
Critical Accounting Policies and Significant Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that management make estimates and assumptions affecting the assets and liabilities (including contingent assets and liabilities) reported at the date of the Consolidated Financial Statements and the revenues and expenses reported for the periods presented. Actual amounts could differ from those estimates. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the measurements that are most affected by management's estimates of future events are:
•Our revenue is derived primarily from contracts with the Federal Government. In 1999, 2000 and 2001, 23%, 22%, 13% of our contracts were fixed-priced contracts. Revenues on fixed-price contracts are recognized using the percentage-of-completion method of accounting. Such revenues are recorded based on the percentage of costs incurred in the applicable reporting period compared to the most recent estimates of total costs to complete each contract. Estimating future costs and, therefore, revenues and profits, is a process requiring a high degree of management judgment. In the event of a change in total estimated contract cost or profit, the cumulative effect of such change is recorded in the period the change in estimate occurs. In the event cost estimates indicate a loss on a contract, the total amount of such loss is recorded in the period in which the loss is first estimated.
•Depreciation and amortization periods for long-lived assets, including property and equipment, intangibles and goodwill.
•Realization values of various assets such as receivables, intangibles assets and goodwill.
Results of Operations
The following table sets forth certain financial data as a percentage of total revenues for the periods indicated.
(a)Gross profit represents revenues less direct costs, which consist primarily of project personnel salaries and benefits and direct expenses incurred to complete projects.
2001 Compared with 2000
Revenues. Revenues increased 59.9% to $109.2 million for 2001 from $68.3 million for 2000. The increase in revenue primarily reflects increases in the amount of services to existing clients and the addition of the EDS (NMCI) subcontract which accounted for 26.0% of revenue (as discussed above). We expect our growth rate to be the same or higher in 2002.
Direct Costs. Direct costs increased 61.9% to $60.4 million for 2001 from $37.3 million for 2000. The increase was due primarily to an increase in project personnel to 1,140 as of December 31, 2001, as compared to 513 as of December 31, 2000. As a service provider, our direct costs increase in conjunction with our increased revenues. Direct costs increased as a percentage of revenues to 55.3% for 2001, from 54.6% for 2000. The increase was principally related to normal fluctuations in labor and other direct costs. We expect the amount of direct costs to increase in 2002 and, as a percentage of revenues, to remain comparable to 2001.
Gross Profit. Gross profit increased 57.4% to $48.8 million for 2001 from $31.0 million for 2000. Gross profit as a percentage of revenues decreased to 44.7% for 2001 from 45.4% for 2000 because direct costs grew at a faster rate than revenues. This decrease was principally related to normal fluctuations in labor and other direct costs. We expect gross profits to be approximately 44-45% of revenues in 2002.
General and Administrative Expenses. General and administrative expenses increased 37.5% to $24.4 million for 2001 from $17.7 million for 2000. These costs, such as rent and other facility costs, recruiting expenses and depreciation of equipment purchased, were related to the increase in project personnel. Facilities costs increased for 2001 due to the opening of our new offices in Fairfax and Norfolk, Virginia, San Antonio, Texas, San Diego, California and Honolulu, Hawaii. Our total general and administrative headcount increased to 134 employees as of December 31, 2001, compared to 75 employees as of December 31, 2000, consistent with our plans. We expect to incur increased facilities costs in 2002 in connection with opening new offices in Fairfax, Virginia and Columbia, Maryland. We expect the amount of general and administrative expenses to increase in 2002, and to be higher than 2001 as a percentage of revenues.
Sales and Marketing. Sales and marketing expenses increased 55.4% to $4.4 million in 2001 from $2.8 million in 2000. This increase was due to an increase in our marketing efforts. We expect the amount of sales and marketing expenses to increase in 2002 and to be comparable to 2001 as a percentage of revenues.
Amortization of Goodwill. For the year ended December 31, 2001, we incurred $0.7 million of amortization expense related to the $3.6 million of goodwill we recorded in connection with the acquisition of Viking compared with $0.2 million in 2000. With the implementation of FAS 141 effective January 1, 2002, we no longer will be required to amortize goodwill.
Amortization of Intangibles. For the year ended December 31, 2001, we incurred $0.1 million of amortization expense related to the $3.0 million of intangibles we recorded in connection with the value of contracts and customer relationships acquired in the acquisition of Troy. We expect such amortization expense to be $0.7 million in 2002.
Operating Income. Operating income increased 88.6% to $19.3 million for 2001 from $10.2 million for 2000. We expect the amount of operating income in 2002 to be in excess of 17% of revenues.
Environmental Costs. We have not incurred any costs in association with environmental issues and do not anticipate incurring any in calendar year 2002.
2000 Compared with 1999
Revenues. Revenues increased 28.4% to $68.3 million for 2000 from $53.2 million for 1999. The increase in revenue primarily reflects increases in the amount of services to existing clients.
Direct Costs. Direct costs increased 22.7% to $37.3 million for 2000 from $30.4 million for 1999. The increase was due primarily to an increase in project personnel to 513 as of December 31, 2000, as compared to 382 as of December 31, 1999. As a service provider, our direct costs increase in conjunction with our increased revenues. Direct costs decreased as a percentage of revenues to 54.6% for 2000, from 57.2% for 1999. The decrease was principally related to normal fluctuations in labor and other direct costs.
