1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
We prepared our interim condensed consolidated financial statements that accompany these notes in conformity with accounting principles generally accepted in the United States of America for interim information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.
The interim financial information is unaudited, but reflects all normal adjustments that are, in our opinion, necessary to provide a fair statement of results for the interim periods presented. Certain information and note disclosures normally included in the annual financial statements have been condensed or omitted pursuant to those instructions. This interim information should be read in conjunction with the consolidated financial statements for the year ended
December 31, 2015
, contained in our Annual Report on Form 10-K and filed with the Securities and Exchange Commission on
March 15, 2016
. Interim results may not be indicative of our full fiscal year performance.
Corporate Organization
The KEYW Holding Corporation (“Holdco” or "KEYW") was incorporated in Maryland in December 2009. Holdco is a holding company and conducts its operations through The KEYW Corporation (“Opco”), and its wholly owned subsidiaries. As further described in Note 12, during the second quarter of 2016, the Company sold the Hexis Cyber Solutions, Inc. ("Hexis") business in its entirety.
KEYW is a highly specialized provider of mission-critical cybersecurity, cyber superiority and geospatial intelligence solutions to US Government defense, intelligence and national security agencies and commercial enterprises. Our core capabilities include solutions, services and products to support the collection, processing, analysis, and use of intelligence data and information in the domains of cyberspace and geospace. Our solutions are designed to respond to meet the critical needs for agile intelligence in the cyber age and to assist the US government in national security priorities.
Principles of Consolidation
The condensed consolidated financial statements include the transactions of KEYW, Opco, Hexis and their wholly owned subsidiaries from the date of their acquisition. All intercompany accounts and transactions have been eliminated.
Revenue Recognition
We derive the majority of our revenue from time-and-materials, firm-fixed-price, cost-plus-fixed-fee, cost-plus-award-fee contracts and software licensing and maintenance.
Revenues from cost reimbursable contracts are recorded as reimbursable costs are incurred, including an estimated share of the applicable contractual fees earned. For performance-based fees under cost reimbursable contracts, we recognize the relevant portion of the expected fee to be awarded by the client at the time such fee can be reasonably estimated, based on factors such as prior award experience and communications with the client regarding performance. For cost reimbursable contracts with performance-based fee incentives, we recognize the relevant portion of the fee upon customer approval. For time-and-materials contracts, revenue is recognized based on billable rates times hours delivered plus materials and other reimbursable costs incurred. For firm-fixed-price service contracts, revenue is recognized using proportional performance based on the estimated total costs of the project. For fixed-price production contracts, revenue and cost are recognized at a rate per unit as the units are delivered or by other methods to measure services provided. This method of accounting requires estimating the total revenues and total contract costs of the contract. During the performance of contracts, these estimates are periodically reviewed and revisions are made as required. The impact on revenue and contract profit as a result of these revisions is included in the periods in which the revisions are made. This method can result in the deferral of costs or the deferral of profit on these contracts. Because we assume the risk of performing a fixed-price contract at a set price, the failure to accurately estimate ultimate costs or to control costs during performance of the work could result, and in some instances has resulted, in reduced profits or losses on such contracts. Estimated losses on contracts at completion are recognized when identified.
Contract revenue recognition inherently involves estimation. Examples of estimates include the contemplated level of effort to accomplish the tasks under the contract, the cost of the effort, and an ongoing assessment of our progress toward completing the contract. From time to time, as part of our management processes, facts develop that require us to revise our estimated total costs or revenue. To the extent that a revised estimate affects contract profit or revenue previously recognized, we record the cumulative effect of the revision in the period in which the facts requiring the revision become known.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
In certain circumstances, and based on correspondence with the end customer, management authorizes work to commence or to continue on a contract option, addition or amendment prior to the signing of formal modifications or amendments. We recognize revenue to the extent it is probable that the formal modifications or amendments will be finalized in a timely manner and that it is probable that the revenue recognized will be collected.
The Company recognizes software licenses, maintenance or related professional services revenue only when there is persuasive evidence of an arrangement, delivery to the customer has occurred, the fee is fixed and determinable and collectability is reasonably assured.
Revenue from software arrangements is allocated to each element of the arrangement based on the relative fair values of the elements, such as software licenses, upgrades, enhancements, maintenance contract types and type of service delivered, installation or training. The determination of fair value is based on objective evidence that is specific to the vendor (“VSOE”). The Company determines VSOE for each element based on historical stand-alone sales to third parties for the elements contained in the initial agreement. In determining VSOE, the Company requires that a substantial majority of the selling process fall within a fairly narrow pricing range. The Company has established VSOE of fair value for maintenance and professional services. If VSOE of fair value for each element of the arrangement does not exist, all revenue from the arrangement is deferred until such time as VSOE of fair value exists or until all elements of the arrangement are delivered, except in those circumstances in which the residual method may be used as described below.
Some software products are licensed on a perpetual basis. In addition, the Company provides maintenance under a separate maintenance agreement, typically for twelve months. Maintenance includes technical support and unspecified software upgrades and enhancements if and when available. Revenue from perpetual software licenses is recognized under the relative selling price method, as noted above, for arrangements in which the software is sold with maintenance and/or professional services. When software is licensed on a subscription basis, revenue is recognized ratably over the length of the subscription, typically one to three years.
Software arrangements that also include hardware where the relative hardware and software components are both essential to the functionality are accounted for under ASC 605-25, “Multiple Element Arrangements”. As such, we allocate revenue to each unit of accounting based on an estimated selling price at the arrangement inception. The estimated selling price for each element is based upon the following hierarchy: VSOE of selling price, if available, third-party evidence ("TPE') of selling price if VSOE of selling price is not available, or best estimate of selling price ("BESP") if neither VSOE of selling price nor TPE of selling price are available. The total arrangement consideration is allocated to each separate unit of accounting using the relative estimated selling prices of each unit based on the aforementioned selling price hierarchy. We limit the amount of revenue recognized for delivered elements to an amount that is not contingent upon future delivery of additional products or services or meeting of any specified performance conditions.
To determine the estimated selling price in multiple element arrangements, the Company determines VSOE for each element based on historical stand-alone sales to third parties for the elements contained in the initial agreement, as noted above. If VSOE of selling price cannot be established for a deliverable, we establish TPE of selling price by evaluating similar and interchangeable competitor products or services in standalone arrangements with similarly situated partners. However, as our products contain a significant element of proprietary technology and offer substantially different features and functionality from our competitors, we are unable to obtain comparable pricing of our competitors’ products with similar functionality on a stand-alone basis. Therefore, we have not been able to obtain reliable evidence of TPE of selling price. If neither VSOE nor TPE of selling price can be established for a deliverable, we establish BESP primarily based on our pricing model and our go-to-market strategy or use our established list price.
Cost of Revenues
Cost of revenues consists primarily of compensation expenses for program personnel, the fringe benefits associated with this compensation and other direct expenses incurred to complete programs, including cost of materials and subcontract efforts.
Inventories
Inventories are valued at the lower of cost or net realizable value. Our inventory consists of specialty products that we manufacture on a limited quantity basis for our customers. As of
September 30, 2016
and
December 31, 2015
, we had an inventory reserve balance of
$0.4 million
and
$0.1 million
respectively, for certain products where the market has not developed as expected.
Accounts Receivable
Accounts receivable are stated at the amount management expects to collect from outstanding balances. Invoice terms range from net
10
days to net
90
days. Management provides for probable uncollectible amounts through a charge to earnings and a credit to a valuation allowance (allowance for doubtful accounts) based on its assessment of the current status of individual accounts.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
Balances that are still outstanding after management has used reasonable collection efforts are written-off through a charge to the valuation allowance and a credit to accounts receivable.
