---

       

	5

The Company derives a substantial majority of its revenue from services provided as a prime contractor or subcontractor on engagements with various agencies of the U.S. government. These contracts represented approximately 97% of the Company’s revenue for the three months ended December 31, 2013 and 98% for the three months ended December 31, 2012 and the six months ended December 31, 2012 and 2013. The Company considers individual agencies that may fall under a larger department as separate customers.  No customer accounted for 10% or more of the Company’s revenue for any of the periods presented.

	⋅	Level 1 – Quoted prices for identical instruments in active markets;
	⋅	Level 2 – Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-derived valuations in which all significant inputs and significant value drivers are observable in active markets; and
	⋅	Level 3 – Valuations derived from valuation techniques in which one or more significant inputs or significant value drivers are unobservable.

	6

The Company’s financial instruments include cash, trade receivables, vendor payables, debt, and derivative financial instruments. As of June 30, 2013 and December 31, 2013, the carrying value of cash, trade receivables and vendor payables approximated their fair value. See Note 5 for a discussion of the fair value of the Company’s debt. See Note 6 for a discussion of the fair value of the Company’s derivative financial instruments.

 

 

Divestiture

 

On July 1, 2013, the Company sold a portion of its Health & Civil business, consisting of six contracts, for approximately $5.5 million. The Company recognized a gain of approximately $1.6 million during the six months ended December 31, 2013 as a component of continuing operations. As a result of the divestiture, goodwill and intangible assets were reduced by approximately $4.2 million and $1.3 million, respectively. 

 

Recent Accounting Pronouncements

 

In February 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update 2013-02, or ASU 2013-02, an update to Comprehensive Income. This update requires the presentation and disclosure of reclassification adjustments out of Accumulated Other Comprehensive Income, or AOCI, in a single note or on the face of the financial statements. This update is effective for fiscal years and interim periods within those years beginning after December 15, 2012, or the Company’s fiscal 2014. The adoption of this ASU did not impact the Company’s financial position, results of operations or cash flows.

 

In July 2013, the FASB issued ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which requires standard presentation of an unrecognized tax benefit when a carryforward related to net operating losses or tax credits exist. This update is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2013, or the Company’s fiscal 2015. The adoption of this ASU will not have an impact on the Company’s financial position, results of operations or cash flows.

	8

 

	12

 

	13

   

	·	provide an overview of our business;
	·	describe selected key metrics evaluated by management;
	·	explain the year-over-year trends in our results of operations;
	·	describe our liquidity and capital resources; and
	·	explain our critical accounting policies and estimates.

·

reduced spending levels including impacts of any government shut down and changing budget priorities of our largest customer, the United States federal government, which accounts for approximately 97% of our revenue;

	·	failure of our customer to fund a contract or exercise options to extend contracts, or our inability to successfully execute awarded contracts;
	·	limitations as a result of our substantial indebtedness which could adversely affect our financial health, operational flexibility and strategic plans;
	·	failure to generate cash sufficient to pay the principal of, interest on, or other amounts due on our debt;
	·	failure to comply with complex laws and regulations, including but not limited to, the False Claims Act, the Federal Acquisition Regulation, the Defense Federal Acquisition Regulation Supplement and the U.S. Government Cost Accounting Standards;
	·	possible delays or overturning of our government contract awards due to bid protests, loss of contract revenue or diminished opportunities based on the existence of organizational conflicts of interest or failure to perform by other companies on which we depend to deliver products and services;
	·	security threats, attacks or other disruptions on our information infrastructure, and failure to comply with complex network security and data privacy legal and contractual obligations or to protect sensitive information;
	·	inability or failure to adequately protect our proprietary information or intellectual property rights or violation of third party intellectual rights;
	·	potential for significant economic or personal liabilities resulting from failures, errors, delays or defects associated with products, services and systems we supply;
	·	adverse changes in federal government practices;
	·	pricing pressure on new work, reduced profitability or loss of market share due to intense competition and commoditization of services we offer;
	·	adverse results of audits and investigations conducted by the Defense Contract Audit Agency, Internal Revenue Service or any of the Inspectors General for various agencies with which we contract, including, without limitation, any determination that our purchasing, property, estimating, cost accounting, labor, billing, compensation, management information systems or contractor internal control systems are deficient;
	·	difficulties accurately estimating contract costs and contract performance requirements;
	·	possible further impairment of goodwill, trade names and other assets as a result of customer budget pressures and reduced U.S. federal government spending;
	·	challenges attracting and retaining key personnel or high-quality employees, particularly those with security clearances;
	·	failure to manage acquisitions or divestitures successfully, including identifying, evaluating, and valuing acquisition targets, integrating acquired companies, losses associated with divestitures, and the inability to effect divestitures at attractive prices and on a desired timeline;
	·	possible future losses that exceed our insurance coverage;
	·	pending litigation and any resulting expenses, payments or sanctions, including but not limited to penalties, compensatory damages or suspension or debarment from future government contracting; and
	·	the effect of our acquisition by entities affiliated with Providence on our business relationships, operating results and business generally.