Gross Profit. Gross profit increased 36.0% to $31.0 million for 2000 from $22.8 million for 1999. Gross profit as a percentage of revenues increased to 45.4% for 2000 from 43.8% for 1999 because revenues grew at a faster rate than direct costs. This increase was principally related to normal fluctuations in labor and other direct costs.
General and Administrative Expenses. General and administrative expenses increased 47.9% to $17.7 million for 2000 from $12.0 million for 1999. These costs, such as rent and other facility costs, recruiting expenses and depreciation of equipment purchased, were related to the increase in project personnel. Facilities costs increased for 2000 due to the opening of our new offices in Fairfax, Virginia. Our total general and administrative headcount increased to 75 employees as of December 31, 2000, compared to 47 employees as of December 31, 1999, consistent with our plans. We expect to incur increased facilities costs in 2001 in connection with opening new offices in San Antonio, Texas and San Diego, California, as well as, adding additional space in Fairfax, Virginia.
Sales and Marketing. Sales and marketing expenses increased 54.0% to $2.8 million in 2000 from $1.8 million in 1999. This increase was due to an increase in our marketing efforts.
Amortization of Goodwill. For the year ended December 31, 2000, we incurred $0.2 million of amortization expense related to the $3.6 million of goodwill we recorded in connection with the acquisition of Viking.
Operating Income. Operating income increased 13.8% to $10.2 million for 2000 from $9.0 million for 1999.
Environmental Costs. We have not incurred any costs in association with environmental issues.
Liquidity and Capital Resources
Prior to the IPO and follow-on offering, we funded our operations primarily through cash generated from operations and the sale of common stock to employees. Net cash provided by operating activities was $3.6 million for the year ended December 31, 2001. Cash provided by operating activities was primarily from net income, adjusted for working capital changes, which were principally increased in accounts receivable.
Net cash used by investing activities was $39.5 million for the year ended December 31, 2001. During the year ended December 31, 2001, we purchased $1.6 million of property and equipment and incurred $0.7 million for capitalized software development costs. We had $10.1 million of net purchases of short-term investments and $10.7 million of net purchases of long-term investments. We also purchased Troy for $15.3 million in cash plus approximately $0.3 million in acquisition costs. We received approximately $1.4 million in cash and $0.3 million of shareholder receivables, which Troy had at the time of the transaction. At December 31, 2001, funds of $1.9 million were held back in the transaction, of which $1.5 million of escrow funds related to the acquisition were included in other current assets with a corresponding liability in other current liabilities.
We invested $3.0 million in an affiliated company, which is building our new office building in Fairfax, Virginia. We are required to make an additional $1.5 million investment at the time of occupancy of the facilities. We have a 48% minority interest in this company and are not obligated to guarantee the non-recourse mortgage obligation, nor are we involved in the management of the construction of the building or the management of the owner-lessor. In accordance with Emerging Issues Task Force Issue No. 97-10 The Effect of Lessee Involvement in Asset Construction, the Company is considered to be the owner of the property (for accounting purposes). Accordingly, the Company recorded contruction costs incurred to date of $2.9 million as construction-in-process with an offsetting long-term lease obligation as of December 31, 2001.
Net cash provided by financing activities was $51.7 million for the year ended December 31, 2001. During the year ended December 31, 2001, we sold $48.3 million of common stock in a follow-on offering and incurred $0.4 million of associated costs in our follow-on offering. We sold $3.0 million of common stock through the exercise of employee stock options including tax benefits. We also sold $0.9 million of common stock through the employee stock purchase plan.
Although dividends have been paid in prior years, including $0.4 million in the year ended December 31, 2000, which were accrued at December 31, 1999, we expect to retain future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any further cash dividends in the foreseeable future. We believe that our current cash position is adequate for our short-term and long-term working capital and capital expenditure needs.
We maintain a $6.0 million line of credit with Bank of America, which bears interest at the one-month LIBOR rate plus 250 basis points per annum and expires on April 30, 2003. As of December 31, 2001, we had no borrowings outstanding under the line of credit. We did have outstanding $3.19 million in letters of credit in lieu of rent deposits.
Under some of our fixed-price contracts, we receive advance payments for work to be performed in future months. If we do not perform the work, the unearned portion of these advances will be returned to our clients. By December 31, 2001, our accounts receivable turnover rate, net of advance payments on contracts, was approximately four times a year.
The following summarizes the Company's obligations associated with leases and other commitments at December 31, 2001, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands):
As described above, the Company has entered into a lease for a facility to be built-to-suit, which will be ready to occupy December 1, 2002. The lease term will expire on December 31, 2018, however, the terms of the lease will be finalized when the final cost of the building is determined. The Company has negotiated a 48% interest in the limited liability corporation that will own the building, and is deemed the owner of the building (for accounting purposes) during construction and throughout the term of the lease. Lease payments made will be allocated between an operating lease for the land the building occupies and a reduction of the long-term lease obligation for the building over the term of the lease.
Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141 (FAS 141), Business Combinations, and No. 142 (FAS 142), Goodwill and Other Intangible Assets. FAS 141 supersedes Accounting Principles Board Opinion (APB) No. 16, Business Combination. The provisions of FAS 141 (1) require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, (2) provide specific criteria for the initial recognition and measurement of intangible assets apart from goodwill, and (3) require that unamortized negative goodwill be written off immediately as an extraordinary gain instead of being deferred and amortized. FAS 142 supersedes APB 17, Intangible Assets, and is effective for fiscal years beginning after December 15, 2001. FAS 142 primarily addresses the accounting for goodwill and intangible assets subsequent to their initial recognition. The provisions of FAS 142 (1) prohibit the amortization of goodwill and indefinite-lived intangible assets, (2) require that goodwill and indefinite-lived intangibles assets be tested at least annually for impairment, (3) require that reporting units be identified for the purpose of assessing potential future impairments of goodwill, and (4) remove the forty-year limitation on the amortization period of intangible assets that have finite lives.
The Company will adopt the provisions of FAS 142 in its first quarter ending March 31, 2002. The Company is in the process of preparing for its adoption of FAS 142 and is making the determinations as to what its reporting units are and what amounts of goodwill, intangible assets, other assets, and liabilities should be allocated to those reporting units. The Company expects that is will no longer record $721,000 of annual amortization relating to its goodwill recorded in the purchase of Viking. The Company will also evaluate the useful lives assigned to its intangible assets and does not anticipate any changes to the useful lives. The Company does not expect that the results of the required impairment tests will have a negative impact on its earnings and financial position.
In August 2001, FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets was issued. This statement provides guidance on the accounting for the impairment or disposal of long-lived assets and was effective for the Corporation on January 1, 2002. Management believes that the adoption of SFAS No. 144 will not have a material impact on its consolidated financial position, results of operations or cash flows.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We invest our cash in a variety of financial instruments, including U.S. Treasury and Agency obligations, money market instruments of domestic and foreign issuers denominated in U.S. dollars of commercial paper, bankers' acceptances, certificates of deposit, euro-dollar time deposits and variable rate issues, corporate note and bonds, asset-backed securities, repurchase agreements, municipal notes and bonds and auction rate preferred securities.
Investments in both fixed and floating rate interest earning instruments carry a degree of risk. Fixed securities may have their fair market value adversely impacted because of a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, the Company's future investment income may fall short of expectations because of changes in interest rates or the Company may suffer losses in principal if forced to sell securities which have seen a decline in market value because of changes in interest rates. A 10% change in interest rates could have approximately a $150,000 impact on our interest income.
Our investments are made in accordance with an investment policy approved by the Board of Directors. Under this policy no investment securities can have maturities exceeding two years and the average duration of the portfolio cannot exceed 12 months.
Item 8.
Item 8. Financial Statements and Supplementary Data
The information required by Item 8 of Part II is incorporated herein by reference to the Consolidated Financial Statements and financial statement schedules filed with this report: see Item 14 of Part IV.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The section entitled "Election of Directors" and "Executive Officers" appearing in the Registrant's proxy statement for the annual meeting of stockholders to be held on May 22, 2002, sets forth certain information with respect to the directors and executive officers of the Registrant and are incorporated herein by reference.
Item 11.
Item 11. Executive Compensation
The section entitled "Executive Compensation" appearing in the Registrant's proxy statement for the annual meeting of stockholders to be held on May 22, 2002, sets forth certain information with respect to the compensation of management of the Registrant and is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The section entitled "Stock Ownership" appearing in the Registrant's proxy statement for the annual meeting of stockholders to be held on May 22, 2002, sets forth information concerning shares of common stock of the Company beneficially owned by management and others and is incorporated herein by reference.
Item 13.
Item 13. Certain Relationships and Related Transactions
The section entitled "Certain Relationships and Related Transactions" appearing in the Registrant's proxy statement for the annual meeting of stockholders to be held on May 22, 2002, sets forth information concerning certain relationships and transactions with the Company and others and is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a)Documents filed as part of the report:
All Schedules except the one listed above have been omitted because they are not applicable or not required or because the required information is included elsewhere in the financial statements in this filing.
(b)Exhibits
The following exhibits are filed or incorporated by reference, as state below:
Exhibit
Number
Description
3.1*
Certificate of Incorporation of PEC Solutions, Inc.
3.2*
By-Laws
10.1*
Office Lease Agreement between Building IV Associates L.P. and PEC Solutions, Inc.
10.2*
Amendment No. 1 to Office Lease Agreement between Building IV Associates L.P. and PEC Solutions, Inc.
10.3*
Office Lease Agreement between Building V Associates L.P. and PEC Solutions, Inc.
10.4*
Employment Agreement between PEC Solutions, Inc. and David C. Karlgaard., dated January 1, 2000
10.5*
Employment Agreement between PEC Solutions, Inc. and Paul C. Rice, dated January 1, 2000
10.6*
Employment Agreement between PEC Solutions, Inc. and Alan H. Harbitter, dated January 1, 2000
10.7*
Employment Agreement between PEC Solutions, Inc. and Stuart R. Lloyd, dated December 31, 1998
10.8*
2000 Stock Incentive Plan
10.9*
1995 Nonqualified Stock Option Plan
10.10*
1987 Stock Option Agreement, as amended
10.11*
Nonqualified Executive Supplemental Retirement Program Agreement dated December 1998
10.12*
2000 Employee Stock Option Plan
10.13*
Amended and Restated Loan Agreement between PEC Solutions, Inc. and NationsBank, N.A. (Bank of America)
10.14**
Amendment No. 2 to Office Lease Agreement between Building IV Associates L.P. and PEC Solutions, Inc.