Property and Equipment
All property and equipment are stated at acquisition cost or, in the case of self-constructed assets, the cost of labor and a reasonable allocation of overhead costs (no general and administrative costs are included). The cost of maintenance and repairs, which do not significantly improve or extend the life of the respective assets, are charged to operations as incurred.
Provisions for depreciation and amortization are computed on either a straight-line method or accelerated methods acceptable under accounting principles generally accepted in the United States of America (“US GAAP”) over the estimated useful lives of between
3
and
7 years
. Leasehold improvements are amortized over the lesser of the lives of the underlying leases or the estimated useful lives of the assets.
Lease Incentives
As part of entering into certain building leases, the lessors have provided the Company with tenant improvement allowances. Typically, such allowances represent reimbursements to the Company for tenant improvements made to the leased space. These improvements are capitalized as property and equipment, and the allowances are classified as a deferred lease incentive liability. This incentive is considered a reduction of rental expense by the lessee over the term of the lease and is recognized on a straight-line basis over the same term.
Software Development Costs
Costs of internally developed software for resale are expensed until the technological feasibility of the software product has been established. In accordance with the Accounting Standards Codification (“ASC”), software development costs are capitalized and amortized over the product's estimated useful life. As of
September 30, 2016
and
December 31, 2015
, we had capitalized
$2.1 million
and
$1.9 million
of software development costs, respectively. Capitalized software development costs are amortized using the greater of the straight-line method or as a percentage of revenue recognized from the sale of the capitalized software. During the
nine months ended September 30, 2016
, the Company recorded related amortization of
$0.4 million
. During the
nine months ended September 30, 2015
, the Company had
no
computer software amortization costs, due to the products still being under development and not having been placed into service during those periods.
Long-Lived Assets (Excluding Goodwill)
The Company follows the provisions of Financial Accounting Standards Board ("FASB") ASC topic 360-10-35,
Impairment or Disposal of Long-Lived Assets,
in accounting for long-lived assets such as property and equipment and intangible assets subject to amortization. The guidance requires that long-lived assets be reviewed for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The possibility of impairment exists if the sum of the long-term undiscounted cash flows is less than the carrying amount of the long-lived asset being evaluated. Impairment losses are measured as the difference between the carrying value of long-lived assets and their fair market value based on discounted cash flows of the related assets. Impairment losses are treated as permanent reductions in the carrying amount of the assets. The Company has not recorded any long-lived asset impairments since inception.
Goodwill
Purchase price in excess of the fair value of tangible assets and identifiable intangible assets acquired and liabilities assumed in a business combination is recorded as goodwill. In accordance with FASB ASC Topic 350-20,
Goodwill
, the Company tests for impairment at least annually. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit's carrying amount, including goodwill, to the fair value of the reporting unit. The fair value of each reporting unit is estimated using either qualitative analysis or a combination of income and market approaches. If the carrying amount of the unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any.
Determining the fair value of a reporting unit is a judgment involving significant estimates and assumptions. These estimates and assumptions include revenue growth rates, operating margins and working capital requirements used to calculate projected future cash flows, risk-adjusted discount rates, selected multiples, control premiums and future economic and market conditions. We have based our fair value estimates on assumptions that we believe to be reasonable, but that are unpredictable and inherently uncertain. The Company evaluated goodwill at the beginning of the fourth quarter of fiscal year 2015 and found no impairment to the carrying value of goodwill.
Late in the fourth quarter of 2015, management began to evaluate strategic alternatives related to its Commercial Cyber Solutions segment. The Company began exploring the possibility of minority investments into this segment, the sale of the entire segment or the possibility of altering the level of investment going forward. The Company also implemented cost reductions in this segment subsequent to December 31, 2015, to reduce the funding required to cover operating losses and further committed to a reduced
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
level of internal funding targeted to a range of
$5 million
to
$7 million
for 2016. Management believed these activities represented a triggering event and further believed that it was more likely than not that as a result of these activities and information, which came to light subsequent to December 31, 2015, relative to indications from potential transaction parties, that the fair value of the segment had fallen below the carrying value. As such the Company completed a Step 1 analysis of goodwill, which indicated the fair value was lower than the segment’s carrying value. In accordance with ASC 350-20-35-18 management elected to make an estimate of the goodwill impairment charge as of December 31, 2015, subject to finalizing a Step 2 analysis during the first quarter of 2016. The estimate was based on a number of factors including the estimated fair value of working capital assets, fixed assets, customer relationships, deferred revenue and developed technology as well as relevant market related data. The estimated impairment to goodwill for the Commercial Cyber Solutions segment as of December 31, 2015, was
$8 million
. During the first quarter of 2016 the Company completed the Step 2 analysis of goodwill for the Commercial Cyber Solutions segment and determined that no additional goodwill impairment charge was needed as of December 31, 2015.
Subsequently, during the first quarter of 2016 the Company determined to divest of the Commercial Cyber Solutions segment (see Note 12). In accordance with applicable accounting guidance for the disposal of long-lived assets, the results of the Commercial Cyber Solutions segment are presented as discontinued operations. As a result, the goodwill attributable to the Commercial Cyber Solutions segment as of
December 31, 2015
, is excluded from the following table and is reported as part of assets of discontinued operations in the Condensed Consolidated Balance Sheets.
In March 2016, the Company completed the divestiture of its systems engineering and technical assistance ("SETA") business to Quantech Services, Inc. for
$11.2 million
in cash (see Note 12). The Company has determined that the relative fair value of the goodwill associated with the SETA business disposed of was
$7.2 million
.
A summary of the changes to goodwill, is as follows (in thousands):
|
|
|
|
|
|
|
Goodwill as of December 31, 2015
|
$
|
297,223
|
|
Acquisition
|
782
|
|
Divestiture
|
(7,233
|
)
|
Goodwill as of September 30, 2016
|
$
|
290,772
|
|
Intangibles
Intangible assets consist of the value of customer related intangibles acquired in various acquisitions. Intangible assets are amortized on a straight line basis over their estimated useful lives unless the pattern of usage of the benefits indicates an alternative method is more representative. The useful lives of the intangibles range from
one
to
seven
years.
Concentrations of Credit Risk
We maintain cash balances that at times exceed the federally insured limit on a per financial institution basis. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk related to cash. In addition, we have credit risk associated with our receivables that arise in the ordinary course of business. In excess of
90%
of our total revenue is derived from contracts where the end customer is the US Government and any disruption to cash payments from our end customer could put the Company at risk.
Use of Estimates
Management uses estimates and assumptions in preparing these condensed consolidated financial statements in accordance with US GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Significant estimates include useful lives of long-lived assets, revenue based on proportional performance, VSOE, TPE, BESP, inventory obsolescence reserves, accruals for medical self-insurance incurred but not reported ("IBNR") claims, income taxes and stock compensation expense. Actual results could vary from the estimates that were used.
Cash and Cash Equivalents
We consider all highly liquid investments purchased with original maturities of three months or less, when purchased, to be cash equivalents.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
Fair Value of Financial Instruments
The balance sheet includes various financial instruments consisting of cash and cash equivalents, accounts receivable, and accounts payable. The fair values of these instruments approximate the carrying values due to the short maturity of these instruments. The balance sheet also includes our convertible senior notes, which the fair value is estimated using a market approach with Level 2 inputs.