	16

	17

   

	18

	·	Cost-plus-fee contracts. Cost-plus-fee contracts provide for reimbursement of allowable costs and the payment of a fee, which is our profit. In addition, some cost-plus-fee contracts provide for an award fee or incentive fee for meeting the requirements of the contract.
	·	Time-and-materials contracts. Time-and-materials contracts provide for a fixed hourly rate for each direct labor hour expended plus reimbursement of allowable material costs and out-of-pocket expenses.
	·	Fixed-price contracts. Fixed-price contracts provide for a pre-determined fixed price for specified products and/or services. Fixed-price-level-of-effort contracts are similar to time-and-materials contracts except they require a specified level of effort over a stated period of time. To the extent our actual costs vary from the estimates upon which the price of the fixed-price contract was negotiated, we will generate more or less than the anticipated amount of profit or could incur a loss.

	19

 

	20

  

	·	Stock compensation expense related to the stock incentive plans. The charges are included in SG&A expenses in the condensed consolidated statement of operations.
	·	Severance charges incurred to primarily reduce our indirect labor force. The gross charges are included in SG&A expenses in the condensed consolidated statement of operations.
	·	Facility exit charges related to the exit of underutilized space in certain of our leased facilities. The charges are included in SG&A expenses in the condensed consolidated statement of operations.
	·	Certain other non-recurring items including the following:

	·	Transaction costs for accelerated stock compensation expense, accounting, investment banking, legal, severance, and other services related to the Transaction;
	·	Impairment of goodwill and trade names as a result of the annual impairment analysis during fiscal 2013;
	·	Gain on the sale of a portion of our Health and Civil business in the first quarter of fiscal 2014;
	·	The acquisition of MorganFranklin Corporation’s National Security Solutions division, or NSS, in December 2012. In calculating Adjusted EBITDA, we add the estimated EBITDA impact of acquisitions as if the businesses had been acquired on the first day of the respective period in which an adjustment is recorded.
	·	As defined in our credit agreement, cost savings represents the EBITDA impact of quantifiable run-rate cost savings for actions taken or expected to be taken within 12 months of the reporting date as if they had been realized on the first day of the relevant period. Specifically, for the periods presented, the cost savings adjustment represents the estimated EBITDA impact of actions taken to exit underutilized space in certain of our leased facilities, the run-rate cost savings associated with indirect labor reductions, and savings associated with certain fringe benefit changes.

	22

 

 

NMF = Not meaningful

 

Cost of services consisted of the following for the periods presented (dollars in thousands):

 

		Three months ended December 31, 2012			% of total			Three months ended December 31, 2013			% of total
Direct labor and related overhead		$	137,840		48.3	%		$	128,742		49.5	%
Subcontractor labor			88,713		31.1	%			80,320		30.9	%
Materials and other reimbursable costs			58,868		20.6	%			50,988		19.6	%
Total cost of services		$	285,421					$	260,050

 

		Six months ended December 31, 2012			% of total			Six months ended December 31, 2013			% of total
Direct labor and related overhead		$	287,850		49.4	%		$	263,018		50.2	%
Subcontractor labor			184,189		31.6	%			166,891		31.8	%
Materials and other reimbursable costs			110,363		19.0	%			94,278		18.0	%
Total cost of services		$	582,402					$	524,187

 

Cost of services decreased in the three and six months ended December 31, 2013 compared to the three and six months ended December 31, 2012.  This decrease is due to lower business volume resulting from federal budget pressures, contract award delays and the government shutdown.  As a percentage of revenue, cost of services increased in the three and six months ended December 31, 2013 compared to the three and six months ended December 31, 2012.  This increase is partially attributable to the loss of revenue due to the shutdown of the U.S. federal government in October 2013, which reduced labor services costs and revenue but did not reduce the fixed portions of overhead or fringe costs.  The increase was also driven by ongoing heightened competition and pricing pressures, both for new business opportunities and recompetes of our existing programs.

 

 

	23

 

Cost of services as a percentage of revenue varies from period to period depending on the mix of direct labor, subcontractor labor, and materials and other reimbursable costs. In periods where we have more materials and other reimbursable content, our costs of services as a percentage of revenue will be higher. We seek to optimize our labor content in performance of our contracts since we typically generate greater gross margin from our labor services, particularly from services that our employees provide, compared with other reimbursable items.