10.15**
Amendment No. 3 to Office Lease Agreement between Building IV Associates L.P. and PEC Solutions, Inc.
10.16**
Office Lease Agreement between Building VI L.C. and PEC Solutions, Inc.
10.17***
First Amendment to Lease Agreement between Building VI L.C. and PEC Solutions, Inc.
10.18***
Second Amendment to Lease Agreement between Building VI L.C. and PEC Solutions, Inc.
10.19***
Operating Agreement between Building VI Investment L.C. and PEC Solutions, Inc.
10.20***
First Amendment to Operating Agreement between Building VI L.C. and PEC Solutions, Inc.
10.21***
Bank of America Promissory Note
10.22***
Bank of America Revolving Note
21.1
Subsidiaries of PEC Solutions, Inc.
23.1
Consent of PricewaterhouseCoopers LLP
*Incorporated herein by reference to the Company's Registration Statement on Form S-1. No. 333-95331.
**Incorporated herein by reference to the Company's Annual Report on Form 10K/A filed April 19, 2001.
***Incorporated herein by reference to the Company's Quarterly Report on From 10-Q for the quarter ended June 30, 2001, filed August 13, 2001.
(b)Reports on Form 8-K
(1) We filed a Current Report on Form 8-K on December 4, 2001, reporting under Item 2 the acquisition of Troy Systems, Inc.
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.
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, each person whose signature appears below in so signing also makes, constitutes and appoints David C. Karlgaard and Nancy A. Spangler, and each of them acting alone, his true and lawful attorney-in-fact, with full power of substitution, for him in any and all capacities, to execute and cause to be filed with the Securities and Exchange Commission any and all amendments to this Report, with exhibits thereto and other documents in connection therewith, and hereby ratifies and confirms all that said attorney-in-fact or his substitute or substitutes may do or cause to be done by virtue hereof
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Name
Title
Date
/s/ DAVID C. KARLGAARD David C. Karlgaard, PH. D.
Chief Executive Officer, President and Chairman of the Board of Directors (Principal Executive Officer)
March 29, 2002
/s/ STUART R. LLOYD Stuart R. Lloyd
Senior Vice President and Chief Financial Officer and Director (Principal Financial and Accounting Officer)
March 29, 2002
/s/ PAUL G. RICE Paul G. Rice
Chief Operating Officer and Director
March 29, 2002
/s/ ALAN H. HARBITTER Alan H. Harbitter
Chief Technology Officer and Director
March 29, 2002
/s/ JESSE BROWN Jesse Brown
Director
March 29, 2002
/s/ FRANK J. CARR Frank J. Carr
Director
March 29, 2002
/s/ R. JERRY GROSSMAN R. Jerry Grossman
Director
March 29, 2002
/s/ SHARON M. OWLETT Sharon M. Owlett
Director
March 29, 2002
Report of Independent Accountants
To the Board of Directors and Stockholders of
PEC Solutions, Inc.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of cash flows and of stockholders' equity and comprehensive income (loss) present fairly, in all material respects, the financial position of PEC Solutions, Inc. (the "Company") and subsidiaries at December 31, 2000 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
February 11,
McLean, VA
PEC SOLUTIONS, INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
PEC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF INCOME
The accompanying notes are an integral part of these financial statements.
PEC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
PEC SOLUTIONS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
AND COMPREHENSIVE INCOME (LOSS)
The accompanying notes are an integral part of these financial statements.
PEC SOLUTIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Principles
Company
Performance Engineering Corporation (PEC) was incorporated June 25, 1985, under the laws of the Commonwealth of Virginia. On January 1, 2000, PEC was reincorporated, under the laws of the state of Delaware, as PEC Solutions, Inc. (PEC Solutions or the Company). The Company provides professional technology services that enable government entities to use the Internet to enhance productivity and improve services to the public.
The Company's primary customers are executive agencies and departments of the Federal government, the Federal Judiciary, and prime contractors to the United States government. Two of these customers accounted for 37% of the Company's revenue during 2001. For 1999, the Company's contracts and subcontracts were time and materials contracts (62%), fixed-price contracts (23%), and cost reimbursable contracts (15%). For 2000, these contracts and subcontracts were time and materials contracts (66%), fixed-priced contracts (22%), and cost-reimbursable contracts (12%). For 2001, these contracts and subcontracts were time and materials contracts (71%), fixed-priced contracts (13%), and cost-reimbursable contracts (16%).
Principles of Consolidation
The consolidated financial statements include all majority-owned or controlled subsidiaries. All significant intercompany balances and transactions have been eliminated.