Research and Development
Internally funded research and development expenses are expensed as incurred and are included in operating expenses in the accompanying condensed consolidated statement of operations. In accordance with FASB ASC Topic 730,
Research and Development
, such costs consist primarily of payroll, materials, subcontractor and an allocation of overhead costs related to product development. Research and development costs totaled
$1.2 million
and
$0.7 million
for the
three months ended September 30, 2016
and 2015, respectively. Research and development costs totaled
$3.3 million
and
$2.2 million
for the
nine months ended September 30, 2016
and
2015
, respectively.
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enacted date. In evaluating our ability to realize our deferred tax assets, we consider all available positive and negative evidence, including cumulative historic earnings, reversal of deferred tax liabilities, projected taxable income, and tax planning strategies. The assumptions utilized in evaluating both positive and negative evidence require the use of significant judgment concerning our business plans.
For a tax position that meets the more-likely-than-not recognition threshold, the Company initially and subsequently measures the tax liability or benefit as the largest amount that it judges to have a greater than
50%
likelihood of being realized upon ultimate settlement with a taxing authority. The liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances, such as the progress of tax audits, case law developments and new or emerging legislation. Such adjustments are recognized entirely in the period in which they are identified. The effective tax rate includes the net impact of changes in the liability for unrecognized tax obligations or benefits and subsequent adjustments as considered appropriate by management. The Company's policy is to record interest and penalties as an increase in the liability for uncertain tax obligations or benefits and a corresponding increase to the income tax provision. No such adjustments were recorded during the
three or nine months
ended
September 30, 2016
or the respective periods for 2015.
(Loss) Earnings per Share
Basic net (loss) earnings per share is calculated by dividing net (loss) income by the weighted average number of common shares outstanding during the period. Diluted (loss) earnings per share is calculated by dividing net (loss) income by the diluted weighted average common shares, which reflects the potential dilution of stock options, warrants, and contingently issuable shares that could share in our (loss) income if the securities were exercised.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
The following table presents the calculation of basic and diluted net loss per share (in thousands except per share amounts):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended September 30,
|
|
Nine months ended September 30,
|
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Net Income (Loss) from Continuing Operations
|
$
|
3,504
|
|
|
$
|
(7,129
|
)
|
|
$
|
4,978
|
|
|
$
|
(28,005
|
)
|
Loss on Discontinued Operations
|
(1,040
|
)
|
|
(875
|
)
|
|
(27,496
|
)
|
|
(17,522
|
)
|
Net Income (Loss)
|
$
|
2,464
|
|
|
$
|
(8,004
|
)
|
|
$
|
(22,518
|
)
|
|
$
|
(45,527
|
)
|
Weighted average shares – basic
|
40,955
|
|
|
39,145
|
|
|
40,368
|
|
|
38,340
|
|
Effect of dilutive potential common shares
|
351
|
|
|
—
|
|
|
563
|
|
|
—
|
|
Weighted average shares – diluted
|
41,306
|
|
|
39,145
|
|
|
40,931
|
|
|
38,340
|
|
|
|
|
|
|
|
|
|
Net Income (Loss) per share from Continuing Operations – basic
|
$
|
0.09
|
|
|
$
|
(0.18
|
)
|
|
$
|
0.12
|
|
|
$
|
(0.73
|
)
|
Net Loss per share from Discontinued Operations – basic
|
(0.03
|
)
|
|
(0.02
|
)
|
|
(0.68
|
)
|
|
(0.46
|
)
|
Net Income (Loss) per share – basic
|
$
|
0.06
|
|
|
$
|
(0.20
|
)
|
|
$
|
(0.56
|
)
|
|
$
|
(1.19
|
)
|
Net Income (Loss) per share from Continuing Operations – diluted
|
$
|
0.09
|
|
|
$
|
(0.18
|
)
|
|
$
|
0.12
|
|
|
$
|
(0.73
|
)
|
Net Loss per share from Discontinued Operations – diluted
|
(0.03
|
)
|
|
(0.02
|
)
|
|
(0.67
|
)
|
|
(0.46
|
)
|
Net Income (Loss) per share – diluted
|
$
|
0.06
|
|
|
$
|
(0.20
|
)
|
|
$
|
(0.55
|
)
|
|
$
|
(1.19
|
)
|
Outstanding options and warrants, total
|
1,591
|
|
|
5,358
|
|
|
1,591
|
|
|
5,358
|
|
Employee equity share options, restricted shares and warrants granted by the Company are treated as potential common shares outstanding in computing diluted earnings (loss) per share. Diluted shares outstanding include the dilutive effect of in-the-money options and in-the-money warrants and unvested restricted stock. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible, are collectively assumed to be used to repurchase shares.
The Company uses the treasury stock method for calculating any potential dilutive effect of the conversion spread of our Convertible Senior Notes due 2019 (the "Notes") on diluted earnings per share, if applicable. The conversion spread will have a dilutive impact on diluted earnings per share of common stock when the average market price of our common stock for a given period exceeds the Notes' conversion price of
$14.83
. For the three and
nine months ended September 30, 2016
,
10.1 million
shares related to the Notes have been excluded from the computation of diluted earnings per share as the effect would be anti-dilutive since the conversion price of the Notes exceeded the average market price of the Company’s common shares for the three and
nine months ended September 30, 2016
.
Stock Based Compensation
A
s discussed in Note 10, the Company applies the fair value method that requires all share-based payments to employees and non-employee directors to be expensed over their requisite service period based on their fair value at the grant date, using a prescribed option-pricing model. The expense recognized is based on the straight-line amortization of each individually vesting piece of a grant. The calculated expense is required to be based upon awards that ultimately vest and we have accordingly reduced the expense by estimated forfeitures.
The following assumptions were used for share-based awards granted.
Dividend Yield — The Company has never declared or paid dividends on its common stock and has no plans to do so in the foreseeable future.
Risk-Free Interest Rate — Risk-free interest rate is based on US Treasury zero-coupon issues with a remaining term approximating the expected life of the share-based award term assumed at the date of grant.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
Expected Volatility — Volatility is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. The Company's expected volatility is based on its historical volatility for a period that approximates the estimated life of the share-based awards.
Expected Term of the Share-based Awards — This is the period of time that the share-based awards granted are expected to remain unexercised. The Company estimates the expected life of the share-based award term based on the expected tenure of employees and historical experience.
Forfeiture Rate — The Company estimates the percentage of share-based awards granted that are expected to be forfeited or canceled on an annual basis before share-based awards become fully vested. The Company uses the forfeiture rate that is a blend of past turnover data and a projection of expected results over the following twelve-month period based on projected levels of operations and headcount levels at various classification levels with the Company.
Segment Reporting
FASB ASC Section 280,
Segment Reporting
, establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that these enterprises report selected information about operating segments in interim financial reports. The guidance also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company defines its reportable segments based on the way the chief operating decision maker ("CODM"), currently its chief executive officer, manages the operations of the Company for allocating resources and assessing performance. The Company has historically operated
two
segments, Government Solutions and Commercial Cyber Solutions. The Company disposed of the assets and liabilities of its Commercial Cyber Solutions during the second quarter of 2016, (see Note 12). Therefore, we have also reclassified the results of our Hexis business, which comprised our entire Commercial Cyber Solutions reportable segment, as discontinued operations for all periods presented in our condensed consolidated financial statements and determined that the Company is now operating
one
reporting segment.