 

SG&A expenses decreased $10.0 million in the three months ended December 31, 2013 compared to the three months ended December 31, 2012 and $17.8 million in the six months ended December 31, 2013 compared to the same period of the prior year. Excluding stock compensation expense, severance charges to reduce our indirect labor force, officer compensation and other non-recurring costs, which are all discussed in greater detail in the section listed “Items Affecting the Comparability of Our Operating Results,” SG&A expenses decreased approximately $8.3 million and $14.5 million in the three and six months ended December 31, 2013, respectively, compared to the comparable periods of the prior year. The decrease is primarily a result of actions taken to align our indirect costs with our volume of business and maintain competitive cost position. Additionally, the impact of the federal government shutdown reduced SG&A costs for the second quarter of fiscal 2014 by approximately $1 million.

 

Depreciation and amortization of property and equipment decreased in the three and six months ended December 31, 2013 compared to the three and six months ended December 31, 2012 due to the continued use of fully depreciated assets.

 

Amortization of intangible assets decreased in the three and six months ended December 31, 2013 as compared to the three and six months ended December 31, 2012 as amortization is recorded on an accelerated basis based on the expected benefits of the assets.

 

Interest

 

		Three months ended December 31,						Six months ended December 31,
		2012			2013			2012			2013
Interest expense		$	(25,241)		$	(26,356)		$	(50,722)		$	(52,527)
Interest income			9			24			21			34
Interest, net		$	(25,232)		$	(26,332)		$	(50,701)		$	(52,493)

 

Interest expense increased in three and six months ended December 31, 2013 by $1.1 million and $1.8 million, respectively, compared to the comparable prior year periods primarily due to an increase of the fixed rates on our interest rate swaps. Interest expense for the three and six months ended December 31, 2012 and 2013 includes amortization of original issue discount and debt issuance costs of $1.8 million and $3.7 million, respectively, compared to $1.8 million and $3.7 million in the comparable prior year periods. We manage our exposure to interest rate movements through the use of interest rate swap agreements. As of December 31, 2013, we had fixed the interest rate on all but $150.0 million of our outstanding total debt.

 

Income Taxes

 

The effective tax rate for the six months ended December 31, 2012 and 2013 was a tax benefit of 35.9% and 37.8%, respectively, which is lower than the statutory income tax rates primarily due to non-deductible permanent items. The increase in the tax benefit is due to the reinstatement of the federal research and development credit that was not in effect during the six months ended December 31, 2012.

 

Liquidity and Capital Resources

 

Our primary capital needs are to finance the costs of operations, pending the billing and collection of accounts receivable and to make acquisitions. Our working capital (current assets minus current liabilities) as of December 31, 2013 was $67.5 million compared to $96.8 million as of June 30, 2013. As of December 31, 2013, our total unrestricted cash was $53.9 million and our total outstanding debt was $1.1 billion, excluding unamortized discount.

 

 

	24

 

		Six months ended December 31,
		2012			2013
Net cash provided by operating activities		$	39,991		$	48,105
Net cash (used in) provided by investing activities			(40,022)			731
Net cash used in financing activities			-			-
Net (decrease) increase in cash and cash equivalents		$	(31)		$	48,836

 

Cash Flow

 

Accounts receivable represent our largest working capital requirement. We bill the majority of our clients monthly after services are rendered. Our operating cash flow is primarily affected by the overall profitability of our contracts, our ability to invoice and collect from our clients in a timely manner, and the timing of vendor and tax payments.

 

Net cash provided by operating activities was $40.0 million and $48.1 million in the six months ended December 31, 2012 and 2013, respectively. In the six months ended December 31, 2013, the increase in cash provided by operating activities was primarily due to the timing of vendor payments, lower payments of accrued payroll and employee benefits, offset by the timing of billings and collections of our accounts receivable.

 

Net cash used in investing activities was $40.0 million in the six months ended December 31, 2012 and the net cash provided by investing activities was $0.7 million in the six months ended December 31, 2013. In the six months ended December 31, 2013, net cash provided by investing activities represented the sale of a portion of the Health & Civil business of $5.5 million partially offset by $4.8 million of capital expenditures. In the six months ended December 31, 2012, net cash used in investing activities was driven by $34.2 million used to acquire NSS and capital expenditures of $5.8 million.

 

Net cash used in financing activities was zero in the six months ended December 31, 2012 and 2013. Borrowings on our revolving credit facility during the six months ended December 31, 2013 of $100.0 million were repaid during the six months.