Revenue Recognition
The Company's revenue is derived primarily from contracts with the Federal Government. Revenues on time and materials contracts are recognized based on actual hours delivered at the contracted billable hourly rate plus the cost of materials incurred. Revenues on fixed-price contracts are recognized using the percentage-of-completion method based on costs incurred in relation to total estimated costs. Revenue on cost-type contracts is recognized to the extent of costs incurred plus a proportionate amount of fee earned. The fees under certain 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. Provisions for anticipated contract losses are recognized at the time they become known and estimable.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and in banks. The Company also considers all highly liquid investments with a maturity of three months or less when purchased to be cash equivalents. As of December 31, 2000 and 2001, cash equivalents included money market funds of approximately $2,709,483 and $5,593,048, respectively, and commercial paper, United States Treasuries bills and municipal bonds of approximately $6,793,322 and $13,496,454, respectively.
Concentration of Credit Risk
At times during the year, the Company maintains cash balances at financial institutions in excess of Federal Deposit Insurance Corporation (FDIC) limits. Management believes the risk in these situations to be minimal. In addition, the Company had cash balances of $2,709,483 and $5,593,048 held in money market funds at local financial institutions as of December 31, 2000 and 2001, respectively. The
Company also held commercial paper, United States Treasury bills and municipal bonds in the amount of $55,619,459 as of December 31, 2001. These funds are not insured by the FDIC.
Marketable Securities
The Company determines the appropriate classification of marketable securities at the time of purchase and reevaluates such designation as of each balance sheet date. The Company's marketable securities are categorized as available-for-sale and stated at fair value.
Property and Equipment
Property and equipment are stated at cost less accumulated depreciation. For additions prior to January 1, 1999, depreciation is computed on property and equipment using the double declining balance method over the estimated useful lives of the assets, generally 3 to 5 years. Effective January 1, 1999, depreciation is computed on property and equipment using the straight-line method. Depreciation is computed on leasehold improvements using the straight-line method over the shorter of the lease term or the useful life of the respective assets
Long-lived Assets
The Company evaluates the recoverability of its long-lived assets in accordance with Statement of Financial Accounting Standards No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, (SFAS No. 121). SFAS No. 121 requires recognition of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted net cash flows attributable to such assets. Impairment, if any, is recognized in the period of identification to the extent the carrying amount of an asset exceeds discounted net cash flows attributable to such assets. Based on its most recent analysis, the Company believes that there was no impairment of its long-lived assets as of December 31, 2001.
Goodwill
Goodwill represents the excess of the purchase price over fair value of net assets acquired. Goodwill recognized pursuant to the Viking Technology, Inc. acquisition is amortized on a straight-line basis over a 5-year period. Accumulated amortization was $961,296 as of December 31, 2001. The Company will adopt FAS 142 effective January 1, 2002 and discontinue the amortization the Viking goodwill.
The Company also recognized goodwill pursuant to its acquisition of Troy Systems, Inc. in November 2001. This acquisition has been accounted for as a purchase pursuant to the guidance Statement of Financial Accounting Standards No. 141 (FAS 141), Business Combinations. Therefore, goodwill of $9.9 million will not be amortized and will be evaluated on an annual basis for impairment. (See Notes 3 and 14 for additional information.)
Intangibles
Intangibles representing the value of customer contracts and related relationships purchased in the acquisition of Troy Systems, Inc. on November 20, 2001, amounting to $3,025,000, are amortized on a straight-line basis over a 4.5-year period. Accumulated amortization was $56,019 as of December 31, 2001.
Software Research and Development Costs
The Company capitalizes research and development costs for marketable software incurred from the time the product is determined to be technologically feasible until it is available for sale. It has also
acquired marketable software, which it has capitalized. Acquired software and software development costs are amortized and recorded as direct costs using the straight-line method over a period not to exceed three years. As of December 31, 2001, $1,539,166 was capitalized with an accumulated amortization balance of $280,722 and is included in other assets. Amortization expense of $68,281, and $212,441 was recognized during 2000 and 2001 respectively.
Contract Advance Payments
The Company invoices the Federal Government for some of its contracts based on provisional indirect cost rates. These invoiced amounts are adjusted when the actual rates have been determined by audit. Other Federal Government contracts are billed periodically independent of the percentage of the contract actually completed which, in some situations, results in funds being advanced to the Company in excess of amounts earned.
Common Stock Splits
Effective January 1, 2000, in connection with its reincorporation, the Company's common stock was split 3-for-1. Effective March 1, 2000, the Company's common stock was split 2-for-1. All prior share and per share information in the financial statements have been restated to give effect to these stock splits.
Stock-based Compensation
The Company accounts for stock-based employee compensation arrangements in accordance with provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," (APB No. 25) and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," (SFAS No. 123).
Income Taxes
The Company accounts for deferred income taxes using the asset and liability method, under which the expected future tax consequences of differences between the book and tax bases of assets and liabilities are recognized as deferred tax assets and liabilities.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Such estimates include reserves for doubtful accounts, valuation allowance for deferred taxes, estimates to complete for contracts, and certain accrued expenses. Accordingly, actual results could differ from those estimates.
Segment Reporting
The Company operates as a single segment and will evaluate additional disclosure requirements as it expands its operations.