Recently Issued Accounting Pronouncements
I
n May 2014, the FASB issued ASU 2014-09,
Revenue from Contracts with Customers
, an accounting pronouncement related to revenue recognition (FASB ASC Topic 606), which amends the guidance in former ASC Topic 605,
Revenue Recognition
, and provides a single, comprehensive revenue recognition model for all contracts with customers. This standard contains principles that an entity will apply to determine the measurement of revenue and timing of when it is recognized. The entity will recognize revenue to reflect the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. This pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The FASB also approved permitting early adoption of the standard, but not before January 1, 2017. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.
In November 2015, the FASB issued ASU 2015-17,
Income Taxes
, amending the accounting for income taxes and requiring all deferred tax assets and liabilities to be classified as non-current on the consolidated balance sheet. The ASU is effective for reporting periods beginning after December 15, 2016, with early adoption permitted. The ASU may be adopted either prospectively or retrospectively. We are currently evaluating the method of adoption and the impact on our consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02,
Leases
. The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.
In March 2016, the FASB issued ASU 2016-09,
Improvements to Employee Share-Based Payment Accounting
. The amendments in ASU 2016-09 to Topic 718, Compensation - Stock Compensation, require recognition of all excess tax benefits and tax deficiencies through income tax expense or benefit in the income statement. Other amendments in this new standard include guidance on the classification of share-based payment transactions in the statement of cash flows and an option to account for forfeitures of share-based awards as they occur rather than estimating the compensation cost based on the number of awards that are expected to vest. The amendments in the new standard are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted in any interim or annual period. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15,
Statement of Cash Flows.
The new guidance addresses the diversity in practice in how certain cash receipts and payments are classified in the statement of cash flows, including debt prepayment or extinguishment
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
costs, the settlement of contingent liabilities arising from a business combination, proceeds from insurance settlements, and distributions from certain equity method investees. The guidance is effective for interim and annual periods beginning after December 15, 2017, and early adoption is permitted. The guidance requires application using a retrospective transition method. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.
2. ACQUISITIONS
The Company has completed multiple acquisitions since it began operations in August 2008. The acquisitions were made to increase the Company’s skill sets and to create sufficient critical mass to be able to serve as prime contractor on significant contracts. Most of the acquisitions resulted in the Company recording goodwill and other intangibles. The goodwill was primarily a result of acquiring cleared personnel to expand our presence with our main customers. The value of having that personnel generated the majority of the goodwill from the transactions and drove much of the purchase price in addition to other identified intangibles including contracts, customer relationships, contract rights and intellectual property. Several of the acquisitions involved issuance of Company common stock. The stock price for acquisition accounting was determined by the fair value on the acquisition date.
Details of the acquisitions completed since January 1, 2015 are outlined below:
During the first and second quarters of 2015, the Company acquired Milestone Intelligence Group, Inc. ("Milestone"), Ponte Technologies, LLC ("Ponte Tech") and certain assets of Innovative Engineering Solutions, Inc. in three separate transactions. The total consideration paid for these three acquisitions was
$21.4 million
in cash and
242,250
shares of KEYW stock valued at
$1.9 million
. These acquisitions are not considered material to the financial results of KEYW.
During the second quarter of 2016, in conjunction with the Milestone Intelligence Group acquisition earnout, the Company issued
129,530
shares of KEYW common stock with an approximate value of
$1 million
.
The total purchase price paid for the 2015 acquisitions described above have been allocated as follows (in thousands):
|
|
|
|
|
|
2015 Acquisitions
|
|
|
Cash
|
$
|
643
|
|
Current assets, net of cash acquired
|
1,533
|
|
Fixed assets
|
155
|
|
Intangibles
|
5,059
|
|
Goodwill
|
16,706
|
|
Total Assets Acquired
|
24,096
|
|
Total Liabilities Assumed
|
844
|
|
Net Assets Acquired
|
$
|
23,252
|
|
Net Cash Paid
|
$
|
20,751
|
|
Equity Issued
|
1,858
|
|
Actual Cash Paid
|
$
|
21,394
|
|
During the third quarter of 2016, the Company acquired a geospatial intelligence collection business for a preliminary purchase price of
$3.9 million
. The purchase price included
$2.5 million
of cash and contingent cash consideration of up to
$2.5 million
, preliminarily valued at
$1.4 million
as of the acquisition date. The contingent cash consideration is based on the acquired company achieving certain revenue targets by March 31, 2018.
All acquisitions were accounted for using the acquisition method of accounting. Results of operations for each acquired entity were included in the condensed consolidated financial statements from the date of each acquisition.
Pro forma income statements are not presented for the
nine months ended September 30, 2016
and
2015
, as there were no material acquisitions during that period.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
3. FAIR VALUE MEASUREMENTS
The fair value hierarchy prioritizes the inputs to valuation techniques used to measure the fair value of financial assets and liabilities on a recurring basis into three broad levels:
|
|
|
Level 1
|
Inputs are unadjusted quoted prices in active markets for identical assets or liabilities the Company has the ability to access.
|
|
|
|
Level 2
|
Inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
|
|
|
|
Level 3
|
Inputs are unobservable for the asset or liability and rely on management’s own assumptions about what market participants would use in pricing the asset or liability.
|
At
September 30, 2016
, we did not have any assets or liabilities measured at fair value on a recurring basis that would require disclosure based on the fair value hierarchy of valuation techniques.
4. RECEIVABLES
Receivables consist of the following:
|
|
|
|
|
|
|
|
|
|
September 30, 2016
|
|
December 31, 2015
|
|
(In thousands)
|
Receivables
|
|
|
|
|
|
Billed
|
$
|
30,055
|
|
|
$
|
36,278
|
|
Unbilled
|
17,417
|
|
|
16,833
|
|
Total Receivables
|
$
|
47,472
|
|
|
$
|
53,111
|
|
Unbilled amounts represent revenue recognized which could not be billed by the period end based on contract terms. The majority of the unbilled amounts were billed subsequent to period end. Retainages typically exist at the end of a project and/or if there is a disputed item on an invoice received by a customer, at
September 30, 2016
and
December 31, 2015
, retained amounts are insignificant and are expected to be collected subsequent to the balance sheet date.
Most of the Company's revenues are derived from contracts with the US Government, in which we are either the prime contractor or a subcontractor, depending on the award.
5. INVENTORIES
Inventories at
September 30, 2016
and
December 31, 2015
consist of work in process at various stages of production and finished goods. This inventory, which consists primarily of mobile communications devices, aeroptic cameras and radars, are valued at the lower of cost (as calculated using the weighted average method) or net realizable value. The cost of the work in process consists of materials put into production, the cost of labor and an allocation of overhead costs. At
September 30, 2016
, and
December 31, 2015
, we had an inventory reserve balance of
$0.4 million
and
$0.1 million
respectively, for certain products where the market has not developed as expected.
6. PREPAID EXPENSES
Prepaid expenses at
September 30, 2016
and
December 31, 2015
, primarily consist of prepaid insurance, deferred financing costs and software licenses.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
7. PROPERTY AND EQUIPMENT
Property and equipment are as follows:
|
|
|
|
|
|
|
|
|
|
September 30, 2016
|
|
December 31, 2015
|
|
(In thousands)
|
Property and Equipment
|
|
|
|
|
|
Aircraft
|
$
|
15,883
|
|
|
$
|
11,296
|
|
Leasehold Improvements
|
23,032
|
|
|
22,469
|
|
Manufacturing Equipment
|
5,799
|
|
|
5,452
|
|
Software Development Costs
|
2,132
|
|
|
1,942
|
|
Office Equipment
|
13,174
|
|
|
10,967
|
|
Total
|
60,020
|
|
|
52,126
|
|
Accumulated Depreciation
|
(27,960
|
)
|
|
(23,376
|
)
|
Property and Equipment, net
|
$
|
32,060
|
|
|
$
|
28,750
|
|
Depreciation expense charged to operations was
$1.5 million
and
$1.5 million
for the
three months ended September 30, 2016
and
2015
, respectively. Depreciation expense charged to operations was
$5.0 million
and
$4.3 million
for the
nine months ended
September 30, 2016
and
2015
, respectively.