 

Indebtedness

 

Our Term Loan B Facility requires quarterly installment payments of approximately $2.2 million per quarter commencing on December 31, 2011. In addition, we are required to make annual payments equal to 75% of excess cash flow, or ECF (as defined in the credit agreement), with a reduction to 50% based upon achievement of a net senior secured leverage ratio, or NSSLR, of less than 3.5x, 25% if less than 2.75x and zero if less than 2.0x. Any required ECF payments are due on October 15 each year.

 

We repaid $140.0 million of our Term Loan B Facility in fiscal 2012, which satisfied all of the required quarterly principal payments for the term of the loan and satisfied our required ECF principal payments for fiscal 2012. We repaid $20.0 million of our Term Loan B Facility in fiscal 2013, which satisfied our required ECF principal payments for fiscal 2013. We estimate the fiscal 2014 ECF requirement to be $45.0 million, which is due October 15, 2014 and is included in current liabilities on the condensed consolidated balance sheet.

 

We are required to meet the NSSLR covenant quarterly if any revolving loan, swing-line loan or letter of credit is outstanding on the last day of the quarter. As of December 31, 2013, we had no outstanding letters of credit or borrowings under our Revolver. The ratio is calculated as the consolidated net secured indebtedness as of the last day of the quarter (defined as consolidated net secured debt less any cash and permitted investments) to the preceding four quarters’ consolidated EBITDA (as defined in the Credit Agreement). The required ratio decreases over time from less than or equal to 5.25x as of December 31, 2013 to less than or equal to 4.5x as of June 30, 2016. As of December 31, 2013, our net senior secured leverage ratio was 3.5x. We were in compliance with all of our covenants as of December 31, 2013.

 

The $400.0 million of Notes bear interest at a rate of 11% per annum and mature on October 19, 2019. Interest on the Notes is payable semi-annually. The Notes are redeemable in whole or in part, at our option, at varying redemption prices that generally include premiums. In addition, until October 1, 2014, we may, at our option, redeem up to 35% of the then outstanding aggregate principal amount of the Notes with the net cash proceeds from certain equity offerings at a redemption price equal to 111% of the aggregate principal amount thereof.

 

The Senior Secured Credit Facilities and the Notes are guaranteed by all of our wholly-owned subsidiaries. The Senior Secured Credit Facilities are also guaranteed by Sterling Parent. The guarantees are full and unconditional and joint and several. Each of our subsidiary guarantors are 100% owned and have no independent assets or operations.

 

 

	25

 

Capital Requirements

 

We believe the capital resources available to us under the Revolver portion of our Senior Secured Credit Facilities and cash from our operations are adequate to fund our normal working capital needs as well as our capital expenditure requirements, which are expected to be less than 1.0% of revenue, for at least the next twelve months.

 

Income Taxes

 

The Transaction accelerated the recognition of expense for stock options and restricted stock, creating a tax deduction of approximately $80.0 million in fiscal 2012. As a result of net operating loss carryforwards resulting primarily from this stock compensation deduction, as well as Transaction costs and tax-deductible interest expense, we do not expect to make any material U.S. federal income tax payments for the next twelve months.

 

Accounts Receivable Factoring

 

During the second quarter of fiscal 2014, we entered into an accounts receivable purchase facility that enables us to sell accounts receivable under certain contracts to a third party. The balance of the receivables may not exceed $50.0 million at any time. As of December 31, 2013, there was no activity under this facility.

 

Off-Balance Sheet Arrangements

 

As of December 31, 2013, other than operating leases, we had no material off-balance sheet arrangements, including retained or contingent interests in assets transferred to unconsolidated entities; derivative instruments indexed to our stock and classified in stockholder’s equity on the condensed consolidated balance sheet; or variable interests in entities that provide us with financing, liquidity, market risk or credit risk support or engage with us in leasing, hedging or research and development services. We utilize interest rate derivatives to add stability to interest expense and to manage our exposure to interest rate movements.

 

For further discussion of our derivative instruments and hedging activities see Item 3 below and Note 6 to our condensed consolidated financial statements as of and for the period ended December 31, 2013 included in this quarterly report on Form 10-Q.

 

Description of Critical Accounting Policies and Estimates

 

The preparation of our financial statements in accordance with GAAP requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, as well as the disclosure of contingent assets and liabilities. These estimates are based on our historical experience and various other factors that are deemed reasonable at the time the estimates are made. Actual results may differ significantly from these estimates under different assumptions or conditions. We re-evaluate these estimates quarterly and test goodwill and trade names for impairment at least annually during the fourth quarter as of April 1. We believe the critical accounting policies requiring significant estimates and judgments are revenue recognition, accounting for acquisitions, including the identification of intangible assets and the ongoing impairment assessments of goodwill and intangible assets, accounting for stock compensation expense and income taxes. If any of these estimates or judgments proves to be inaccurate, our results could be materially affected in the future.