Lease Financing Arrangement
Emerging Issues Task Force (EITF) Issue No. 97-10, The Effect of Lessee Involvement in Asset Construction, is applicable to entities involved on behalf of an owner-lessor with the construction of an asset that will be leased when construction of the asset is completed. EITF Issue 97-10 requires the Company to be considered the owner (for accounting purposes) of these types of projects during the construction period as well as when construction of the asset is completed. This is the case even though
the Company is not obligated to guarantee the non-recourse mortgage obligation, nor is it involved in the management of the construction of the building or the management of the owner-lessor. Therefore, as discussed in Note 14, the Company is required to record such building costs as construction-in-process with an offsetting long-term lease obligation.
Reclassifications
Certain reclassifications have been made to the prior-period financial statements in order to conform to the 2001 presentation.
2. Initial Public Offering and Follow-on Offering
The Company completed an initial public offering of common stock in April 2000. The Company sold 3,000,000 shares of common stock generating $25.6 million in proceeds, net of offering expenses. The Company completed a follow-on offering of common stock in June 2001. The Company sold 3,000,000 shares of common stock generating $47.9 million in proceeds, net of offering expenses.
3. Acquisitions
On August 28, 2000, the Company acquired all of the outstanding capital stock of Viking Technology, Inc. (Viking) for $2 million cash plus the assumption of debt in a business combination accounted for as a purchase. The results of Viking's operations have been included in the consolidated financial statements since that date. Viking is a provider of integrated software and advanced technology solutions for state and local law enforcement, fire and emergency medical service agencies. Assets acquired were $2.6 million and liabilities assumed were $4.2 million. The excess of the purchase price over the fair value of the net liabilities assumed was approximately $3.6 million, which was recorded as goodwill. Pro forma results of operations had the acquisition occurred on January 1, 1999 would not have been significantly different than reported results for the year ended December 31, 2000.
On November 20, 2001, the Company acquired all of the outstanding common shares of Troy Systems, Inc. (Troy). The results of Troy's operations have been included in the consolidated financial statements since that date. Troy derives revenue from system development, networking, engineering, integration services, and information systems security and its primary customer is the federal government. Troy's depth of experience in the defense and health care IT sectors represents an important set of new vertical markets for the Company and will significantly broaden its client base.
The aggregate purchase price was $18.6 million, including acquisition costs of $0.3 million, and consisting of $15.3 million of cash and common stock valued at $3.0 million (103,065 shares). The number of shares was determined using the average closing price of the stock for the five trading days immediately prior to the acquisition. At December 31, 2001, there were $1.5 million of escrow funds related to the acquisition included in other current assets with a corresponding liability in other current liabilities.
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. Third party valuations were obtained in determining the allocation of the purchase price for certain intangible assets.
The $3.0 million of acquired intangible assets was assigned to customer contracts and related relationships with a weighted-average useful life of 4.5 years. The transaction resulted in $9.9 million of goodwill, all of which is expected to be deductible for tax purposes.
Unaudited pro forma results of operations as if the acquisition has occurred at the beginning of each period presented are as follows:
The pro forma consolidated results of operations include adjustments to give effect to amortization of goodwill and other adjustments, together with related income tax effects. The unaudited pro forma information is not necessarily indicative of the results of operations that would have occurred had the purchase been made at the beginning of the periods presented or the future results of the combined operations.
4. Accounts Receivable
Accounts receivable consisted of the following as of:
Unbilled accounts receivable consist of recognized recoverable costs and accrued profits on contracts for which billings had not been presented to clients as of the balance sheet date. Management anticipates the collection of these amounts within 90 days of the balance sheet date. Payments to the Company on contracts with agencies and departments of the Federal Government are subject to adjustment upon audit by the Federal Government. All years subsequent to 1997 are subject to audit. Management believes that audit adjustments, if any, on periods not yet audited, will not have a material effect on the financial statements.
During 2001 the Company had two customers that each accounted for more than 10% of revenue. For the year ended December 31, 2001, EDS (Navy Marine Corps Intranet) had $27.3 million, and the Special Projects Division of the Drug Enforcement Agency had $12.4 million of revenue and, as of December 31, 2001, each had $7.3 million and $1.7 million of accounts receivable, respectively.
5. Property and Equipment
Property and equipment consisted of the following as of:
Depreciation expense was $585,194, $649,713 and $865,158 for the years ended December 31, 1999, 2000 and 2001, respectively.
6. Line of Credit
The Company has a loan agreement with Bank of America which provides for a line of credit with a limit of $6,000,000 at the one-month LIBOR Rate plus 250 basis points per annum (9.5% and 4.4% as of December 31, 2000 and 2001, respectively). The line is collateralized by the assets of the Company. As of December 31, 2000, and 2001 the balance due under the line was zero. The bank has issued Letters of Credit in the amount of $3,187,009 against the line of credit in lieu of rent deposits as of December 31, 2001. The agreement expires April 30, 2003.
7. Other current liabilities
Other liabilities consisted of the following:
8. Stock Option Plans
On February 1, 1987, the Company established an incentive stock option agreement (the Agreement), to attract, retain and reward employees and on January 1, 1995 the Company established a nonqualified stock option plan (the Plan, collectively, the Plans) to attract, retain and reward key employees. The Plans are administered by the Board of Directors, which has the authority to determine which officers and key employees are awarded options pursuant to the Plans and the related terms and option prices. The number of options available for grant under the Plans is limited to the number of Company common shares authorized and available.