8. AMORTIZATION OF INTANGIBLE ASSETS
Intangible assets consisted of the following:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2016 (In thousands)
|
Intangible
|
|
Gross Carrying
Value
|
|
Accumulated
Amortization
|
|
Net Carrying
Value
|
Customer Relationships and Contracts
|
|
$
|
26,837
|
|
|
$
|
(19,441
|
)
|
|
$
|
7,396
|
|
Software Technology and Other
|
|
2,162
|
|
|
(37
|
)
|
|
2,125
|
|
|
|
$
|
28,999
|
|
|
$
|
(19,478
|
)
|
|
$
|
9,521
|
|
The Company recorded amortization expense of
$1.5 million
and
$1.8 million
for the
three months ended September 30, 2016
and
2015
, respectively. The Company recorded amortization expense of
$4.5 million
and
$5.4 million
for the
nine months ended September 30, 2016
and
2015
, respectively.
|
|
|
|
|
|
|
|
|
|
|
|
Estimated future intangible amortization expense by year as of September 30, 2016 (In thousands):
|
Remainder of 2016
|
|
2017
|
|
2018
|
|
2019
|
|
2020
|
|
Thereafter
|
$1,650
|
|
$5,555
|
|
$996
|
|
$626
|
|
$416
|
|
$278
|
9. DEBT
2.5% Convertible Senior Notes
In July 2014, the Company initially issued
$130.0 million
aggregate principal amount of Notes in an underwritten public offering. The Company granted an option to the underwriters to purchase up to an additional
$19.5 million
aggregate principal amount of Notes, which was subsequently exercised in full in August 2014, resulting in a total issuance of
$149.5 million
aggregate principal amount of Notes. The Notes bear interest at a rate of
2.50%
per annum on the principal amount, payable semi-annually in arrears on January 15 and July 15 of each year, beginning on January 15, 2015, to holders of record at the close of business on the preceding January 1 and July 1, respectively. The Notes mature on July 15, 2019, unless earlier repurchased or converted. The Company may not redeem the Notes prior to their stated maturity date.
Holders of the Notes may convert their notes at their option under the following circumstances: (i) during any calendar quarter commencing after the calendar quarter ending September 30, 2014, if the last reported sale price of the Company’s common stock for at least
20
trading days (whether or not consecutive) in the period of
30
consecutive trading days ending on the last trading
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
day of the immediately preceding calendar quarter is greater than or equal to
130%
of the conversion price for the Notes on each applicable trading day; (ii) during the five business day period immediately after any five consecutive trading day period in which the trading price per
$1,000
principal amount of Notes for each trading day of that period was less than
98%
of the product of the last reported sale price of Company’s common stock and the conversion rate for the Notes for each such trading day; or (iii) upon the occurrence of specified corporate events. On and after January 15, 2019, holders may convert their Notes at any time, regardless of the foregoing circumstances.
Upon conversion, the Company will settle the Notes in cash, shares of Company common stock or a combination of cash and shares of Company common stock, at the Company’s election. The Notes have an initial conversion rate of
67.41
shares of common shares per
$1,000
principal amount of the Notes, which is equal to an initial conversion price of approximately
$14.83
per common share. The conversion price is subject to adjustments upon the occurrence of certain specified events.
In addition, upon the occurrence of a fundamental change (as defined in the Indenture), holders of the Notes may require the Company to repurchase the Notes at a purchase price of
100%
of the principal amount of the Notes, plus accrued and unpaid interest, if any, to, but excluding, the fundamental change repurchase date.
The Company incurred approximately
$5.7 million
of debt issuance costs during the third quarter of 2014 as a result of issuing the Notes. Of the approximately
$5.7 million
incurred, the Company recorded
$4.6 million
and
$1.1 million
to deferred financing costs and additional paid-in capital, respectively, in proportion to the allocation of the proceeds of the Notes as discussed below. The Company is amortizing the deferred financing costs over the contractual term of the Notes using the effective interest method.
The Company used the net proceeds from the Notes to repay the outstanding balances under the credit facility the Company entered into in 2012, (the "2012 Credit Agreement"). Net proceeds also will be used for working capital, capital expenditures and other general corporate purposes, including potential acquisitions.
The Company allocated the
$149.5 million
proceeds from the issuance of the Notes between long-term debt, the liability component, and additional paid-in-capital, the equity component, in the amounts of
$122.1 million
and
$27.4 million
, respectively. The initial value of liability component was measured using the nonconvertible debt interest rate. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the face value of the Notes. Since the Company must still settle the Notes at face value at or prior to maturity, the Company will accrete the liability component to its face value resulting in additional non-cash interest expense being recognized in the Company’s condensed consolidated statements of operations while the Notes remain outstanding. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.
As of
September 30, 2016
, the outstanding principal of the Notes was
$149.5 million
, the unamortized debt discount was
$16.0 million
, the unamortized deferred financing costs were
$2.6 million
and the carrying amount of the liability component was
$130.9 million
, which was recorded as long-term debt within the Company’s condensed consolidated balance sheet. As of
September 30, 2016
, the fair value of the liability component relating to the Notes, based on a market approach, was approximately
$133.9 million
and represents a Level 2 valuation.
During the
three months ended September 30, 2016
, the Company recognized
$2.5 million
of interest expense related to the Notes, which included
$1.3 million
for noncash interest expense relating to the debt discount and
$0.2 million
relating to amortization of deferred financing costs. During the
nine months ended September 30, 2016
, the Company recognized
$7.5 million
of interest expense related to the Notes, which included
$4.0 million
for noncash interest expense relating to the debt discount and
$0.7 million
relating to amortization of deferred financing costs. During the
three months ended September 30, 2015
, the Company recognized
$2.5 million
of interest expense related to the Notes, which included
$1.3 million
for noncash interest expense relating to the debt discount and
$0.2 million
relating to amortization of deferred financing costs. During the
nine months ended September 30, 2015
, the Company recognized
$7.4 million
of interest expense relating to the Notes, which included
$3.8 million
for noncash interest expense relating to the debt discount and
$0.7 million
relating to amortization of deferred financing costs.
Capped Call
During the third quarter of 2014 in conjunction with the issuance of the Notes, the Company paid approximately
$18.4 million
to enter into capped call transactions with respect to its common shares, (the "Capped Call Transactions"), with certain financial institutions. The Capped Call Transactions generally are expected to reduce the potential dilution to the Company's common stock upon conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount of any converted Notes, as the case may be, in the event that the market price of the common stock is greater than the strike price of the Capped Call Transactions, initially set at
$14.83
, with such reduction of potential dilution subject to a cap based on the cap price, which is initially set at
$19.38
. The strike price and cap price are subject to anti-dilution adjustments under the terms of the Capped Call Transactions.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
2014 Revolving Credit Facility
In July 2014, the Company, as guarantor and certain of the Company's subsidiaries, entered into a senior secured credit agreement, (the "2014 Credit Agreement") with certain financial institutions. The 2014 Credit Agreement provided the Company a
$42.5 million
revolving credit facility (the "2014 Revolver"). The 2014 Revolver includes a swing line loan commitment of up to
$10 million
and a letter of credit facility of up to
$15 million
. The Company has not drawn on the 2014 Credit Agreement.