 

For a full discussion of our critical accounting policies, refer to the "Description of Critical Accounting Estimates" section included in our annual report on Form 10-K filed with the Securities and Exchange Commission on August 9, 2013.

 

Recent Accounting Pronouncements

 

In February 2013, the Financial Accounting Standards Board, or FASB, issued Accounting Standards Update 2013-02, or ASU 2013-02, an update to Comprehensive Income. This update requires the presentation and disclosure of reclassification adjustments out of Accumulated Other Comprehensive Income, or AOCI, in a single note or on the face of the financial statements. This update is effective for fiscal years and interim periods within those years beginning after December 15, 2012, or our fiscal 2014. The adoption of this ASU did not impact our financial position, results of operations or cash flows.

 

In July 2013, the FASB issued ASU 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists, which requires standard presentation of an unrecognized tax benefit when a carryforward related to net operating losses or tax credits exist. This update is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2013, or our fiscal 2015. The adoption of this ASU will not have an impact on our financial position, results of operations or cash flows.

 

 

	26

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

We are subject to market risk, primarily relating to potential losses arising from adverse changes in interest rates. For a further discussion of market risks we may encounter, refer to our “Risk Factors” section included in our Form 10-K filed with the Securities and Exchange Commission on August 9, 2013.

 

Interest Rate Risk

 

Borrowings under our senior secured credit facilities are at variable interest rates and expose us to interest rate risk. However, we manage our exposure to interest rate movements through the use of interest rate swap agreements. The interest rate swap derivatives decrease over time to a notional value of $475.0 million upon maturity in July 2016. As of December 31, 2013 we had fixed the interest rate on $565.0 million of our outstanding Term Loan B Facility. The interest rate on the remaining $150.0 million of our outstanding Term Loan B Facility was variable. Borrowings under our Term Loan B Facility bear interest at a rate equal to an applicable margin plus London Interbank Offered Rate, or LIBOR, with a 1.25% floor, or, at our option, an applicable margin plus an alternative base rate determined by reference to the higher of the prime rate or the federal funds rate plus 0.5%, with a 2.25% floor. The three-month LIBOR was 0.25% at December 31, 2013. A hypothetical 1% increase in LIBOR over the 1.25% floor could increase our annual interest expense and related cash flows by approximately $1.5 million based on the unhedged portion of our senior secured credit facilities outstanding as of December 31, 2013.

 

Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures

 

As of December 31, 2013, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer (our principal executive officer and principal financial officer, respectively), management evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Exchange Act. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective, as of the end of the period covered by this quarterly report on Form 10-Q, such that the information relating to us that is required to be disclosed in our reports filed with the SEC (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and (ii) is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

 

Change in Internal Control over Financial Reporting

 

No change in our internal control over financial reporting occurred during the fiscal quarter ended December 31, 2013 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

 

	27

 

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

For information relating to legal proceedings, see Note 7 to the condensed consolidated financial statements contained in Part I, Item 1 of this quarterly report on Form 10-Q.

 

Item 1A. Risk Factors

 

There were no material changes from the risk factors disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2013 and filed with the Securities and Exchange Commission on August 9, 2013 and our Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 and filed with the Securities and Exchange Commission on November 8, 2013.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

None.

 

Item 3. Defaults Upon Senior Securities

 

None.

 

Item 4. Mine Safety Disclosures

 

None.

 

Item 5. Other Information

 

On February 3, 2014, we became aware that our complaint filed with the U.S. Court of Federal Claims relating to the Federal Deposit Insurance Corporation contract was dismissed by the court. On February 4, 2014, we filed an appeal with the Court of Appeals for the Federal Circuit.

 

 

	28

 

Item 6. Exhibits

 

Exhibit No.		Description
31.1	+	Rule 13a-14(a)/15d-14(a) Certification of the Chief Executive Officer
31.2	+	Rule 13a-14(a)/15d-14(a) Certification of the Chief Financial Officer
32.1	+	Certification of the Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)
32.2	+	Certification of the Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350)

 

+

Filed herewith

 

 

	29

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the county of Fairfax, Virginia on the 7th day of February, 2014.

 

	SRA INTERNATIONAL, INC.
	By:		/S/ WILLIAM L. BALLHAUS
			William L. Ballhaus President and Chief Executive Officer (Principal Executive Officer)
	By:		/S/ RICHARD J. NADEAU
			Richard J. Nadeau Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

 

 

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