Each stock option granted pursuant to the Plans has an exercise price equal to the fair market value of the underlying common stock at the date of grant. Each stock option granted under the Agreement has a five-year term and a two-year vesting period. Each stock option granted pursuant to the Plan has a ten-year term and no vesting period.
In January 2000, the Company established a stock plan (the 2000 Plan), which includes both incentive and non-qualified stock options. Under the 2000 Plan, options to purchase 1,500,000 shares of common stock are available for 2000. Beginning in 2001, the number of options eligible for grant in each year will be equal to the sum of 6.25% of the number of outstanding shares on January 1 of that year, plus the number of shares eligible for grant in the prior year that were not granted. No more than 15,000,000 options may be granted during the 10-year term of the 2000 Plan. Each stock option granted pursuant to the 2000 Plan has a ten-year term and a two-year vesting period for incentive options and no vesting period for non-qualified options.
In January 2000, the Company established an employee stock purchase plan (the Purchase Plan). Under the Purchase Plan, employees, through payroll deductions, are granted options to purchase shares of common stock at a price no less than 85% of the fair market value of the common stock on the first or last trading day of each six month option period or the date the shares of common stock are purchased. There are 2,000,000 shares of common stock available for purchase under the Purchase Plan. On January 2, 2001, 76,534 shares were issued under the plan at prices ranging from $6.27 to $6.75 per share. On July 12, 2001, 49,191 shares were issued under the plan at prices ranging from $6.75 to $8.93 per share.
The following table summarizes the Company's activity for all of its stock option awards granted under the Agreement and the plans:
The following table summarizes additional information about stock options outstanding as of December 31, 2001:
The Company applies APB Opinion No. 25 and related interpretations in accounting for its plans. Accordingly, compensation cost is recognized for its stock plans based on the intrinsic value of the stock option at date of grant (i.e., the difference between the exercise price and the fair value of the Company's common stock).
Had compensation cost for the Company's stock-based compensation plans been determined based on the fair value at the grant dates for awards under the plans in 1999, 2000, and 2001, consistent with
the method of SFAS No.123, the Company's net income and net income per share would have been reduced to the pro forma amounts indicated below.
The fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. All significant assumptions and the weighted-average fair value per share granted during the years ended December 31 are as follows:
9. Basic Earnings Per Share and Diluted Earnings Per Share
Basic net income per common share is computed on the basis of the weighted-average number of common shares outstanding for the periods. Diluted net income per common share includes the weighted-average effect of dilutive options outstanding during the periods. The weighted average number of shares issuable upon the exercise of outstanding stock options assumes that the applicable proceeds from such exercises are used to acquire treasury shares at the average price of common stock during the periods.
Basic and diluted earnings per share for 1999, 2000, and 2001, were determined as follows:
10. Employee Benefit Plan
During 1985, the Company established a qualified profit sharing plan in accordance with Section 401(k) of the Internal Revenue Service Code. Under the plan, the Company makes contributions out of profits of the Company based on an amount determined at the discretion of the Board of Directors. All full-time employees and part-time employees working at least 20 hours a week are eligible to participate in the plan. Eligibility is restricted for new employees, who are not permitted to participate until the first day of the first calendar quarter following date of hire. The Company contributed $1,226,316, $1,714,364 and $2,676,688 for 1999, 2000 and 2001, respectively.
11. Supplemental Retirement Program
In December 1998, the Company adopted a funded Executive Supplemental Retirement Program for a select group of management or highly compensated employees. The program allows these employees to defer a portion of their salary and bonus. The Company has the option of adding additional amounts of deferred compensation at its sole discretion. The Company contributions are vested after five years. Employee deferrals were $60,093, $72,163 and $87,045 in 1999, 2000 and 2001, respectively. The Company contributed $99,367, $112,663 and $146,639 to the program in 1999, 2000 and 2001, respectively.
12. Dividends
The Company declared dividends in the amount of $413,149 for 1999, which were paid in 2000, but did not declare any dividends for 2000 and 2001. The Company expects to retain future earnings, if any, for use in the operation and expansion of the business and does not anticipate paying any further cash dividends in the foreseeable future.
13. Income Taxes
The provision for income taxes consisted of the following:
Deferred tax assets were comprised of the following:
A reconciliation between the Company's statutory tax rate and the effective tax rate is as follows:
14. Commitments and Contingencies
Through its acquisition of Troy Systems, Inc. the Company has assumed several equipment leases, which are classified as capital leases. The economic substance of such transactions is that the Company
is acquiring assets using lease financing. The future minimum lease payments under capital leases as of December 31, 2001, are as follows:
At December 31, 2001, equipment under capital leases of $126,375, net of accumulated depreciation of $7,437, is included with property and equipment.
The Company leases office facilities and equipment under noncancelable operating lease agreements, which expire in various years through 2013. Future minimum lease payments under operating leases that have noncancelable lease terms in excess of one year as of December 31, 2001 are as follows:
The total rental expense under operating leases was $2,169,811, $4,267,350 and $5,615,636 for the years ended December 31, 1999, 2000 and 2001, respectively.