Borrowings under the 2014 Credit Agreement bear interest at a rate equal to an applicable rate plus, at the Company’s option, either (a) adjusted LIBOR or (b) a base rate. The Company is required to pay a facility fee to the Lenders for any unused commitments and customary letter of credit fees.
The 2014 Revolver will mature on the earlier to occur of (i) the
fifth
anniversary of the closing of the 2014 Credit Agreement, and (ii) the date that is
180 days
prior to the maturity date of the Notes unless the Notes are converted into equity, repaid, refinanced or otherwise satisfied on terms permitted under the 2014 Credit Agreement. The Company may voluntarily repay outstanding loans under the 2014 Revolver at any time without premium or penalty, subject to customary fees in the case of prepayment of LIBOR based loans.
In February 2016, the Company amended the 2014 Credit Agreement. The amendment permanently decreases the amount available under the revolver to
$20.0 million
. At
September 30, 2016
, we were in compliance with all of our debt covenants under the 2014 Credit Agreement. As a result of the amendment permanently decreasing the amount available under the revolver the Company wrote off
$0.3 million
of unamortized deferred financing costs, which were included as part of interest expense.
10. STOCK - BASED COMPENSATION
At September 30, 2016, KEYW had stock-based compensation awards outstanding under the following plans: The 2008 Stock Incentive Plan ("2008 Plan"), The 2009 Stock Incentive Plan ("2009 Plan") and The Amended and Restated 2013 Stock Incentive Plan ("2013 Plan").
On August 15, 2012, the shareholders approved the 2013 KEYW Holding Corporation Stock Incentive Plan. The 2013 plan, which took effect on
January 1, 2013
, replaced the 2009 Plan and provides for the issuance of additional restricted stock, stock options, and restricted stock units. Pursuant to an amendment approved by the Company’s shareholders on August 12, 2015, the number of shares available for issuance under the 2013 Plan was increased by
700,000
shares to a maximum of
2,700,000
shares.
|
|
|
|
2013 Stock Incentive Plan
|
|
Total equity available to issue
|
2,700,000
|
|
Total equity outstanding or exercised
|
1,998,998
|
|
Total equity remaining for future grants
|
701,002
|
|
The Company has awarded stock options, restricted stock awards, restricted stock units and Long-Term Incentive Stock grants to attract and retain highly qualified officers, directors, key employees, and other persons, and to motivate such persons to serve the Company and to expend maximum effort to improve the business results and earnings of the Company, by providing to such persons an opportunity to acquire or increase a direct proprietary interest in the operations and future success of the Company and align employee and shareholder interests.
Stock Options
The Company has issued stock option awards that vest over varying periods, ranging from
three
to
five years
, and have a
ten
-year life. We estimate the fair value of stock options using the Black-Scholes option-pricing model. We use historical data to determine volatility of our stock. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards. All option awards terminate within
ninety days
or sooner after termination of service with the Company, except as provided in certain circumstances under our senior executive employment agreements.
No stock options were issued during the
nine months ended September 30, 2016
. Historically all equity issuances have an exercise price at market value or higher based upon our publicly-traded share price on the date of grant. The Black-Scholes model requires inputs related to dividend yield, risk-free interest rate, expected volatility and forfeitures in order to price the option values.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
2016 Stock Option Exchanges
During 2016, the Company completed two shareholder-approved exchanges of options.
During July 2016, the Company completed an offer to exchange certain previously granted employee stock options for new restricted stock units on a three-for-one basis with certain eligible employees, excluding members of the Board of Directors and named executive officers.
390,570
options were exchanged for
130,265
restricted stock units. The restricted stock units granted will vest over a one year period from the date of the exchange. The exchange resulted in a modification charge of approximately
$0.1 million
, which will be recognized over the one year vesting period of the new restricted stock units. Terms of the restricted stock units are discussed in more detail below.
During August 2016, the Company completed an exchange of certain previously granted employee stock options for new Long-Term Incentive Shares on a three-for-one basis with certain members of the non-executive leadership team, excluding members of the Board of Directors and named executive officers.
178,900
options were exchanged for
59,636
Long-Term Incentive Shares. The Long-Term Incentive Shares granted have a weighted-average requisite service period of
2.2
years. There was
no
modification charge as result of the exchange. Long-Term Incentive Shares are discussed in more detail below.
A summary of stock option activity for the period ended
September 30, 2016
is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
Number of
Shares
|
|
Option Exercise
Price
|
|
Weighted Average
Exercise Price
|
Options Outstanding January 1, 2016
|
2,332,889
|
|
|
|
|
|
Granted
|
—
|
|
|
—
|
|
|
—
|
|
Exercised
|
(60,050
|
)
|
|
$5.00 - $9.25
|
|
|
$
|
6.41
|
|
Cancelled
|
(1,000,167
|
)
|
|
$5.00 - $17.71
|
|
|
$
|
13.59
|
|
Options Outstanding September 30, 2016
|
1,272,672
|
|
|
|
|
|
|
As of
September 30, 2016
, outstanding stock options were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercise Price
|
Options
Outstanding
|
|
Intrinsic
Value
|
|
Options
Vested
|
|
Intrinsic
Value
|
|
Weighted Average
Remaining Life
(Years)
|
$5.00 – $5.50
|
272,450
|
|
|
$
|
1,539,448
|
|
|
272,450
|
|
|
$
|
1,539,448
|
|
|
2.85
|
$6.90 – $7.66
|
204,261
|
|
|
736,580
|
|
|
204,261
|
|
|
736,580
|
|
|
5.32
|
$7.96 – $8.14
|
67,700
|
|
|
207,580
|
|
|
67,700
|
|
|
207,580
|
|
|
5.12
|
$9.17 – $10.98
|
142,263
|
|
|
197,275
|
|
|
142,263
|
|
|
197,275
|
|
|
4.30
|
$11.18 - $11.99
|
154,025
|
|
|
—
|
|
|
153,900
|
|
|
—
|
|
|
5.86
|
$12.28 - $12.97
|
111,849
|
|
|
—
|
|
|
111,849
|
|
|
—
|
|
|
6.04
|
$13.00 - $13.48
|
58,500
|
|
|
—
|
|
|
57,876
|
|
|
—
|
|
|
6.36
|
$14.03 - $14.88
|
82,124
|
|
|
—
|
|
|
82,124
|
|
|
—
|
|
|
4.57
|
$16.08 - $17.11
|
179,500
|
|
|
—
|
|
|
134,939
|
|
|
—
|
|
|
7.35
|
|
1,272,672
|
|
|
$
|
2,680,883
|
|
|
1,227,362
|
|
|
$
|
2,680,883
|
|
|
|
Restricted Stock Awards
During the first nine months of 2016, the Company issued
183,791
shares of restricted common stock as part of employee incentive plans and to new hires. The Company issued
74,100
shares of restricted common stock to existing employees under the long-term incentive plan and an additional
79,441
shares of restricted common stock to board members. The Company also issued
29,250
shares of restricted common stock to new employees. An additional
1,000
shares were issued to an existing employee as a discretionary award. The expense for these shares will be recognized over the vesting life of each individual tranche of shares based upon the fair value of a share of stock at the date of grant. All of the above shares cliff vest after
three years
, except for the shares issued to our board members. The shares granted to board members vest 50% on the 1st anniversary of the grant date and 50% on the 2nd anniversary of the grant date.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
The following table summarizes the activities for our unvested restricted stock awards for the
nine months ended September 30, 2016
:
|
|
|
|
|
Unvested Shares
|
Outstanding January 1, 2016
|
959,733
|
|
Granted
|
183,791
|
|
Vested
|
(258,582
|
)
|
Cancelled
|
(159,193
|
)
|
Outstanding September 30, 2016
|
725,749
|
|
Restricted Stock Units
As discussed above, the Company issued
130,265
restricted stock units as part of the July 2016 option exchange. The following table summarizes the activities for our unvested restricted stock units for the
nine months ended September 30, 2016
:
|
|
|
|
|
Unvested Units
|
Outstanding January 1, 2016
|
—
|
|
Granted
|
130,265
|
|
Vested
|
(334
|
)
|
Cancelled
|
(5,168
|
)
|
Outstanding September 30, 2016
|
124,763
|
|
Long-Term Incentive Share Grants
During the first nine months of 2016, the Company granted
1,040,000
Long-Term Incentive Shares.
535,000
of these shares were granted to new hires,
445,364
were granted as part of employee incentive plans and
59,636
were granted as part of the August 2016 option exchange, discussed above. Of the grants to new hires
505,000
of the Long-Term Incentive Shares were granted outside of the 2013 Plan, in accordance with Section 4(2) of the Securities Act of 1933. The Long-Term Incentive Shares will be subject to a two-year holding period following the vesting date. The granting and vesting of the Long-Term Incentive Shares will be contingent upon the employees continued employment with KEYW, subject to acceleration upon certain events. We measured the fair value of the Long-Term Incentive Share grants using a Monte Carlo simulation approach with the following assumptions: risk-free interest rate ranging between
1.01%
and
1.76%
, expected volatility ranging between
53.15%
and
59.5%
and dividend yield of
0%
. The grant-date fair value of these long term incentive shares is
$5.2 million
. The expense for these grants will be recognized over the requisite service period of each individual tranche, which have weighted average requisite service periods range from
2.2 years
and
4.9 years
.
The following table summarizes the activities for our Long-Term Incentive Share grants for the
nine months ended September 30, 2016
:
|
|
|
|
|
Unvested Long-Term Incentive Shares
|
Outstanding January 1, 2016
|
400,000
|
|
Granted
|
1,040,000
|
|
Outstanding September 30, 2016
|
1,440,000
|
|
These Long-Term Incentive Share grants consist of five vesting tranches, which will vest at any time prior to the fifth anniversary of their grant date that the closing market price of the Company’s common stock over any 30 consecutive trading days is at or greater than the target price, set forth in the table below.
|
|
|
Target Price Per Share
|
Long-Term Incentive Shares
|
$13.00
|
180,000
|
$16.00
|
180,000
|
$20.00
|
360,000
|
$25.00
|
360,000
|
$30.00
|
360,000
|
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
All stock based compensation has been recorded as part of operating expenses. Accounting standards require forfeitures to be estimated at the time an award is granted and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Share-based compensation expense is based on awards ultimately expected to vest and has been reduced for estimated forfeitures for the periods ended
September 30, 2016
and
2015
. The Company recorded total stock compensation expense of
$1.0 million
and
$1.1 million
for the
three months ended September 30, 2016
and
2015
, respectively. The Company recorded total stock compensation expense of
$2.2 million
and
$4.4 million
for the
nine months ended September 30, 2016
and
2015
, respectively. The total unrecognized stock compensation expense at
September 30, 2016
, is approximately
$9.6 million
, which is expected to be recognized over a weighted average period of
2.6 years
.
11. WARRANTS
During the
nine months ended September 30, 2016
, warrant holders exercised
2,213,935
warrants, with
349,144
exercised for cash and
1,864,791
exercised cashlessly. The warrants exercised for cash were exercised at $
5.50
per share. The total cash received from these exercises was
$1.9 million
. Under our warrant agreements, warrants may be exercised cashlessly based on the average price of the Company's common stock for the five days prior to exercise. Under this methodology the warrants that were exercised cashlessly were exchanged for
471,504
shares of the Company's common stock.
As of
September 30, 2016
, outstanding warrants were as follows:
|
|
|
|
|
|
|
|
|
|
|
|
Exercise Price
|
|
Warrants Outstanding
|
|
Warrants Vested
|
|
Weighted Average
Remaining Life (Years)
|
$
|
9.25
|
|
|
160,000
|
|
|
160,000
|
|
|
0.46
|
$
|
12.65
|
|
|
158,116
|
|
|
158,116
|
|
|
3.16
|
|
|
|
318,116
|
|
|
318,116
|
|
|
|
12. BUSINESSES HELD FOR SALE, DISCONTINUED OPERATIONS AND DISPOSITIONS
Dispositions - Discontinued Operations
In our annual report for the fiscal year ended December 31, 2015, we announced that we were exploring strategic alternatives for our Hexis business. Our Hexis business marketed our HawkEye products and related maintenance and services to the commercial cyber sector and comprised our entire former Commercial Cyber Solutions reportable segment. As previously announced, the alternatives that we were evaluating included seeking an investment in or an outright sale of this business in one or more transactions to unrelated buyers.
During the first quarter of fiscal year 2016, we completed our assessment of the alternatives for the Hexis business and, the Company committed to a plan to sell the business in its entirety. Management and the Board decided that although the Hexis business had consistently demonstrated impressive capabilities in its product suites and gained some commercial traction in the marketplace, the progress had not been sufficient for the Company to continue to operate the business in the manner that it has been operated in the past. Accordingly, management decided that rather than continuing to commit the resources and investment that would be required to continue to grow the Hexis business, the Company would sell the business and refocus the use of resources and its strategy on the Government Solutions business.
The Company determined that the assets and liabilities of its Commercial Cyber Solutions business meet the held for sale criteria set forth in ASC 360 - Property, Plant, and Equipment, as (a) management with appropriate authority has committed to a plan to sell the disposal group, (b) the disposal group is available for immediate sale in its present condition, (c) actions to locate a buyer have been initiated, (d) management has concluded that the sale and transfer of the disposal is probable to occur within one year, (e) the disposal group is being actively marketed at a price that is reasonable in relation to its current fair value, and (f) management has concluded that it is unlikely that the Company will make significant changes to or withdraw its plan to sell the disposal group.
ASC 360 requires a disposal group that is reclassified as held for sale, but not yet sold, to be measured at the lower of its carrying amount or fair value less cost to sell. In addition, an entity ceases to recognize depreciation on assets included in the disposal group that has been classified as held for sale. Based upon this guidance, we compared the carrying value of the Hexis business to our estimate of the disposal group’s fair value less cost to sell. Development of an estimate of the fair value of the disposal group in this circumstance is complex, as consideration must be given to the nature of the potential sales transaction(s); the composition of the disposal group; market participant expectations regarding the performance, risks, and required returns of and for the disposal group; and the expected results of ongoing negotiations with potential buyers of the business - amongst other factors. These considerations require the application of assumptions that are deemed to be Level 3 inputs on the fair value hierarchy. Based upon our estimate of the fair value of the disposal group less cost to sale, we determined that the carrying value of the Hexis
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
business was greater than its fair value less cost to sell and, accordingly, we recorded an additional impairment charge of
$7.0 million
to our Commercial Cyber Solutions segment goodwill based on the preliminary asset purchase agreements and additional expense of
$2.3 million
representing the estimated cost to sell the disposal group. As a result we reduced the recorded carrying value of our Commercial Cyber Segment to
$3.1 million
at the end of the first quarter of 2016. The sale of the Hexis Cyber Solutions product lines during the second quarter of 2016, resulted in a pre-tax loss of approximately
$5.5 million
. This loss reflects the difference between the consideration received for Hexis and the net carrying value of the business less transaction costs.
We further note that from inception of the Hexis business through our decision to sell the business, we had been a relatively new participant in the commercial cyber security market. Accordingly, the Hexis business had historically required a significant amount of investment of the Company’s resources. The business has historically incurred losses and was expected to continue to include losses until we gained sufficient traction within the marketplace. Following completion of the sale of the Hexis business, the Company will no longer offer or market any products or services to the commercial cyber security market and does not intend to make similar investments in the development of commercial cyber security products. After consideration of these factors, we concluded that our decision to sell the Hexis business constitutes a strategic shift that is expected to have a major effect on our operations and financial results. Therefore, we also reclassified the results of our Hexis business, which comprised our entire Commercial Cyber Solutions reportable segment, as discontinued operations for all periods presented in our condensed consolidated financial statements. The results of our Commercial Cyber Solutions segment previously included the allocation of certain general corporate costs, which we have reallocated to our remaining continuing operations on a retrospective basis.
The following table summarizes the aggregate carrying amounts of the major classes of Hexis assets and liabilities included in discontinued operations as of
September 30, 2016
and
December 31, 2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
September 30, 2016
|
|
December 31, 2015
|
Receivables
|
$
|
3,072
|
|
|
$
|
5,256
|
|
Inventories, net
|
—
|
|
|
2,164
|
|
Prepaid expenses
|
—
|
|
|
345
|
|
Property and equipment, net
|
—
|
|
|
5,341
|
|
Goodwill
|
—
|
|
|
7,467
|
|
Other intangibles, net
|
—
|
|
|
2,600
|
|
Total assets classified as held for sale:
|
$
|
3,072
|
|
|
$
|
23,173
|
|
|
|
|
|
Accounts payable and other accrued expenses
|
$
|
2,620
|
|
|
$
|
3,686
|
|
Deferred revenue
|
—
|
|
|
3,398
|
|
Total liabilities held for sale
|
$
|
2,620
|
|
|
$
|
7,084
|
|
The following table provides a summary of the operating results of Hexis, which we have reflected as discontinued operations for the three and
nine months ended September 30, 2016
and
2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
Three months ended September 30,
|
Nine months ended September 30,
|
|
2016
|
|
2015
|
2016
|
|
2015
|
Revenues
|
16
|
|
|
2,998
|
|
2,894
|
|
|
8,301
|
|
Costs of Revenues, excluding amortization
|
194
|
|
|
1,189
|
|
1,881
|
|
|
3,159
|
|
Operating expenses
|
866
|
|
|
9,485
|
|
16,133
|
|
|
30,141
|
|
Impairment of goodwill
|
—
|
|
|
—
|
|
6,980
|
|
|
—
|
|
Intangible amortization expense
|
—
|
|
|
1,178
|
|
381
|
|
|
3,703
|
|
Loss on disposal of Hexis
|
—
|
|
|
—
|
|
5,509
|
|
|
—
|
|
Loss before Income Taxes from Discontinued Operations
|
(1,044
|
)
|
|
(8,854
|
)
|
(27,990
|
)
|
|
(28,702
|
)
|
Income Tax Benefit, net on Discontinued Operations
|
(4
|
)
|
|
(7,979
|
)
|
(494
|
)
|
|
(11,180
|
)
|
Loss on Discontinued Operations
|
(1,040
|
)
|
|
(875
|
)
|
(27,496
|
)
|
|
(17,522
|
)
|
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
The following table presents the operating and investing cash flows of our discontinued Hexis business for the
nine months ended September 30, 2016
and
2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
Nine months ended September 30,
|
|
2016
|
|
2015
|
Non-Cash Operating Items
|
|
|
|
Depreciation and amortization expense
|
$
|
1,016
|
|
|
$
|
5,546
|
|
Impairment of Commercial Cyber Solutions Goodwill
|
6,980
|
|
|
—
|
|
Loss on disposal of long-lived assets
|
3,568
|
|
|
—
|
|
Cash Flows from Investing Activities
|
|
|
|
Purchases of property and equipment
|
(471
|
)
|
|
718
|
|
Proceeds from Hexis asset divestiture
|
$
|
5,000
|
|
|
$
|
—
|
|
Other Dispositions
In March 2016, we completed the sale of our SETA business to Quantech Services, Inc. for approximately
$11.2 million
in cash. The SETA business was not deemed an individually significant component of our Company. Management decided to sell the SETA business in connection with the ongoing strategic review of our overall business, through which we have determined that the growth potential of both KEYW's core business and the SETA business could be maximized if the two businesses were separated. The sale of SETA eliminated KEYW’s conflicts at two key government agencies and will allow our Company to focus 100% on technology development opportunities across the Intelligence Community. However, the sale of SETA did not represent a strategic shift that will have a major effect on our operations and financial results and, accordingly, the business historical results and the gain on sale were classified within continuing operations on our Condensed Consolidated Statements of Operations. Because the sale of SETA was not deemed a discontinued operation, its assets and liabilities of the business were not reclassified as held for sale on our December 31, 2015, balance sheet.
In connection with the sale of SETA, we recognized a pre-tax gain of approximately
$3.0 million
. This gain was reported within non-operating expense, net
on our condensed consolidated statement of operations and reflects the difference between the consideration received for SETA and the net carrying value of the business less transaction costs. The net carrying value of the SETA business was deemed to include approximately
$7.2 million
of goodwill that, in accordance with ASC 350, was allocated to the business based upon the relative fair values of SETA and the overall Government Solutions reporting unit within which the SETA business has been historically reported.
13. INCOME TAXES
The Company’s quarterly provision for income taxes is measured using an estimated annual effective tax rate adjusted for discrete items that occur within the quarter. The provision for income taxes for continuing operations in the quarter ended
September 30, 2016
and 2015 was a benefit of
$1.9 million
and an expense of
$7.9 million
, respectively. For the
nine months ended September 30, 2016
and
2015
, the provision for income taxes for continuing operations was an expense of
$2.5 million
and
$32.8 million
, respectively. The provision for income tax expense for the three and
nine months ended September 30, 2015
, includes the recording of a valuation allowance of
$19.6 million
to as a discrete item resulting in an effective rate that is significantly different than the Company’s statutory rate. The effective tax rate on income from continuing operations was
(115.2)%
and
1,054.4%
for the
three months ended September 30, 2016
and
2015
, respectively. The effective tax rate on income from continuing operations was
33.4%
and
684.0%
for the
nine months ended September 30, 2016
and
2015
, respectively.
A full valuation allowance was established during the second quarter 2015 due to the uncertainty of the utilization of deferred tax assets in future periods. In evaluating the Company’s ability to realize the deferred tax assets we considered all available positive and negative evidence, including cumulative historical earnings, reversal of temporary difference, projected taxable income and tax planning strategies. The Company’s negative evidence currently outweighs its positive evidence, therefore it is more likely than not that we will not realize a significant portion of our deferred tax asset. The amount of the deferred tax asset to be realized in the future could however be adjusted if objective negative evidence is no longer present.
14. SUBSEQUENT EVENTS
In connection with the preparation of its condensed consolidated financial statements for the
nine months ended September 30, 2016
, the Company has evaluated events that occurred subsequent to
September 30, 2016
, to determine whether any of these
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES
events required recognition or disclosure in the
three or nine months
of the
2016
condensed consolidated financial statements. The Company is not aware of any subsequent events which would require recognition or disclosure in the condensed consolidated financial statements.
THE KEYW HOLDING CORPORATION AND SUBSIDIARIES