The Company subleases space in one of its facilities. Sublease rental income was $182,745 and $315,658 for the years ended December 31, 2000 and 2001, respectively.
The Company entered into a new lease for a facility to be built-to-suit, which will be ready to occupy December 1, 2002. The lease will expire on December 31, 2018. The terms of the lease will be finalized when the final cost of the building is determined. The Company has negotiated a 48% equity position in the limited liability corporation that will own the building for a total investment of $4,500,000. As of December 31, 2001, $3,000,000 of the investment has been paid and the balance will be due upon occupancy of the building. As discussed in Note 1, the Emerging Issues Task Force (EITF) released in 1998, Issue No. 97-10, The Effect of Lessee Involvement in Asset Construction. EITF Issue No. 97-10 is applicable to entities involved on behalf of an owner-lessor with the construction of an asset that will be leased to the lessee when construction of the asset is completed. Issue No. 97-10 requires the Company be considered the owner (for accounting purposes) of these types of projects during the construction period as well as when the construction of the asset is completed. This is the case even though the Company is not obligated to guarantee the non-recourse mortgage obligation, nor is it involved in the management of the construction of the building or the management of the owner-lessor. Accordingly, the Company recorded construction costs incurred to date of $2.9 million as construction-in-process with an offsetting long-term lease obligation as of December 31, 2001.
In the ordinary course of business, the Company may be party to various legal proceedings. In the opinion of management, the Company's liability, if any, in all pending litigation or other legal proceedings will not have a material effect upon the financial condition, results of operations or liquidity of the Company.
15. Recent Accounting Pronouncements
In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 141 (FAS 141), Business Combinations, and No. 142 (FAS 142), Goodwill and Other Intangible Assets. FAS 141 supersedes Accounting Principles Board Opinion (APB) No. 16, Business Combination. The provisions of FAS 141 (1) require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001, (2) provide specific criteria for the initial recognition and measurement of intangible assets apart from goodwill, and (3) require that unamortized negative goodwill be written off immediately as an extraordinary gain instead of being deferred and amortized. FAS 142 supersedes APB 17, Intangible Assets, and is effective for fiscal years beginning after December 15, 2001. FAS 142 primarily addresses the accounting for goodwill and intangible assets subsequent to their initial recognition. The provisions of FAS 142 (1) prohibit the amortization of goodwill and indefinite-lived intangible assets, (2) require that goodwill and indefinite-lived intangibles assets be tested at least annually for impairment, (3) require that reporting units be identified for the purpose of assessing potential future impairments of goodwill, and (4) remove the forty-year limitation on the amortization period of intangible assets that have finite lives.
The Company will adopt the provisions of FAS 142 in its first quarter ending March 31, 2002. The Company is in the process of preparing for its adoption of FAS 142 and is making the determinations as to what its reporting units are and what amounts of goodwill, intangible assets, other assets, and liabilities should be allocated to those reporting units. The Company expects that is will no longer record $721,000 of annual amortization relating to its goodwill recorded in the purchase of Viking. The Company will also evaluate the useful lives assigned to its intangible assets and does not anticipate any changes to the useful lives. The Company does not expect that the results of the required impairment tests will have a negative impact on its earnings and financial position.
In August 2001, FAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets was issued. This statement provides guidance on the accounting for the impairment or disposal of long-lived assets and was effective for the Corporation on January 1, 2002. Management believes that the adoption of SFAS No. 144 will not have a material impact on its consolidated financial position, results of operations or cash flows.
16. Unaudited Selected Quarterly Financing Information
Report of Independent Accountants on
Financial Statement Schedule
To the Board of Directors and Stockholders of
PEC Solutions, Inc.
Our audits of the consolidated financial statements referred to in our report dated February 11, 2002, appearing in this Annual Report on Form 10-K, also included an audit of the financial statement schedule appearing on page S-2. In our opinion, this financial statement schedule presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.
/s/ Pricewaterhouse Coopers LLP
McLean, Virginia
February 11, 2002
S-1
PEC Solutions, Inc.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
(1)Reflects amounts written off against the allowance and related accounts receivable accounts and settlement of doubtful accounts.
(2)Addition related to the acquisition of Troy Systems, Inc. on November 20, 2001. S-2
FORM 10-K INDEX
PART I
Item 1. Business
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters To a Vote of Security Holders
PART II
Item 5. Market for the Company's Common Equity and Related Stockholder Matters
Item 6. Selected Financial Data
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
PART III
Item 10. Directors and Executive Officers of the Registrant
Item 11. Executive Compensation
Item 12. Security Ownership of Certain Beneficial Owners and Management
Item 13. Certain Relationships and Related Transactions
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
SIGNATURES
POWER OF ATTORNEY
Report of Independent Accountants
PEC SOLUTIONS, INC. CONSOLIDATED BALANCE SHEETS
PEC SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF INCOME
PEC SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
PEC SOLUTIONS, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME (LOSS)
PEC SOLUTIONS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Accountants on Financial Statement Schedule
PEC Solutions, Inc. SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS