filings.toolsItem 8. Financial Statements and Supplementary Data
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Item 8. Financial Statements and Supplementary Data
LEIDOS HOLDINGS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Financial statement schedules are omitted because they are not applicable or the required information is presented in the consolidated financial statements or the notes thereto.
Leidos Holdings, Inc. Annual Report - 46
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the shareholders and the Board of Directors of Leidos Holdings, Inc.
Reston, Virginia
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Leidos Holdings, Inc. and subsidiaries (the "Company") as of January 3, 2020 and December 28, 2018, the related consolidated statements of income, comprehensive income, equity, and cash flows, for the fiscal years ended January 3, 2020, December 28, 2018, and December 29, 2017, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of January 3, 2020 and December 28, 2018, and the results of its operations and its cash flows for the fiscal years ended January 3, 2020, December 28, 2018, and December 29, 2017, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of January 3, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 18, 2020, expressed an unqualified opinion on the Company's internal control over financial reporting.
Basis for Opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.
Critical Audit Matter
The critical audit matter communicated below is a matter arising from the current-period audit of the financial statements that was communicated or required to be communicated to the audit committee and that (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates.
Revenues - Refer to Note 3 and Note 4 to the financial statements
Critical Audit Matter Description
The Company recognizes revenue on service-based contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the Company performs the promised services. The accounting conclusions for contracts involves judgment, particularly as it relates to determining whether multiple promises within a single contract are highly interrelated and represent a single performance obligation and whether or not the Company is acting as a principal in the fulfillment of the identified performance obligations on certain contracts.
Leidos Holdings, Inc. Annual Report - 47
On firm-fixed-price (FFP) contracts requiring system integration, and cost-plus contracts with variable consideration, revenue is recognized over time using a method that measures the extent of progress towards completion of a performance obligation, principally using a cost-input method (referred to as the cost-to-cost method). Under the cost-to-cost method, revenue is recognized based on the proportion of total costs incurred to estimated total costs-at-completion ("EAC"). A performance obligation's EAC includes all direct costs such as materials, labor, subcontract costs, overhead and a ratable portion of general and administrative costs. The accounting for these contracts involves judgment, particularly as it relates to the process of estimating total costs for the performance obligation.
Given the judgments necessary to determine whether multiple promises within a single contract represent a single performance obligation, whether or not the Company is acting as principal in the fulfillment of the identified performance obligations on certain contracts, and estimates of total costs for the performance obligations that recognize revenue using the cost-to-cost method, auditing such accounting conclusions and estimates required extensive audit effort due to the volume and complexity of these contracts and a high degree of auditor judgment when performing audit procedures and evaluating the results of those procedures.
How the Critical Audit Matter Was Addressed in the Audit
Our audit procedures related to management’s conclusions regarding whether multiple promises within a single contract represent a single performance obligation, whether or not the Company is acting as a principal or an agent in fulfilling identified performance obligations on certain contracts, and estimates of total costs for the performance obligations that recognize revenue using the cost-to-cost method included the following, among others:
| • | We tested the effectiveness of controls over contract revenue, including management’s controls over the initial setup of new contract arrangements and the estimates of total costs for identified performance obligations. |
| • | We tested recorded revenue using a combination of analytical procedures and detailed contract testing. |
| • | For a selection of contracts, including all new significant contracts, we performed elements of the following for each contract: |
| ◦ | Evaluated the terms and conditions of each contract and the appropriateness of the accounting treatment in accordance with generally accepted accounting principles, by: |
| ▪ | Inspecting the executed contract to verify that the facts on which management’s conclusions were reached were consistent with the actual terms and conditions of the contract. |
| ▪ | Evaluating the contract within the context of the five-step model prescribed by ASC 606 and that management’s conclusions were appropriate by evaluating the nature of the promises within the contract, the interrelationship of the promised services provided, the pattern by which obligations are fulfilled, the number of performance obligations identified, and which party is acting as principal in the fulfillment of the identified performance obligations. |
| ▪ | Involving industry experts in evaluating the appropriateness of management’s conclusions. |
| ◦ | Tested the mathematical accuracy of management’s calculation of revenue for the performance obligation. |
| • | We analyzed cumulative adjustments recorded during the year and tested a sample to determine that the adjustments were the result of changes in facts and circumstances and not estimates that were previously inaccurate. |
/s/ Deloitte & Touche LLP
McLean, Virginia
February 18, 2020
We have served as the Company's auditor since fiscal 2000.
Leidos Holdings, Inc. Annual Report - 48
LEIDOS HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
| January 3, 2020 | December 28, 2018 | |||||||
| (in millions) | ||||||||
| ASSETS | ||||||||
| Cash and cash equivalents | $ | 668 | $ | 327 | ||||
| Receivables, net | 1,734 | 1,877 | ||||||
| Other current assets | 410 | 543 | ||||||
| Assets held for sale | — | 92 | ||||||
| Total current assets | 2,812 | 2,839 | ||||||
| Property, plant and equipment, net | 287 | 237 | ||||||
| Intangible assets, net | 530 | 652 | ||||||
| Goodwill | 4,912 | 4,860 | ||||||
| Operating lease right-of-use assets, net | 400 | — | ||||||
| Other assets | 426 | 182 | ||||||
| $ | 9,367 | $ | 8,770 | |||||
| LIABILITIES AND EQUITY | ||||||||
| Accounts payable and accrued liabilities | $ | 1,837 | $ | 1,491 | ||||
| Accrued payroll and employee benefits | 435 | 473 | ||||||
| Long-term debt, current portion | 61 | 72 | ||||||
| Liabilities held for sale | — | 23 | ||||||
| Total current liabilities | 2,333 | 2,059 | ||||||
| Long-term debt, net of current portion | 2,925 | 3,052 | ||||||
| Operating lease liabilities | 326 | — | ||||||
| Deferred tax liabilities | 184 | 170 | ||||||
| Other long-term liabilities | 182 | 178 | ||||||
| Commitments and contingencies (Notes 13, 25 and 26) | ||||||||
| Stockholders’ equity: | ||||||||
| Preferred stock, $.0001 par value, 10 million shares authorized and no shares issued and outstanding at January 3, 2020 and December 28, 2018 | — | — | ||||||
| Common stock, $.0001 par value, 500 million shares authorized, 141 million and 146 million shares issued and outstanding at January 3, 2020 and December 28, 2018, respectively | — | — | ||||||
| Additional paid-in capital | 2,587 | 2,966 | ||||||
| Retained earnings | 896 | 372 | ||||||
| Accumulated other comprehensive loss | (70 | ) | (30 | ) | ||||
| Total Leidos stockholders’ equity | 3,413 | 3,308 | ||||||
| Non-controlling interest | 4 | 3 | ||||||
| Total equity | 3,417 | 3,311 | ||||||
| $ | 9,367 | $ | 8,770 |
See accompanying notes to consolidated financial statements.
Leidos Holdings, Inc. Annual Report - 49
LEIDOS HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF INCOME
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions, except per share amounts) | ||||||||||||
| Revenues | $ | 11,094 | $ | 10,194 | $ | 10,170 | ||||||
| Cost of revenues | 9,546 | 8,690 | 8,738 | |||||||||
| Selling, general and administrative expenses | 689 | 729 | 737 | |||||||||
| Bad debt expense and recoveries | (40 | ) | — | 10 | ||||||||
| Acquisition, integration and restructuring costs | 5 | 37 | 139 | |||||||||
| Asset impairment charges | — | 7 | — | |||||||||
| Equity earnings of non-consolidated subsidiaries | (18 | ) | (18 | ) | (13 | ) | ||||||
| Operating income | 912 | 749 | 559 | |||||||||
| Non-operating expense: | ||||||||||||
| Interest expense, net | (133 | ) | (138 | ) | (140 | ) | ||||||
| Other income (expense), net | 87 | (1 | ) | (26 | ) | |||||||
| Income before income taxes | 866 | 610 | 393 | |||||||||
| Income tax expense | (196 | ) | (28 | ) | (29 | ) | ||||||
| Net income | 670 | 582 | 364 | |||||||||
| Less: net income (loss) attributable to non-controlling interest | 3 | 1 | (2 | ) | ||||||||
| Net income attributable to Leidos common stockholders | $ | 667 | $ | 581 | $ | 366 | ||||||
| Earnings per share: | ||||||||||||
| Basic | $ | 4.66 | $ | 3.85 | $ | 2.41 | ||||||
| Diluted | 4.60 | 3.80 | 2.38 |
See accompanying notes to consolidated financial statements.
Leidos Holdings, Inc. Annual Report - 50
LEIDOS HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Net income | $ | 670 | $ | 582 | $ | 364 | ||||||
| Foreign currency translation adjustments | 8 | (61 | ) | 24 | ||||||||
| Unrecognized (loss) gain on derivative instruments | (47 | ) | (10 | ) | 4 | |||||||
| Pension adjustments | (1 | ) | (1 | ) | 9 | |||||||
| Total other comprehensive (loss) income, net of taxes | (40 | ) | (72 | ) | 37 | |||||||
| Comprehensive income | 630 | 510 | 401 | |||||||||
| Less: comprehensive income (loss) attributable to non-controlling interest | 3 | 1 | (2 | ) | ||||||||
| Comprehensive income attributable to Leidos common stockholders | $ | 627 | $ | 509 | $ | 403 |
See accompanying notes to consolidated financial statements.
Leidos Holdings, Inc. Annual Report - 51
LEIDOS HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF EQUITY
| Shares of common stock | Additional paid-in capital | Accumulated earnings (deficit) | Accumulated other comprehensive (loss) income | Leidos Holdings, Inc. stockholders' equity | Non-controlling interest | Total | |||||||||||||||||||||
| (in millions, except for per share amounts) | |||||||||||||||||||||||||||
| Balance at December 30, 2016 | 150 | $ | 3,316 | $ | (177 | ) | $ | (4 | ) | $ | 3,135 | $ | 12 | $ | 3,147 | ||||||||||||
| Net income (loss) | — | — | 366 | — | 366 | (2 | ) | 364 | |||||||||||||||||||
| Other comprehensive income, net of taxes | — | — | — | 37 | 37 | — | 37 | ||||||||||||||||||||
| Issuances of stock (less forfeitures) | 1 | 16 | — | — | 16 | — | 16 | ||||||||||||||||||||
| Repurchases of stock and other | — | (31 | ) | — | — | (31 | ) | — | (31 | ) | |||||||||||||||||
| Dividends of $1.28 per share | — | — | (196 | ) | — | (196 | ) | — | (196 | ) | |||||||||||||||||
| Stock-based compensation | — | 43 | — | — | 43 | — | 43 | ||||||||||||||||||||
| Adjustment to original purchase price allocation | — | — | — | — | — | 3 | 3 | ||||||||||||||||||||
| Balance at December 29, 2017 | 151 | 3,344 | (7 | ) | 33 | 3,370 | 13 | 3,383 | |||||||||||||||||||
| Cumulative adjustments related to ASU adoptions | — | — | (8 | ) | 9 | 1 | — | 1 | |||||||||||||||||||
| Balance at December 30, 2017 | 151 | 3,344 | (15 | ) | 42 | 3,371 | 13 | 3,384 | |||||||||||||||||||
| Net income | — | — | 581 | — | 581 | 1 | 582 | ||||||||||||||||||||
| Other comprehensive loss, net of taxes | — | — | — | (72 | ) | (72 | ) | — | (72 | ) | |||||||||||||||||
| Issuances of stock (less forfeitures) | 1 | 17 | — | — | 17 | — | 17 | ||||||||||||||||||||
| Repurchases of stock and other | (6 | ) | (438 | ) | — | — | (438 | ) | — | (438 | ) | ||||||||||||||||
| Dividends of $1.28 per share | — | — | (194 | ) | — | (194 | ) | — | (194 | ) | |||||||||||||||||
| Stock-based compensation | — | 44 | — | — | 44 | — | 44 | ||||||||||||||||||||
| Purchase of a noncontrolling interest | — | (1 | ) | — | — | (1 | ) | (10 | ) | (11 | ) | ||||||||||||||||
| Other | — | — | — | — | — | (1 | ) | (1 | ) | ||||||||||||||||||
| Balance at December 28, 2018 | 146 | 2,966 | 372 | (30 | ) | 3,308 | 3 | 3,311 | |||||||||||||||||||
| Cumulative adjustments related to ASU adoptions | — | — | 48 | — | 48 | — | 48 | ||||||||||||||||||||
| Balance at December 29, 2018 | 146 | 2,966 | 420 | (30 | ) | 3,356 | 3 | 3,359 | |||||||||||||||||||
| Net income | — | — | 667 | — | 667 | 3 | 670 | ||||||||||||||||||||
| Other comprehensive loss, net of taxes | — | — | — | (40 | ) | (40 | ) | — | (40 | ) | |||||||||||||||||
| Issuances of stock (less forfeitures) | 1 | 28 | — | — | 28 | — | 28 | ||||||||||||||||||||
| Repurchases of stock and other | (6 | ) | (458 | ) | — | — | (458 | ) | — | (458 | ) | ||||||||||||||||
| Dividends of $1.32 per share | — | — | (191 | ) | — | (191 | ) | — | (191 | ) | |||||||||||||||||
| Stock-based compensation | — | 52 | — | — | 52 | — | 52 | ||||||||||||||||||||
| Other | — | (1 | ) | — | — | (1 | ) | (2 | ) | (3 | ) | ||||||||||||||||
| Balance at January 3, 2020 | 141 | $ | 2,587 | $ | 896 | $ | (70 | ) | $ | 3,413 | $ | 4 | $ | 3,417 |
See accompanying notes to consolidated financial statements.
Leidos Holdings, Inc. Annual Report - 52
LEIDOS HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Cash flows from operations: | ||||||||||||
| Net income | $ | 670 | $ | 582 | $ | 364 | ||||||
| Adjustments to reconcile net income to net cash provided by operations: | ||||||||||||
| Gain on sale of businesses | (88 | ) | — | — | ||||||||
| Depreciation and amortization | 234 | 257 | 336 | |||||||||
| Amortization of equity method investments | 11 | 10 | 14 | |||||||||
| Stock-based compensation | 52 | 44 | 43 | |||||||||
| Deferred income taxes | 18 | (49 | ) | 132 | ||||||||
| Bad debt expense | 12 | — | 10 | |||||||||
| Non-cash interest (income) expense | (10 | ) | 6 | 12 | ||||||||
| Asset impairment charges | — | 7 | — | |||||||||
| Promissory note impairment | — | — | 33 | |||||||||
| Other | 2 | 2 | 9 | |||||||||
| Change in assets and liabilities, net of effects of acquisitions and dispositions: | ||||||||||||
| Receivables | 116 | (58 | ) | (191 | ) | |||||||
| Other current assets | (44 | ) | (73 | ) | (76 | ) | ||||||
| Accounts payable and accrued liabilities | 116 | (46 | ) | 152 | ||||||||
| Accrued payroll and employee benefits | (29 | ) | (12 | ) | 8 | |||||||
| Income taxes receivable/payable | 34 | 10 | (283 | ) | ||||||||
| Other long-term assets | (49 | ) | 56 | 36 | ||||||||
| Other long-term liabilities | (53 | ) | 32 | (73 | ) | |||||||
| Net cash provided by operating activities | 992 | 768 | 526 | |||||||||
| Cash flows from investing activities: | ||||||||||||
| Proceeds from disposition of businesses | 178 | — | — | |||||||||
| Payments for property, equipment and software | (121 | ) | (73 | ) | (81 | ) | ||||||
| Net proceeds from sale of assets | 96 | — | 8 | |||||||||
| Acquisitions of businesses | (94 | ) | (81 | ) | — | |||||||
| Collections on promissory notes | 5 | 40 | 2 | |||||||||
| Other | 1 | — | — | |||||||||
| Net cash provided by (used in) investing activities | 65 | (114 | ) | (71 | ) | |||||||
| Cash flows from financing activities: | ||||||||||||
| Repurchases of stock and other | (458 | ) | (438 | ) | (31 | ) | ||||||
| Dividend payments | (198 | ) | (198 | ) | (198 | ) | ||||||
| Payments of long-term debt | (80 | ) | (59 | ) | (209 | ) | ||||||
| Proceeds from issuances of stock | 27 | 14 | 13 | |||||||||
| Payment of tax indemnification liability | — | (23 | ) | — | ||||||||
| Proceeds from real estate financing transaction | — | 14 | — | |||||||||
| Other | — | (17 | ) | (4 | ) | |||||||
| Net cash used in financing activities | (709 | ) | (707 | ) | (429 | ) |
Leidos Holdings, Inc. Annual Report - 53
LEIDOS HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS [CONTINUED]
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Net increase (decrease) in cash, cash equivalents and restricted cash | 348 | (53 | ) | 26 | ||||||||
| Cash, cash equivalents and restricted cash at beginning of year | 369 | 422 | 396 | |||||||||
| Cash, cash equivalents and restricted cash at end of year | $ | 717 | $ | 369 | $ | 422 |
See accompanying notes to consolidated financial statements.
Leidos Holdings, Inc. Annual Report - 54
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1—Nature of Operations and Basis of Presentation
Nature of Operations and Basis of Presentation
Leidos Holdings, Inc. ("Leidos"), a Delaware corporation, is a holding company whose direct 100%-owned subsidiary and principal operating company is Leidos, Inc. Leidos is a FORTUNE 500® science, engineering and information technology company that provides services and solutions in the defense, intelligence, civil and health markets. Leidos' domestic customers include the U.S. Department of Defense ("DoD"), the U.S. Intelligence Community, the U.S. Department of Homeland Security ("DHS"), the Federal Aviation Administration, the Department of Veterans Affairs and many other U.S. government civilian agencies, as well as state and local government agencies. Leidos' international customers include foreign governments and their agencies, primarily located in Australia and the United Kingdom ("U.K."). Unless indicated otherwise, references to the "Company," "we," "us" and "our" refer collectively to Leidos Holdings, Inc. and its consolidated subsidiaries. The Company operates in three reportable segments: Defense Solutions, Civil and Health. Additionally, the Company separately presents the unallocable costs associated with corporate functions as Corporate.
The Company has an 88% controlling interest in Mission Support Alliance, LLC ("MSA"), a joint venture with Centerra Group, LLC, which includes 41% purchased from Jacobs Group, LLC on January 26, 2018. The Company consolidates the financial results for MSA into its consolidated financial statements.
The consolidated financial statements also include the balances of all voting interest entities in which Leidos has a controlling voting interest ("subsidiaries") and a variable interest entity ("VIE") in which Leidos is the primary beneficiary. The consolidated balances of the Company's VIE are not material to the Company's consolidated financial statements for the periods presented. Intercompany accounts and transactions between consolidated companies have been eliminated in consolidation.
Effective December 29, 2018, the Company adopted the requirements of Accounting Standards Update ("ASU") 2016-02 using the modified retrospective approach (see "Note 2—Accounting Standards"). Comparative information for the prior fiscal year has not been retrospectively adjusted.
Effective the beginning of fiscal 2019, certain contracts were reassigned between the Civil and Defense Solutions reportable segments (see "Note 24—Business Segments"). While this activity did not have a material impact on the Company's reportable segments, fiscal 2018 and 2017 segment results and disclosures have been recast to reflect this change.
Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation. The Company classifies indirect costs incurred within or allocated to its U.S. government customers as overhead (included in "Cost of revenues") or general administrative expenses in the same manner as such costs are defined in the Company's disclosure statements under U.S. government Cost Accounting Standards ("CAS"). Effective the beginning of fiscal 2018, the Company established a new CAS structure and revised its disclosure statements accordingly to reflect the related cost accounting practice changes. Consequently, $185 million was reclassified from "Cost of revenues" to "Selling, general and administrative expenses" on the consolidated statements of income for fiscal 2017.
The Company combined "Dividends payable" and "Income taxes payable" with "Accounts payable and accrued liabilities" on the consolidated balance sheets. Additionally, the Company separately disclosed "Deferred income taxes" and "Income taxes receivable/payable", as well as "Other long-term assets" and "Other long-term liabilities", within operating activities on the consolidated statements of cash flows. The Company also combined "Payments for debt issuance and modification costs" and "Payments for non-controlling interest acquired" with "Other" within financing activities on the consolidated statements of cash flows.
Leidos Holdings, Inc. Annual Report - 55
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 2—Accounting Standards
Accounting Standards Updates Adopted
ASU 2016-02, ASU 2018-10, ASU 2018-11, ASU 2018-20, and ASU 2019-01, Leases (Topic 842)
In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU 2016-02 ("ASC 842") and subsequent updates, which supersedes the lease guidance under Leases (Topic 840) and requires an entity to recognize a right-of-use ("ROU") asset and corresponding lease obligation on the balance sheet, classified as financing or operating, as appropriate. The update is effective for public companies for annual and interim reporting periods beginning after December 15, 2018, and should be adopted under the modified retrospective approach.
Effective December 29, 2018, the Company adopted the requirements of ASC 842 using the modified retrospective approach. Comparative information for the prior fiscal year has not been retrospectively adjusted.
As a result of the adoption of the new standard, the Company recorded $433 million and $486 million of ROU assets and lease liabilities, respectively, primarily due to its operating leases, on the Company's consolidated balance sheets. The standard did not have a material impact on the consolidated statements of income and consolidated statements of cash flows. The Company also recorded a $48 million increase in retained earnings due to the cumulative effect of recognizing the gain, net of taxes, related to the sale of the San Diego properties (see "Note 12—Property, Plant and Equipment").
The Company has elected to adopt certain practical expedients provided under ASC 842, including the options to not apply lease recognition for short-term leases, reassess whether expired or existing contracts contain leases, reassess lease classification for expired or existing leases, reassess initial direct costs, and combine lease and non-lease components in revenue arrangements when (i) the timing and pattern of revenue recognition for the components are the same and (ii) the lease component if accounted for separately, would be classified as an operating lease. The Company did not elect the hindsight practical expedient to determine the lease term for existing leases and in assessing impairment for the ROU assets. The Company also applies a single discount rate to a portfolio of leased assets with similar durations.
The cumulative effect of the changes made to the Company's consolidated balance sheet for the adoption of ASU 2016-02 was as follows:
| Balance at December 28, 2018 | Adjustments due to ASU 2016-02 | Balance at December 29, 2018 | ||||||||||
| (in millions) | ||||||||||||
| Assets - non-current: | ||||||||||||
| Property, plant and equipment, net | $ | 237 | $ | 1 | $ | 238 | ||||||
| Operating lease right-of-use assets, net | — | 418 | 418 | |||||||||
| Liabilities - current: | ||||||||||||
| Accounts payable and accrued liabilities | $ | 1,491 | $ | 132 | $ | 1,623 | ||||||
| Long-term debt, current portion | 72 | 8 | 80 | |||||||||
| Liabilities - non-current: | ||||||||||||
| Long-term debt, net of current portion | $ | 3,052 | $ | (72 | ) | $ | 2,980 | |||||
| Operating lease liabilities | — | 320 | 320 | |||||||||
| Deferred tax liabilities | 170 | 17 | 187 | |||||||||
| Other long-term liabilities | 178 | (34 | ) | 144 | ||||||||
| Equity: | ||||||||||||
| Retained earnings | $ | 372 | $ | 48 | $ | 420 |
Leidos Holdings, Inc. Annual Report - 56
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ASU 2018-13 Fair Value Measurement (Topic 820)
In August 2018, the FASB issued ASU 2018-13 "Fair Value Measurement (Topic 820) Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement" to improve the effectiveness of disclosures in the notes to the financial statements. During the quarter ended January 3, 2020, the Company early adopted the provisions related to disclosure requirements that were removed from Topic 820, including the valuation processes for Level 3 fair value measurements.
Accounting Standards Updates Issued But Not Yet Adopted
ASU 2016-13, ASU 2018-19, ASU 2019-05, and ASU 2019-11 Financial Instruments – Credit Losses (Topic 326)
In June 2016, the FASB issued ASU 2016-13 and subsequent updates, which eliminates the requirement that a credit loss on a financial instrument be "probable" prior to recognition. Instead, a valuation allowance will be recorded to reflect an entity's current estimate of all expected credit losses, based on both historical and forecasted information related to an instrument. The update is effective for public companies for annual and interim reporting periods beginning after December 15, 2019, and should be adopted using a modified retrospective approach, which applies a cumulative-effect adjustment to retained earnings as of the beginning of the first reporting period in which the guidance is effective. A prospective approach is required for debt securities for which an other-than-temporary impairment had been recognized before the effective date and loans and debt securities acquired with deteriorated credit quality. Early adoption is permitted.
The Company expects the impacts that this standard update will have on certain financial assets, including trade receivables, note receivables and receivables on sales-type leases and processes to be immaterial.
Note 3—Summary of Significant Accounting Policies
Reporting Periods
Leidos' fiscal year ends on the Friday nearest the end of December. The Company's fiscal 2019 ended January 3, 2020. Fiscal 2019 included 53 weeks and fiscal 2018 and 2017 each included 52 weeks.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingencies at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Management evaluates these estimates and assumptions on an ongoing basis, including those relating to estimated profitability of long-term contracts, indirect billing rates, allowances for doubtful accounts, inventories, fair value measurements and impairment of intangible assets and goodwill, income taxes, pension benefits, stock-based compensation expense and contingencies. These estimates have been prepared by management on the basis of the most current and best available information; however, actual results could differ materially from those estimates.
Operating Cycle
The Company's operating cycle for long-term contracts may be greater than one year and is measured by the average time intervening between the inception and the completion of those contracts.
Business Combinations, Investments and Variable Interest Entities
Business Combinations
The accounting for business combinations requires the Company to make judgments and estimates related to the fair value of assets acquired, including the identification and valuation of intangible assets, as well as liabilities and contingencies assumed. Such judgments and estimates directly impact the amount of goodwill recognized in connection with an acquisition.
Investments
Investments in entities and corporate joint ventures where the Company has a non-controlling ownership interest but over which the Company has the ability to exercise significant influence, are accounted for under the equity method of accounting. The Company recognizes its proportionate share of the entities' net income or loss and does not consolidate the entities' assets and liabilities.
Leidos Holdings, Inc. Annual Report - 57
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Equity investments in entities over which the Company does not have the ability to exercise significant influence and whose securities do not have a readily determinable fair value are carried at cost or cost net of other-than-temporary impairments.
Variable Interest Entities
The Company occasionally forms joint ventures and/or enters into arrangements with special purpose limited liability companies for the purpose of bidding and executing on specific projects. The Company analyzes each such arrangement to determine whether it represents a VIE. If the arrangement is determined to be a VIE, the Company assesses whether it is the primary beneficiary of the VIE and is consequently required to consolidate the VIE.
Divestitures
From time-to-time, the Company may dispose (or management may commit to plans to dispose) of strategic or non-strategic components of the business. Divestitures representing a strategic shift that has (or will have) a major effect in operations and financial results are classified as discontinued operations, whereas non-strategic divestitures remain in continuing operations.
Restructuring Expenses
Restructuring expenses are incurred in connection with programs aimed at reducing the Company's costs and primarily include termination costs associated with headcount reduction.
The Company's restructuring actions include one-time involuntary termination benefits as well as certain contractual termination benefits or employee terminations under ongoing benefit arrangements. One-time involuntary termination benefits are recognized as a liability at estimated fair value when the plan of termination has been communicated to employees and certain other criteria are met. Ongoing termination benefit arrangements are recognized as a liability at estimated fair value when it is probable that amounts will be paid to employees and such amounts are reasonably estimable. Costs associated with exit or disposal activities, including the related one-time and ongoing involuntary termination benefits, are included as "Acquisition, integration and restructuring costs" on the consolidated statements of income. See "Note 8—Restructuring Expenses" for additional information about the Company's restructuring activities.
Revenue Recognition
The Company's revenues from contracts with customers are from offerings including cyber; digital modernization; integrated systems; mission software systems; mission support; operations and logistics; and sensors, collection and phenomenology, primarily with the U.S. government and its agencies. The Company also serves various state and local governments, foreign governments and U.S. commercial customers.
The Company performs under various types of contracts, which include firm-fixed-price ("FFP"), time-and-materials ("T&M"), fixed-price-level-of-effort ("FP-LOE"), cost-plus-fixed-fee, cost-plus-award-fee, cost-plus-incentive-fee and fixed-price-incentive-fee ("FP-IF") contracts.
To determine the proper revenue recognition, the Company first evaluates whether it has a duly approved and enforceable contract with a customer, in which the rights of the parties and payment terms are identified, and collectability is probable. The Company also evaluates whether two or more contracts should be combined and accounted for as a single contract, including the task orders issued under an indefinite delivery/indefinite quantity ("IDIQ") award. In addition, the Company assesses contract modifications to determine whether changes to existing contracts should be accounted for as part of the original contract or as a separate contract. Contract modifications for the Company generally relate to changes in contract specifications and requirements and do not add distinct services, and therefore are accounted for as part of the original contract. If contract modifications add distinct goods or services and increase the contract value by an amount that reflects the standalone selling price, those modifications are accounted for as separate contracts.
Leidos Holdings, Inc. Annual Report - 58
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Most of the Company's contracts are comprised of multiple promises including the design and build of software-based systems, integration of hardware and software solutions, running and maintaining of IT infrastructure and procurement services. In all cases, the Company assesses if the multiple promises should be accounted for as separate performance obligations or combined into a single performance obligation. The Company generally separates multiple promises in a contract as separate performance obligations if those promises are distinct, both individually and in the context of the contract. If multiple promises in a contract are highly interrelated or require significant integration or customization within a group, they are combined and accounted for as a single performance obligation.
The Company's contracts with the U.S. government often contain options to renew existing contracts for an additional period of time (generally a year at a time) under the same terms and conditions as the original contract, and generally do not provide the customer any material rights under the contract. The Company accounts for renewal options as separate contracts when they include distinct goods or services at standalone selling prices.
Contracts with the U.S. government are subject to the Federal Acquisition Regulation ("FAR") and priced on estimated or actual costs of providing the goods or services. The FAR provides guidance on types of costs that are allowable in establishing prices for goods and services provided to the U.S. government and its agencies. Each contract is competitively priced and bid separately. Pricing for non-U.S. government agencies and commercial customers is based on specific negotiations with each customer. In circumstances where the standalone selling price is not directly observable, we estimate the standalone selling price using the expected cost-plus margin approach. The Company excludes any taxes collected or imposed when determining the transaction price.
Certain of the Company's cost-plus and fixed-price contracts contain award fees, incentive fees or other provisions that may either increase or decrease the transaction price. These variable amounts generally are awarded upon achievement of certain performance metrics, program milestones or cost targets and can be based upon customer discretion. The Company estimates variable consideration at the most probable amount that it expects to be entitled to, based on the assessment of the contractual variable fee criteria, complexity of work and related risks, extent of customer discretion, amount of variable consideration received historically and the potential of significant reversal of revenue.
The Company allocates the transaction price of a contract to its performance obligations in the proportion of its respective standalone selling prices. The standalone selling price of the Company's performance obligations is generally based on an expected cost-plus margin approach, in accordance with the FAR. For certain product sales, the Company uses prices from other standalone sales. Substantially all of the Company's contracts do not contain a significant financing component, which would require an adjustment to the transaction price of the contract.
The Company recognizes revenue on its service based contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the Company performs the promised services. For U.S. government contracts, continuous transfer of control to the customer is evidenced by clauses in the contract that allow the customer to unilaterally terminate the contract for convenience, pay for costs incurred plus a reasonable profit and take control of any work-in-process. Similarly, for non-U.S. government contracts, the customer typically controls the work-in-process as evidenced by rights to payment for work performed to date plus a reasonable profit to deliver products or services that do not have an alternate use to the Company. Anticipated losses on service based contracts are recognized when known. In certain product sales, where the products have an alternate use, the Company recognizes revenue at a point in time when the customer takes control of the asset usually denoted by possession and legal title.
Leidos Holdings, Inc. Annual Report - 59
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On FFP contracts requiring system integration and cost-plus contracts with variable consideration, revenue is recognized over time generally using a method that measures the extent of progress towards completion of a performance obligation, principally using a cost-input method (referred to as the cost-to-cost method). Under the cost-to-cost method, revenue is recognized based on the proportion of total costs incurred to estimated total costs-at-completion ("EAC"). A performance obligation's EAC includes all direct costs such as materials, labor, subcontract costs, overhead and a ratable portion of general and administrative costs. In addition, the Company includes in an EAC of a performance obligation future losses estimated to be incurred on onerous contracts, as and when known. On certain other contracts, principally T&M, FP-LOE and cost-plus-fixed-fee, revenue is generally recognized using the right-to-invoice practical expedient as the Company is contractually able to invoice the customer based on the control transferred to the customer. Additionally, on maintenance (generally FFP) performance obligations, revenue is recognized over time using a straight-line method as the control of the services is provided to the customer evenly over the period of performance.
For certain performance obligations where the Company is not primarily responsible for fulfilling the promise to provide the goods or service to the customer, does not have inventory risk and does not have discretion in establishing the price for the goods or service, the Company recognizes revenue on a net basis.
Contract Costs
Contract costs generally include direct costs such as labor, materials, subcontract costs and indirect costs identifiable with or allocable to a specific contract. Costs are expensed as incurred unless they qualify for deferral and capitalization. The Company does not incur significant incremental costs to acquire contracts. Contract costs incurred for U.S. government contracts, including indirect costs, are subject to audit and adjustment by the Defense Contract Audit Agency ("DCAA") (see "Note 25—Contingencies").
Pre-contract Costs
Costs incurred on projects as pre-contract costs are deferred as assets when the Company has been requested by the customer to begin work under a new arrangement prior to contract execution and it is probable that the Company will recover the costs through the issuance of a contract. When the formal contract has been executed, the costs are recorded to the contract and revenue is recognized.
Transition Costs
Under certain service contracts, costs are incurred, usually at the beginning of the contract performance, to transition the services, employees and equipment to or from the customer, the Company's prior contract or prior contractor. These costs are generally capitalized as deferred assets and amortized on a straight-line basis over the anticipated term of the contract, including unexercised option periods that are reasonably certain of being exercised.
Project Assets
Purchases of project assets are capitalized for specific contracts where delivery to a customer has not yet occurred, ownership is maintained by the Company over the life of the contract or the benefit is received over a period of time. Project assets include enterprise software licenses, dedicated hardware, maintenance agreements and significant material purchases and other costs incurred on contracts. Project assets are amortized from the balance sheet using the straight-line method over the estimated useful life of the asset or over the expected term of the period of performance, whichever is shorter.
Changes in Estimates on Contracts
Changes in estimates related to contracts accounted for using the cost-to-cost method of accounting are recognized in the period in which such changes are made for the inception-to-date effect of the changes, with the exception of contracts acquired through a business combination, where the adjustment is made for the period commencing from the date of acquisition.
Leidos Holdings, Inc. Annual Report - 60
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Changes in estimates on contracts for the periods presented were as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions, except for per share amounts) | ||||||||||||
| Favorable impact | $ | 95 | $ | 167 | $ | 185 | ||||||
| Unfavorable impact | (52 | ) | (62 | ) | (82 | ) | ||||||
| Net favorable impact to income before income taxes | $ | 43 | $ | 105 | $ | 103 | ||||||
| Impact on diluted EPS attributable to Leidos common stockholders | $ | 0.23 | $ | 0.52 | $ | 0.41 |
The impact on diluted EPS attributable to Leidos common stockholders is calculated using the Company's statutory tax rate.
Revenue Recognized from Prior Obligations
During fiscal 2019 and 2018, revenue recognized from performance obligations satisfied in previous periods was $56 million and $102 million, respectively. The changes primarily relate to revisions of variable consideration, including award fees, and revisions to estimates at completion resulting from changes in contract scope, mitigation of contract risks or due to true-ups of contract estimates at the end of contract performance.
Selling, General and Administrative Expenses
The Company classifies indirect costs incurred within or allocated to its U.S. government customers as overhead (included in "Cost of revenues") or general and administrative expenses in the same manner as such costs are defined in the Company's disclosure statements under U.S. government CAS.
Selling, general and administrative expenses include general and administrative, bid and proposal and company-funded research and development expenses.
The Company conducts research and development activities under customer-funded contracts and with company-funded research and development funds. Company-funded research and development expense was $49 million, $46 million and $42 million for fiscal 2019, 2018 and 2017, respectively. Expenses for research and development activities performed under customer contracts are charged directly to cost of revenues for those contracts.
Income Taxes
The Company accounts for income taxes under the asset and liability method in accordance with the accounting standard for income taxes. The asset and liability method requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of assets and liabilities. Under this method, changes in tax rates and laws are recognized in income in the period such changes are enacted.
The Company records net deferred tax assets to the extent that it believes these assets will more likely than not be realized. In making such determination, the Company considers all available positive and negative evidence, including future reversals of existing taxable temporary differences, projected future taxable income, tax planning strategies and recent results of operations. If the Company were to determine that it would be able to realize its deferred income tax assets in the future in excess of their net recorded amount or would no longer be able to realize its deferred income tax assets in the future as currently recorded, the Company would make an adjustment to the valuation allowance which would decrease or increase the provision for income taxes.
The provision for federal, state, foreign and local income taxes is calculated on income before income taxes based on current tax law and includes the cumulative effect of any changes in tax rates from those used previously in determining deferred tax assets and liabilities. Such provision differs from the amounts currently payable because certain items of income and expense are recognized in different reporting periods for financial reporting purposes than for income tax purposes.
Leidos Holdings, Inc. Annual Report - 61
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company recognizes liabilities for uncertain tax positions when it is more likely than not that a tax position will not be sustained upon examination and settlement with various taxing authorities. Liabilities for uncertain tax positions are measured based upon the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company recognizes interest and penalties related to uncertain tax positions in its income tax expense.
Cash and Cash Equivalents
The Company's cash equivalents are primarily comprised of investments in several large institutional money market accounts, with original maturity of three months or less. The Company includes outstanding payments within "Cash and cash equivalents" and correspondingly increases "Accounts payable and accrued liabilities" on the consolidated balance sheets. At January 3, 2020, and December 28, 2018, the Company included $169 million and $56 million, respectively, of outstanding payments within "Cash and cash equivalents."
Restricted Cash
The Company has restricted cash balances, primarily representing advances from customers that are restricted as to use for certain expenditures related to that customer's contract. Restricted cash balances are included as "Other current assets" on the consolidated balance sheets.
Receivables
The Company's receivables include amounts billed and currently due from customers, amounts billable where the right to consideration is unconditional and amounts unbilled. Amounts billable and unbilled amounts are recognized at estimated realizable value and consist of costs and fees, substantially all of which are expected to be billed and collected generally within one year. Unbilled amounts also include rate variances that are billable upon negotiation of final indirect rates with the DCAA.
The Company's cost-reimbursable and T&M contracts are generally billed as costs are incurred. FFP contracts are billed either based on milestones, which are the achievement of specific events as defined in the contract, or based on progress payments, which are interim payments up to a designated amount of costs incurred as work progresses. On certain contracts, the customer withholds a certain percentage of the contract price (retainage). These withheld amounts are included within the Company's unbilled receivables and are billed upon contract completion or the occurrence of a specified event, and when negotiation of final indirect rates with the U.S. government is complete. Based on the Company's historical experience, the write-offs of retention balances have not been significant.
When events or conditions indicate that amounts outstanding from customers may become uncollectible, an allowance is estimated and recorded.
Amounts billed and collected on contracts but not yet recorded as revenue because the Company has not performed its obligation under the arrangement with a customer are deferred and included within "Accounts payable and accrued liabilities" or "Other long-term liabilities" on the consolidated balance sheets.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk primarily consist of accounts receivable and derivatives. Since the Company's receivables are primarily with the U.S. government, the Company does not have exposure to a material credit risk. The Company manages its credit risk related to derivatives through the use of multiple counterparties with high credit standards.
Inventories
Inventories are valued at the lower of cost or estimated net realizable value. Raw material inventory is valued using the average cost method. Work-in-process inventory includes raw material costs plus labor costs, including fringe benefits and allocable overhead costs. The majority of finished goods inventory consists of technology and security products, inspection systems and baggage scanning equipment. The Company evaluates inventory against historical and planned usage to determine appropriate provisions for obsolete inventory. Inventory balances are included as "Other current assets" in the consolidated balance sheets.
Leidos Holdings, Inc. Annual Report - 62
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Goodwill
Goodwill represents the excess of the fair value of consideration transferred, plus the fair value of any non-controlling interests in the acquiree, over the fair value of the net assets acquired and liabilities assumed as of the acquisition date. Goodwill is not amortized, but instead is tested annually for impairment at the reporting unit level and tested more frequently if events or circumstances indicate that the carrying value may not be recoverable. The Company's policy is to perform its annual goodwill impairment evaluation as of the first day of the fourth quarter of its fiscal year. During fiscal 2019 and 2018, the Company had six and five reporting units, respectively, for the purpose of testing goodwill for impairment.
Goodwill is evaluated for impairment either under a qualitative assessment option or a quantitative approach depending on the facts and circumstances of a reporting unit, consideration of the excess of a reporting unit's fair value over its carrying amount in previous assessments and changes in business environment.
When performing a qualitative assessment, the Company considers factors including, but not limited to, current macroeconomic conditions, industry and market conditions, cost factors, financial performance and other events relevant to the entity or reporting unit under evaluation to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the Company determines that it is more likely than not that a reporting unit's fair value is less than its carrying amount, a quantitative goodwill impairment test is performed.
When performing a quantitative goodwill impairment test, the reporting unit carrying value is compared to its fair value. Goodwill is deemed impaired if, and the impairment loss is recognized for the amount by which, the reporting unit carrying value exceeds its fair value.
The Company estimates the fair value of each reporting unit using Level 3 inputs when a quantitative analysis is performed.
Intangible Assets
Acquired intangible assets with finite lives and internally developed software are amortized using the method that best reflects how their economic benefits are utilized or, if a pattern of economic benefits cannot be reliably determined, on a straight-line basis over their estimated useful lives. Program and contract intangible assets are amortized over their respective estimated useful lives in proportion to the pattern of economic benefit based on expected future discounted cash flows. Customer relationships and trade name intangible assets are amortized on a straight-line basis over their estimated useful lives. Software and technology intangible assets are amortized either on a straight-line basis over their estimated useful lives or over their respective estimated useful lives in proportion to the pattern of economic benefit based on expected future discounted cash flows, as deemed appropriate.
Intangible assets with finite lives are amortized over the following periods:
| Estimated useful lives (in years) | ||
| Program and contract intangibles | 6-11 | |
| Software and technology | 4-15 | |
| Customer relationships | 8-10 | |
| Trade names | 3 |
Intangible assets with finite lives are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
Intangible assets with indefinite lives are not amortized but are assessed for impairment at the beginning of the fourth quarter and whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
Property, Plant and Equipment
Purchases of property, plant and equipment, including purchases of software and software licenses, as well as costs associated with major renewals and improvements are capitalized. Maintenance, repairs and minor renewals and improvements are expensed as incurred.
Leidos Holdings, Inc. Annual Report - 63
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Construction in Progress ("CIP") is used to accumulate all costs for projects that are not yet complete. CIP balances are transferred to the appropriate asset account when the asset is capitalized and ready for its intended use.
When assets are sold or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is recognized. Depreciation is recognized using the methods and estimated useful lives as follows:
| Depreciation method | Estimated useful lives (in years) | |||
| Computers and other equipment | Straight-line or declining-balance | 2-10 | ||
| Buildings | Straight-line | Not to exceed 40 | ||
| Building improvements and leasehold improvements | Straight-line | Shorter of useful life of asset or remaining lease term | ||
| Office furniture and fixtures | Straight-line or declining-balance | 6-9 |
The Company evaluates its long-lived assets for potential impairment whenever there is evidence that events or changes in circumstances indicate that the carrying value may not be recoverable and the carrying amount of the asset exceeds its estimated fair value.
Leases
Lessee
The Company has facilities and equipment lease arrangements. An arrangement is determined to be a lease at inception if it conveys the right to control the use of identified property and equipment for a period of time in exchange for consideration. ROU assets represent the Company’s right to use an underlying asset over the lease term and lease liabilities represent its obligation to make lease payments arising from the lease.
ROU assets and lease liabilities are recorded on the consolidated balance sheet at lease commencement date based on the present value of the future minimum lease payments over the lease term. As the Company generally does not know the implicit rate for its leases, the discount rate used is the Company’s incremental borrowing rate which is determined based on the rate of interest that the Company would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term. An ROU asset is initially measured by the present value of the remaining lease payments, plus initial direct costs and prepaid lease payments, less any lease incentives received before commencement. The remaining lease cost is allocated over the remaining lease term on a straight-line basis unless another systematic or rational basis is more representative of the pattern in which the underlying asset is expected to be used. ROU assets are evaluated for impairment in a manner consistent with the treatment of other long-lived assets.
Certain of the Company’s facility leases contain options to renew or extend the terms of the lease which are included in the determination of the ROU assets and lease liabilities when it is reasonably certain that the Company will exercise the option. The Company's leases may also include variable lease payments such as an escalation clause based on consumer price index rates, maintenance costs and utilities. Variable lease payments that depend on an index or a rate are included in the determination of ROU assets and lease liabilities using the index or rate at the lease commencement date, whereas variable lease payments that do not depend on an index or rate are recorded as lease expense in the period incurred. At January 3, 2020, the Company did not have any lease agreements with residual value guarantees.
The Company elected the practical expedient to not separate non-lease components from lease components and instead account for both components as a single lease. The practical expedient was applied to all material classes of leased assets.
The related lease payments on the Company’s short-term facilities and equipment leases are recognized as expense on a straight-line basis over the lease term.
Leidos Holdings, Inc. Annual Report - 64
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
ROU assets are assessed for potential impairment whenever there is evidence that events or changes in circumstances indicate that the carrying value of the asset may not be recoverable and the carrying amount of the asset exceeds its estimated fair value. This includes an establishment of a plan of abandonment, which occurs when the Company has committed to a plan to abandon the lease before the end of its previously estimated useful life and there is no expectation that the Company will re-enter or re-purpose the space, including the fact that it cannot be subleased or transferred to another program within the Company.
Lessor
The Company is a lessor on certain equipment sales-type and operating lease arrangements with its customers. To be considered lease revenue, the contract must contain a specified asset, the Company must not have a substantive substitution right, the customer must have the right to direct the use of the specified asset during the period of use and the customer must have the right to obtain substantially all of the economic benefit of the specified asset.
Certain arrangements may contain variable payments that depend on an index or rate and are measured using the index or rate on the commencement date. Variable payments that are not included in the net investments are recorded as revenue as incurred. Arrangements may also contain options to renew or extend the performance period. Option periods are included in the lease term if the Company determines that it is reasonably certain the customer will exercise an option.
The Company has arrangements that contain both lease and non-lease components. The Company will account for them as one unit of account if the timing and pattern of transfer is identical for both the lease and the non-lease components and the lease component would be classified as an operating lease if accounted for separately. If both criteria are met and the predominant component is a lease, then the entire arrangement will be accounted for in accordance with ASC 842. If the Company accounts for an arrangement both as a lease and non-lease component, then the allocation of consideration for each component will be based the relative standalone sales price.
Fair Value Measurements
The accounting standard for fair value measurements establishes a three-level fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows: observable inputs such as quoted prices in active markets (Level 1); inputs other than quoted prices in active markets for identical assets or liabilities that are observable either directly or indirectly or quoted prices that are not active (Level 2); and unobservable inputs in which there is little or no market data (e.g., discounted cash flow and other similar pricing models), which requires the Company to develop its own assumptions (Level 3).
The accounting guidance for fair value measurements requires that the Company maximize the use of observable inputs and minimize the use of unobservable inputs in determining fair value. The accounting guidance provides for the irrevocable option to elect, on a contract-by-contract basis, to measure certain financial assets and liabilities at fair value at inception of the contract and record any subsequent changes in fair value in earnings. The Company has not made fair value option elections on any of its financial assets and liabilities.
The fair value of financial instruments is determined based on quoted market prices, if available, or management's best estimate (see "Financial Instruments" below).
Management evaluates its investments for other-than-temporary impairment at each balance sheet date. When testing long-term investments for recovery of carrying value, the fair value of long-term investments is determined using various valuation techniques and factors, such as market prices of comparable companies (Level 2 input), discounted cash flow models (Level 3 input) and recent capital transactions of the portfolio companies being valued (Level 3 input). If management determines that an other-than-temporary decline in the fair value of an investment has occurred, an impairment loss is recognized to reduce the investment to its estimated fair value.
The Company's non-financial instruments measured at fair value on a non-recurring basis include goodwill, indefinite-lived intangible assets and long-lived tangible assets. The valuation methods used to determine fair value require a significant degree of management judgment to determine the key assumptions. As such, the Company generally classifies non-financial instruments as either Level 2 or Level 3 fair value measurements.
Leidos Holdings, Inc. Annual Report - 65
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Financial Instruments
The Company is exposed to certain market risks which are inherent in certain transactions entered into during the normal course of business. These transactions include sales or purchase contracts denominated in foreign currencies and exposure to changing interest rates. The Company manages its risk to changes in interest rates through the use of derivative instruments.
For fixed rate borrowings, the Company uses variable interest rate swaps, effectively converting fixed rate borrowings to variable rate borrowings. These swaps are designated as fair value hedges. The fair value of these interest rate swaps is determined based on observed values for underlying interest rates on the LIBOR yield curve (Level 2).
For variable rate borrowings, the Company uses fixed interest rate swaps, effectively converting a portion of the variable interest rate payments to fixed interest rate payments. These swaps are designated as cash flow hedges. The fair value of these interest rate swaps is determined based on observed values for the underlying interest rates (Level 2).
The Company does not hold derivative instruments for trading or speculative purposes.
The Company's defined benefit plan assets consist of investments in pooled funds that contain investments with values based on quoted market prices, but for which the pools are not valued on a daily quoted market basis (Level 2).
Stock-Based Compensation
The Company accounts for stock-based compensation at the grant date based on the fair value of the award and is recognized as expense over the requisite service period, which is generally the vesting period, net of an estimated forfeiture rate.
The fair value of restricted stock awards and performance-based stock awards is based on the closing price of the Company's common stock on the date of grant. The fair value of performance-based stock awards with market conditions is based on using the Monte Carlo simulation.
The fair value of stock option awards granted is based on using the Black-Scholes-Merton option pricing model. The estimation of stock option fair value requires management to make estimates and judgments about, among other things, employee exercise behavior, forfeiture rates and the expected volatility of Leidos common stock over the expected option term. These judgments directly affect the amount of compensation expense that will ultimately be recognized.
Foreign Currency
The financial statements of consolidated international subsidiaries, for which the functional currency is not the U.S. dollar, are translated into U.S. dollars using the exchange rate at each balance sheet date for assets and liabilities and a weighted average exchange rate over the reporting period for revenues, expenses, gains and losses. Translation adjustments are recorded as accumulated other comprehensive (loss) income in stockholders' equity. Gains and losses due to movements in foreign currency exchange rates are recognized as "Other income (expense), net" on the consolidated statements of income.
Note 4—Revenues
Remaining Performance Obligations
Remaining performance obligations represent the expected value of exercised contracts, both funded and unfunded, less revenue recognized to date. Remaining performance obligations do not include unexercised option periods and future potential task orders expected to be awarded under IDIQ contracts with the exception of certain IDIQ contracts where task orders are not competitively awarded and separately priced but instead are used as a funding mechanism, and where there is a basis for estimating future revenues and funding on future task orders is anticipated.
As of January 3, 2020, the Company had $10.9 billion of remaining performance obligations, which are expected to be recognized as revenue in the amounts of $6.6 billion, $1.7 billion and $2.6 billion for fiscal 2020, fiscal 2021 and fiscal 2022 and thereafter, respectively.
Leidos Holdings, Inc. Annual Report - 66
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Disaggregation of Revenues
The Company disaggregates revenues by customer-type, contract-type and geographic location for each of its reportable segments. These categories represent how the nature, timing and uncertainty of revenues and cash flows are affected.
Fiscal 2018 amounts have been recast for the contracts that were reassigned between the Defense Solutions and Civil reportable segments (see "Note 24—Business Segments").
Disaggregated revenues by customer-type were as follows:
| Year Ended January 3, 2020 | ||||||||||||||||
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| DoD and U.S. Intelligence Community | $ | 4,660 | $ | 174 | $ | 491 | $ | 5,325 | ||||||||
| Other government agencies(1) | 295 | 2,681 | 1,332 | 4,308 | ||||||||||||
| Commercial and non-U.S. customers | 411 | 781 | 151 | 1,343 | ||||||||||||
| Total | $ | 5,366 | $ | 3,636 | $ | 1,974 | $ | 10,976 |
| Year Ended December 28, 2018 | ||||||||||||||||
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| DoD and U.S. Intelligence Community(2) | $ | 4,359 | $ | 128 | $ | 386 | $ | 4,873 | ||||||||
| Other government agencies(1)(2) | 185 | 2,380 | 1,276 | 3,841 | ||||||||||||
| Commercial and non-U.S. customers | 422 | 903 | 155 | 1,480 | ||||||||||||
| Total | $ | 4,966 | $ | 3,411 | $ | 1,817 | $ | 10,194 |
(1) Includes federal government agencies other than the DoD and U.S. Intelligence Community, as well as state and local government agencies.
(2) The Company reclassified $41 million within the Defense Solutions segment from "Other government agencies" to "DoD and U.S. Intelligence Community" to reflect the change in disaggregation of U.S. government customers in fiscal 2019.
The majority of the Company's revenues are generated from U.S. government contracts, either as a prime contractor or as a subcontractor to other contractors. Revenues from the U.S. government can be adversely impacted by spending caps or changes in budgetary priorities of the U.S. government, as well as delays in program start dates or the award of a contract.
Disaggregated revenues by contract-type were as follows:
| Year Ended January 3, 2020 | ||||||||||||||||
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| Cost-reimbursement and fixed-price-incentive-fee | $ | 3,697 | $ | 1,997 | $ | 234 | $ | 5,928 | ||||||||
| Firm-fixed-price | 1,203 | 1,075 | 1,296 | 3,574 | ||||||||||||
| Time-and-materials and fixed-price-level-of-effort | 466 | 564 | 444 | 1,474 | ||||||||||||
| Total | $ | 5,366 | $ | 3,636 | $ | 1,974 | $ | 10,976 |
Leidos Holdings, Inc. Annual Report - 67
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
| Year Ended December 28, 2018 | ||||||||||||||||
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| Cost-reimbursement and fixed-price-incentive-fee | $ | 3,420 | $ | 1,860 | $ | 189 | $ | 5,469 | ||||||||
| Firm-fixed-price | 1,051 | 984 | 1,134 | 3,169 | ||||||||||||
| Time-and-materials and fixed-price-level-of-effort | 495 | 567 | 494 | 1,556 | ||||||||||||
| Total | $ | 4,966 | $ | 3,411 | $ | 1,817 | $ | 10,194 |
Cost-reimbursement and FP-IF contracts are generally lower risk and have lower profits. T&M and FP-LOE contracts are also low risk but profits may vary depending on actual labor costs compared to negotiated contract billing rates. FFP contracts offer the potential for higher profits while increasing the Company’s exposure to risk of cost overruns.
Disaggregated revenues by geographic location were as follows:
| Year Ended January 3, 2020 | ||||||||||||||||
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| United States | $ | 4,995 | $ | 3,131 | $ | 1,974 | $ | 10,100 | ||||||||
| International | 371 | 505 | — | 876 | ||||||||||||
| Total | $ | 5,366 | $ | 3,636 | $ | 1,974 | $ | 10,976 |
| Year Ended December 28, 2018 | ||||||||||||||||
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| United States | $ | 4,586 | $ | 2,862 | $ | 1,817 | $ | 9,265 | ||||||||
| International | 380 | 549 | — | 929 | ||||||||||||
| Total | $ | 4,966 | $ | 3,411 | $ | 1,817 | $ | 10,194 |
The Company's international business operations, primarily located in Australia and the U.K., are subject to additional and different risks than its U.S. business. Failure to comply with U.S. government laws and regulations applicable to international business, such as the Foreign Corrupt Practices Act or U.S. export control regulations, could have an adverse impact on the Company's business with the U.S. government.
In some countries, there is an increased chance for economic, legal or political changes that may adversely affect the performance of the Company's services, sales of products or repatriation of profits. International transactions can also involve increased financial and legal risks arising from foreign exchange variability, imposition of tariffs or additional taxes and restrictive trade policies and delays or failure to collect amounts due to differing legal systems.
For fiscal 2019, revenues by contract-type, customer-type and geographic location exclude $118 million recognized under ASC 842 (see "Note 13—Leases").
Note 5—Contract Assets and Liabilities
The Company’s performance obligations are satisfied either over time as work progresses or at a point in time. FFP contracts are typically billed to the customer using milestone payments while cost-reimbursable and T&M contracts are typically billed to the customer on a monthly or bi-weekly basis as indicated by the negotiated billing terms and conditions of the contract. As a result, for each of the Company’s contracts, the timing of revenue recognition, customer billings and cash collections results in a net contract asset or liability at the end of each reporting period.
Leidos Holdings, Inc. Annual Report - 68
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The components of contract assets and contract liabilities consisted of the following:
| Balance sheet line item | January 3, 2020 | December 28, 2018 | ||||||||
| (in millions) | ||||||||||
| Contract assets - current: | ||||||||||
| Unbilled receivables(1) | Receivables, net | $ | 735 | $ | 818 | |||||
| Contract liabilities - current: | ||||||||||
| Deferred revenue | Accounts payable and accrued liabilities | $ | 400 | $ | 276 | |||||
| Contract liabilities - non-current: | ||||||||||
| Deferred revenue | Other long-term liabilities | $ | 9 | $ | 10 |
(1) Balances exclude $572 million and $381 million determined to be billable at January 3, 2020, and December 28, 2018, respectively. These amounts are included as billed and billable receivables (see "Note 9—Receivables").
The decrease in unbilled receivables was primarily due to the timing of billings and revenue recognized on certain contracts. The increase in deferred revenue was primarily due to the timing of advance payments from customers partially offset by revenue recognized during the period.
During fiscal 2019 and 2018, the Company recognized revenues of $207 million and $208 million, respectively, relating to amounts that were included as a contract liability at December 28, 2018 and December 30, 2017 (date of adoption).
The Company did not recognize any impairment losses on contract assets during fiscal 2019 and 2018.
Note 6—Acquisitions
The Company may acquire businesses as part of its growth strategy to provide new or enhance existing capabilities and offerings to customers. During fiscal 2019, the Company completed the acquisition of IMX Medical Management Services, Inc. and its affiliated businesses ("IMX"). During fiscal 2016, the Company completed the acquisition of Lockheed Martin's Information Systems & Global Solutions business ("IS&GS Business").
On January 31, 2020, the Company completed the acquisition of Dynetics, Inc. ("Dynetics"), an industry-leading applied research and national security solutions company. Additionally, on February 3, 2020, the Company entered into a definitive agreement to acquire L3Harris Technologies' ("L3Harris") security detection and automation businesses (see "Note 27—Subsequent Events").
IMX Acquisition
On August 15, 2019, the Company completed the acquisition of IMX for preliminary purchase consideration of $94 million, which included $90 million of cash paid and an additional $4 million paid to extinguish IMX's existing term loans and credit facility balances. The acquisition extends the Company's independent medical evaluation coverage area for commercial and federal customers.
The Company recorded $50 million of goodwill (which is deductible for tax purposes) and $42 million of intangible assets. The intangible assets primarily consist of $41 million for customer relationships. The amortization period for the customer relationships is 10 years.
At January 3, 2020, the Company had not finalized the determination of fair values allocated to assets and liabilities, including, but not limited to, accounts receivable.
Lockheed Martin Transaction
On August 16, 2016, a wholly-owned subsidiary of Leidos Holdings, Inc. merged with the IS&GS Business in a Reverse Morris Trust transaction (the "IS&GS Transactions").
Leidos Holdings, Inc. Annual Report - 69
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During fiscal 2017, the Company recorded adjustments to finalize the fair value of acquired assets and liabilities assumed which resulted in a $337 million increase in goodwill. Significant changes included intangible assets, property, plant and equipment, deferred tax assets, other assets, accounts payable and accrued liabilities and deferred tax liabilities.
On January 10, 2018, the final amount of the net working capital of the IS&GS Business was determined through a binding arbitration proceeding in accordance with the Separation Agreement with Lockheed Martin. As a result, $24 million was recorded as acquisition costs in the consolidated statements of income for fiscal 2017. On January 18, 2018, the final working capital amount of $105 million was paid to Lockheed Martin, of which $24 million and $81 million was presented as cash flows from operating and investing activities, respectively, on the consolidated statements of cash flows.
During fiscal 2018, a tax indemnification liability of $23 million was paid to Lockheed Martin in accordance with the Tax Matters Agreement, which was presented as cash flows from financing activities on the consolidated statements of cash flows.
The Company incurred the following expenses related to the acquisition and integration of the IS&GS Business:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Acquisition costs | $ | — | $ | — | $ | 25 | ||||||
| Integration costs | 3 | 29 | 77 | |||||||||
| Total acquisition and integration costs | $ | 3 | $ | 29 | $ | 102 |
These acquisition and integration costs have been recorded within Corporate and presented in "Acquisition, integration and restructuring costs" on the consolidated statements of income.
Note 7—Divestitures
Health Staff Augmentation Business
On September 12, 2019, the Company's Health segment disposed of its health staff augmentation business that was primarily focused on implementation and optimization services to hospital centers. During the quarter ended January 3, 2020, working capital adjustments were finalized, resulting in a final sales price of $13 million. This consideration included $12 million of cash proceeds and expenses the buyer paid on the Company's behalf. The Company recorded an immaterial loss, net of assets divested of $12 million and transaction costs. The loss was recorded in "Other income (expense), net" on the consolidated statements of income. This disposition did not meet the criteria to be classified as a discontinued operation in the Company's financial statements.
Commercial Cybersecurity Business
On February 20, 2019, the Company's Civil segment disposed of its commercial cybersecurity business in order to focus on providing solutions, including cybersecurity, to the Company's core markets of governments and highly regulated industries. In February 2019, the Company received initial proceeds of $171 million. During the quarter ended June 28, 2019, working capital adjustments were finalized, resulting in a final sales price of $166 million. On September 30, 2019, the Company paid $5 million related to the finalization of net working capital. The Company recorded a pre-tax gain on sale of $88 million, net of $68 million of assets divested and $10 million in transaction related costs. The net assets divested included $14 million of receivables, $57 million of goodwill and $13 million of accounts payable and accrued liabilities. The gain was recorded in "Other income (expense), net" on the consolidated statements of income. This disposition did not meet the criteria to be classified as a discontinued operation in the Company's financial statements.
Leidos Holdings, Inc. Annual Report - 70
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Plainfield Renewable Energy Holdings LLC
As part of the sale of its equity interest in Plainfield Renewable Energy Holdings LLC ("Plainfield") in 2015, the Company received a cash payment of $29 million and a secured promissory note of $73 million (the "Note"). In January 2018, the Company entered into negotiations with the equity owners of Plainfield regarding the Plainfield Recapitalization Plan, which resulted in a $40 million net realizable value of the Note as of December 29, 2017. As a result, the Company recorded a $33 million impairment of the Note in fiscal 2017, which was presented in "Other income (expense), net" on the consolidated statements of income.
On August 23, 2018, the Company received proceeds of $40 million in full satisfaction of Plainfield's obligations under the Note.
Note 8—Restructuring Expenses
After the acquisition of the IS&GS Business, the Company began an initiative to reduce its cost structure, which included optimization of its real estate portfolio by vacating certain facilities and consolidating others, and by reducing headcount.
The restructuring expenses related to the acquisition were as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Severance costs | $ | — | $ | 2 | $ | 18 | ||||||
| Lease termination expenses | 1 | 6 | 19 | |||||||||
| Restructuring expenses related to the IS&GS Business | $ | 1 | $ | 8 | $ | 37 |
As of January 3, 2020, the Company has recognized $58 million of restructuring expenses relating to the 2016 acquisition of the IS&GS Business. These restructuring expenses have been recorded within Corporate and presented in "Acquisition, integration and restructuring costs" on the consolidated statements of income.
Note 9—Receivables
The components of receivables, net consisted of the following:
| January 3, 2020 | December 28, 2018 | |||||||
| (in millions) | ||||||||
| Billed and billable receivables | $ | 1,023 | $ | 1,067 | ||||
| Unbilled receivables | 735 | 818 | ||||||
| Allowance for doubtful accounts | (24 | ) | (8 | ) | ||||
| $ | 1,734 | $ | 1,877 |
Leidos Holdings, Inc. Annual Report - 71
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 10—Goodwill
The following table presents changes in the carrying amount of goodwill by reportable segment:
| Defense Solutions | Civil | Health | Total | |||||||||||||
| (in millions) | ||||||||||||||||
| Goodwill at December 29, 2017(1) | $ | 2,055 | $ | 1,998 | $ | 921 | $ | 4,974 | ||||||||
| Foreign currency translation adjustments | (40 | ) | (11 | ) | — | (51 | ) | |||||||||
| Transfers to assets held for sale | — | (57 | ) | — | (57 | ) | ||||||||||
| Adjustment to goodwill | — | (6 | ) | — | (6 | ) | ||||||||||
| Goodwill at December 28, 2018(1) | 2,015 | 1,924 | 921 | 4,860 | ||||||||||||
| Goodwill re-allocation | 25 | (25 | ) | — | — | |||||||||||
| Acquisition of IMX | — | — | 50 | 50 | ||||||||||||
| Divestiture of health staff augmentation business | — | — | (5 | ) | (5 | ) | ||||||||||
| Foreign currency translation adjustments | (4 | ) | 8 | — | 4 | |||||||||||
| Adjustment to goodwill | 3 | — | — | 3 | ||||||||||||
| Goodwill at January 3, 2020**(1)** | $ | 2,039 | $ | 1,907 | $ | 966 | $ | 4,912 |
(1) Carrying amount includes accumulated impairment losses of $369 million and $117 million within the Health and Civil segments, respectively.
Effective the beginning of fiscal 2019, the Company changed the composition of its Defense Solutions reportable segment, which resulted in the identification of new operating segments and reporting units within Defense Solutions. In addition, certain contracts were reassigned between the Civil and Defense Solutions reportable segments (see "Note 24—Business Segments"). Consequently, the carrying amount of goodwill was re-allocated among the reporting units for the purpose of testing goodwill for impairment.
In conjunction with the changes mentioned above, the Company evaluated goodwill for impairment using a quantitative step one analysis, both before and after the changes were made, and determined that goodwill was not impaired.
In fiscal 2019, the Company performed a qualitative analysis for all reporting units and determined that it was more likely than not that the fair values of the reporting units were in excess of the individual reporting units carrying values, and as a result, a quantitative step one analysis was not necessary.
In fiscal 2018, the Company performed a qualitative and quantitative analysis on its reporting units. Based on the qualitative analysis performed during the Company's annual impairment evaluation for fiscal 2018 for certain of its reporting units, it was determined that it was more likely than not that the fair values of the reporting units were in excess of the individual reporting unit carrying values, and as a result, a quantitative step one analysis was not necessary. Additionally, based on the results of the quantitative step one analysis for certain other of its reporting units, it was determined that the fair value was in excess of the individual reporting units carrying values.
In fiscal 2017, the Company performed a quantitative analysis for all reporting units. It was determined that the fair values of all reporting units exceeded their carrying values.
As a result, no goodwill impairments were identified as part of the annual goodwill impairment evaluation for the periods mentioned above.
During the year ended January 3, 2020 and December 28, 2018, the Company recorded an immaterial correction of $3 million and $6 million, respectively, with respect to fair value of assets and liabilities acquired from the IS&GS Transactions.
Leidos Holdings, Inc. Annual Report - 72
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 11—Intangible Assets
Intangible assets consisted of the following:
| January 3, 2020 | December 28, 2018 | |||||||||||||||||||||||
| Gross carrying value | Accumulated amortization | Net carrying value | Gross carrying value | Accumulated amortization | Net carrying value | |||||||||||||||||||
| (in millions) | ||||||||||||||||||||||||
| Finite-lived intangible assets: | ||||||||||||||||||||||||
| Program and contract intangibles | $ | 1,003 | $ | (536 | ) | $ | 467 | $ | 1,003 | $ | (374 | ) | $ | 629 | ||||||||||
| Software and technology | 102 | (83 | ) | 19 | 93 | (74 | ) | 19 | ||||||||||||||||
| Customer relationships | 45 | (6 | ) | 39 | 4 | (4 | ) | — | ||||||||||||||||
| Trade names | 1 | — | 1 | — | — | — | ||||||||||||||||||
| Total finite-lived intangible assets | 1,151 | (625 | ) | 526 | 1,100 | (452 | ) | 648 | ||||||||||||||||
| Indefinite-lived intangible assets: | ||||||||||||||||||||||||
| Trade names | 4 | — | 4 | 4 | — | 4 | ||||||||||||||||||
| Total intangible assets | $ | 1,155 | $ | (625 | ) | $ | 530 | $ | 1,104 | $ | (452 | ) | $ | 652 |
Amortization expense related to intangible assets was $173 million, $201 million and $281 million for fiscal 2019, 2018 and 2017, respectively.
The estimated annual amortization expense related to finite-lived intangible assets as of January 3, 2020, is as follows:
| Fiscal Year Ending | ||||
| (in millions) | ||||
| 2020 | $ | 133 | ||
| 2021 | 112 | |||
| 2022 | 99 | |||
| 2023 | 78 | |||
| 2024 | 39 | |||
| 2025 and thereafter | 65 | |||
| $ | 526 |
Actual amortization expense in future periods could differ from these estimates as a result of future acquisitions, divestitures, impairments, the outcome and timing of completion of in-process research and development projects and other factors.
Leidos Holdings, Inc. Annual Report - 73
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 12—Property, Plant and Equipment
Property, plant and equipment, net consisted of the following:
| January 3, 2020 | December 28, 2018 | |||||||
| (in millions) | ||||||||
| Computers and other equipment | $ | 259 | $ | 233 | ||||
| Leasehold improvements | 203 | 206 | ||||||
| Office furniture and fixtures | 37 | 36 | ||||||
| Buildings and improvements | 23 | 56 | ||||||
| Land | 4 | 40 | ||||||
| Construction in progress | 104 | 15 | ||||||
| 630 | 586 | |||||||
| Less: accumulated depreciation and amortization | (343 | ) | (349 | ) | ||||
| $ | 287 | $ | 237 |
Depreciation expense was $61 million, $56 million and $55 million for fiscal 2019, 2018 and 2017, respectively.
Sale and Leaseback Agreements
Gaithersburg, MD Property
On December 31, 2018, the Company closed the sale and leaseback agreement relating to its land and building in Gaithersburg, MD. The Company received proceeds of $31 million, net of selling costs, for the property, which had a carrying value of $31 million. The term of the lease is expected to end during fiscal 2020.
During the quarter ended March 30, 2018, an impairment charge of $7 million associated with this property was recorded within Corporate.
San Diego, CA Properties
On December 28, 2018, the Company closed the sale and leaseback agreement relating to two buildings and the adjacent land in San Diego, CA for consideration of $79 million, net of selling costs. The carrying value of the land and buildings was $14 million. The Company received cash proceeds of $14 million upon closing, which were recorded as financing activities on the consolidated statements of cash flows, and recognized a short-term receivable for the remaining $65 million of consideration.
Prior to the adoption of ASC 842, the consideration of $79 million was accounted for as a financing transaction and a note payable was recorded. Under ASC 842, the transaction qualified as a sale-leaseback and consequently the debt of $79 million and the carrying value of the property of $14 million, net of the related tax impact of $17 million, were reclassified into retained earnings as a cumulative effect adjustment. The proceeds of $65 million received in fiscal 2019 were recorded as investing activities on the consolidated statements of cash flows.
Former Headquarters
On December 17, 2019, the Company modified the $25 million promissory note received in connection with the sale of the former headquarters in fiscal 2015, thereby extending the maturity date to December 17, 2020, with an option to extend for one additional year. In conjunction with the modification, the Company collected $5 million of principal and $2 million of interest.
Leidos Holdings, Inc. Annual Report - 74
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 13—Leases
Lessee
The Company's ROU assets and lease liabilities consisted of the following:
| Balance sheet line item | January 3, 2020 | |||||
| (in millions) | ||||||
| ROU assets: | ||||||
| Finance leases | Property, plant and equipment, net | $ | 7 | |||
| Operating leases | Operating lease right-of-use assets, net | 400 | ||||
| $ | 407 | |||||
| Current lease liabilities: | ||||||
| Finance leases | Long-term debt, current portion | $ | 5 | |||
| Operating leases | Accounts payable and accrued liabilities | 132 | ||||
| $ | 137 | |||||
| Non-current lease liabilities: | ||||||
| Finance leases | Long-term debt, net of current portion | $ | 2 | |||
| Operating leases | Operating lease liabilities | 326 | ||||
| $ | 328 |
The Company's total lease cost for the periods presented consisted of the following:
| Year Ended | ||||
| January 3, 2020 | ||||
| (in millions) | ||||
| Finance lease cost: | ||||
| Amortization of ROU assets | $ | 8 | ||
| Interest on lease liabilities | 1 | |||
| 9 | ||||
| Operating lease cost(1) | 155 | |||
| Variable lease cost | 107 | |||
| Short-term lease cost | 7 | |||
| Less: Sublease income | (6 | ) | ||
| Total lease cost | $ | 272 |
(1) Includes ROU lease expense of $136 million.
The Company's lease costs and sublease income are included in "Cost of revenues" and "Selling, general and administrative expenses" within the consolidated statements of income.
Leidos Holdings, Inc. Annual Report - 75
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Lease terms and discount rates related to leases were as follows:
| January 3, 2020 | |||
| Weighted-average remaining lease term (in years): | |||
| Finance leases | 2.4 | ||
| Operating leases | 5.7 | ||
| Weighted-average discount rate: | |||
| Finance leases | 4.2 | % | |
| Operating leases | 4.1 | % |
Other information related to leases was as follows:
| Year Ended | ||||
| January 3, 2020 | ||||
| (in millions) | ||||
| Cash paid for amounts included in measurement of lease liabilities: | ||||
| Operating cash related to finance leases | $ | 1 | ||
| Operating cash related to operating leases | 163 | |||
| Financing cash flows related to finance leases | 8 | |||
| Lease liabilities arising from obtaining ROU assets: | ||||
| Operating lease liabilities | $ | 141 |
The change in ROU assets has been netted with the change in lease liabilities within cash flows from operations on the consolidated statements of cash flows.
The Company's future minimum lease commitments of its finance and operating leases on an undiscounted basis, reconciled to the respective lease liability at January 3, 2020, were as follows:
| Fiscal Year Ending | Finance lease commitments | Operating lease commitments | ||||||
| (in millions) | ||||||||
| 2020 | $ | 5 | $ | 145 | ||||
| 2021 | 1 | 91 | ||||||
| 2022 | — | 74 | ||||||
| 2023 | — | 54 | ||||||
| 2024 | — | 39 | ||||||
| 2025 and thereafter | 1 | 113 | ||||||
| Total undiscounted cash flows | 7 | 516 | ||||||
| Less: imputed interest | — | (58 | ) | |||||
| Lease liability as of January 3, 2020 | $ | 7 | $ | 458 |
On January 24, 2018, the Company entered into a lease agreement with its current lessor for office space in a building to be constructed to function as the Company's new corporate headquarters in Reston, VA. The Company will occupy the space for an initial term of 148 months and lease expense will be $11 million for the first lease year, with an annual rent expense increase of 2.5%. The Company currently expects to take occupancy of the building in March 2020, and terminate the lease agreements for its current corporate headquarters in the second quarter of fiscal 2020.
Leidos Holdings, Inc. Annual Report - 76
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Disclosures related to periods prior to ASC 842
Rental expense for facilities and equipment for the periods presented were as follows:
| Year Ended | ||||||||
| December 28, 2018 | December 29, 2017 | |||||||
| (in millions) | ||||||||
| Gross rental expense | $ | 163 | $ | 181 | ||||
| Less: sublease income | (1 | ) | (3 | ) | ||||
| Net rental expense | $ | 162 | $ | 178 |
Future minimum lease commitments and sublease receipts, under non-cancelable operating leases in effect at December 28, 2018, were as follows
| Fiscal Year Ending | Capital lease commitments | Operating lease commitments | Sublease receipts | |||||||||
| (in millions) | ||||||||||||
| 2019 | $ | 3 | $ | 144 | $ | 3 | ||||||
| 2020 | — | 114 | 1 | |||||||||
| 2021 | — | 83 | 1 | |||||||||
| 2022 | — | 71 | — | |||||||||
| 2023 | — | 55 | — | |||||||||
| 2024 and thereafter | — | 246 | — | |||||||||
| Total | $ | 3 | $ | 713 | $ | 5 |
Lessor
As of January 3, 2020, the Company had a total net investment in sales-type leases, which relates to lease payment receivables, of $57 million. The current and non-current portions of net investment in sales-type leases are included within "Other current assets" and "Other assets", respectively, on the Company's consolidated balance sheets.
The components of lease income were as follows:
| Year Ended | ||||||
| Income statement line item | January 3, 2020 | |||||
| (in millions) | ||||||
| Sales-type leases: | ||||||
| Selling price at lease commencement | Revenues | $ | 84 | |||
| Cost of underlying asset | Cost of revenues | 86 | ||||
| Operating loss | (2 | ) | ||||
| Interest income on lease receivables | Revenues | 6 | ||||
| 4 | ||||||
| Operating lease income | Revenues | $ | 28 | |||
| Total lease income | $ | 32 |
Leidos Holdings, Inc. Annual Report - 77
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As of January 3, 2020, undiscounted cash flows for sales-type and operating leases for the next five years and thereafter are as follows:
| Fiscal Year Ending | Sales-type leases | Operating leases | ||||||
| (in millions) | ||||||||
| 2020 | $ | 35 | $ | 22 | ||||
| 2021 | 20 | 22 | ||||||
| 2022 | 8 | 22 | ||||||
| 2023 | 1 | 22 | ||||||
| 2024 | 1 | 22 | ||||||
| 2025 and thereafter | — | — | ||||||
| Total undiscounted cash flows | $ | 65 | $ | 110 | ||||
| Present value of lease payments as lease receivables | 57 | |||||||
| Difference between undiscounted cash flows and discounted cash flows | $ | 8 |
Note 14—Fair Value Measurements
The Company's financial instruments measured on a recurring basis at fair value consisted of the following:
| January 3, 2020 | December 28, 2018 | |||||||||||||||
| Carrying value | Fair value | Carrying value | Fair value | |||||||||||||
| (in millions) | ||||||||||||||||
| Financial assets: | ||||||||||||||||
| Derivatives | $ | 2 | $ | 2 | $ | — | $ | — | ||||||||
| Financial liabilities: | ||||||||||||||||
| Derivatives | 75 | 75 | 35 | 35 |
The Company's derivatives consisted of the fair value interest rate swaps on its $450 million fixed rate 4.45% senior secured notes maturing in December 2020, and cash flow interest rate swaps on $1.5 billion of the Company's variable rate senior secured term loans (see "Note 15—Derivative Instruments"). The fair value of the fair value interest rate swaps and cash flow interest rate swaps is determined based on observed values for underlying interest rates on the LIBOR yield curve and the underlying interest rate, respectively (Level 2 inputs).
The Company's financial instruments measured on a recurring basis at fair value also includes its defined benefit plan assets (Level 2 inputs). See "Note 22—Retirement Plans" for further details on these investments.
The carrying amounts of the Company's financial instruments, other than derivatives, which include cash equivalents, accounts receivable, other short-term receivable, accounts payable and accrued expenses, are reasonable estimates of their related fair values. The carrying value of the Company's note receivable (see "Note 12—Property, Plant and Equipment") of $20 million and $24 million as of January 3, 2020 and December 28, 2018, respectively, approximates fair value as the stated interest rates within the agreements were consistent with the current market rates used in notes with similar terms in the market (Level 2 inputs).
As of January 3, 2020, and December 28, 2018, the fair value of debt was $3.1 billion for both periods, and the carrying amount was $3.0 billion and $3.1 billion, respectively (see "Note 16—Debt"). The fair value of long-term debt is determined based on current interest rates available for debt with terms and maturities similar to the Company's existing debt arrangements (Level 2 inputs).
On August 15, 2019, the Company recorded non-financial instruments measured at fair value on a non-recurring basis in connection with the acquisition of IMX (see "Note 6—Acquisitions"). The preliminary fair values of the assets acquired and liabilities assumed were determined using Level 3 inputs. The Company also had a real estate property measured at fair value (Level 2 inputs) on March 30, 2018, which resulted in an impairment charge of $7 million (see "Note 12—Property, Plant and Equipment"). As of January 3, 2020, and December 28, 2018, the Company did not have any assets or liabilities measured at fair value on a non-recurring basis.
Leidos Holdings, Inc. Annual Report - 78
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 15—Derivative Instruments
The fair value of the Company's interest rate swaps was as follows:
| Asset derivatives | ||||||||||
| Balance sheet line item | January 3, 2020 | December 28, 2018 | ||||||||
| (in millions) | ||||||||||
| Fair value interest rate swaps | Other assets | $ | 2 | $ | — |
| Liability derivatives | ||||||||||
| Balance sheet line item | January 3, 2020 | December 28, 2018 | ||||||||
| (in millions) | ||||||||||
| Fair value interest rate swaps | Other long-term liabilities | $ | — | $ | 3 | |||||
| Cash flow interest rate swaps | Other long-term liabilities | 75 | 32 | |||||||
| $ | 75 | $ | 35 |
The fair value adjustment to the fair value interest rate swap and the underlying debt was an increase of $5 million and a decrease of $3 million for the year ended January 3, 2020, and December 28, 2018, respectively.
The cash flows associated with the interest rate swaps are classified as operating activities in the consolidated statements of cash flows.
Fair Value Hedges
The Company has interest rate swap agreements to hedge the fair value of the $450 million fixed rate 4.45% senior secured notes maturing in December 2020 (the "Notes"). The objective of these instruments is to hedge the Notes against changes in fair value due to the variability in the six-month LIBOR rate (the benchmark interest rate). Under the terms of the interest rate swap agreements, the Company will receive semi-annual interest payments at the coupon rate of 4.45% and will pay variable interest based on the six-month LIBOR rate.
The interest rate swaps were accounted for as a fair value hedge of the Notes and qualified for the shortcut method of hedge accounting, which allows for the assumption of no ineffectiveness. The resulting changes in the fair value of the interest rate swaps are fully offset by the changes in the fair value of the underlying debt (the hedged item) (see "Note 16—Debt").
The fair value of the Notes is stated at an amount that reflects changes in the six-month LIBOR rate subsequent to the inception of the interest rate swaps through the reporting date.
The following amounts were recorded on the consolidated balance sheets related to cumulative basis adjustments for fair value hedges:
| Carrying amount of hedged item | Cumulative amount of fair value adjustment included within the hedged item | |||||||||||||||
| Balance sheet line item of hedged item | January 3, 2020 | December 28, 2018 | January 3, 2020 | December 28, 2018 | ||||||||||||
| (in millions) | ||||||||||||||||
| Long-term debt, net of current portion | $ | 452 | $ | 447 | $ | 2 | $ | (3 | ) |
Leidos Holdings, Inc. Annual Report - 79
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Cash Flow Hedges
The Company has interest rate swap agreements to hedge the cash flows of a portion of its variable rate senior secured term loans (the "Variable Rate Loans"). The objective of these instruments is to reduce variability in the forecasted interest payments of the Company's Variable Rate Loans, which is based on the LIBOR rate. Under the terms of the interest rate swap agreements, the Company will receive monthly variable interest payments based on the one-month LIBOR rate and will pay interest at a fixed rate. In February 2018, the Company entered into interest rate swap agreements to hedge the cash flows of an additional $250 million of its Variable Rate Loans. The interest rate swap agreements on $1.1 billion of the Company's Variable Rate Loans had a maturity date of December 2021 and a fixed interest rate of 1.08%. The interest rate swap agreements on $300 million and $250 million of the Company's Variable Rate Loans both had a maturity date of August 2022 and fixed interest rates of 1.66% and 2.59%, respectively. The counterparties to these agreements are financial institutions.
In September 2018, the Company terminated its existing interest rate swaps. The net derivative gain of $60 million related to the discontinued cash flow hedge remained within accumulated other comprehensive loss and is being reclassified into earnings over the remaining life of the original hedge as the hedged variable rate debt impacts earnings.
Additionally, in September 2018, the Company entered into new interest rate swap agreements to hedge the cash flows of $1.5 billion of the Company's Variable Rate Loans. These interest rate swap agreements have a maturity date of August 2025 and a fixed interest rate of 3.00%.
The interest rate swap transactions were accounted for as cash flow hedges. The gain (loss) on the swap is reported as a component of other comprehensive income (loss) and is reclassified into earnings when the interest payments on the underlying hedged items impact earnings. A qualitative assessment of hedge effectiveness is performed on a quarterly basis, unless facts and circumstances indicate the hedge may no longer be highly effective.
The effect of the Company's cash flow hedges on other comprehensive (loss) income and earnings for the periods presented was as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Total interest expense, net presented in the consolidated statements of income in which the effects of cash flow hedges are recorded | $ | 133 | $ | 138 | $ | 140 | ||||||
| Amount recognized in other comprehensive (loss) income | $ | (55 | ) | $ | (7 | ) | $ | 10 | ||||
| Amount reclassified from accumulated other comprehensive loss to interest expense, net | (7 | ) | (6 | ) | — |
The Company expects to reclassify gains of $1 million from accumulated other comprehensive loss into earnings during the next 12 months.
Leidos Holdings, Inc. Annual Report - 80
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 16—Debt
The Company's debt consisted of the following:
| Stated interest rate | Effective interest rate | January 3, 2020**(1)** | December 28, 2018(1) | |||||||||||
| (in millions) | ||||||||||||||
| Senior secured notes: | ||||||||||||||
| $450 million notes, due December 2020 | 4.45 | % | 4.53 | % | $ | 452 | $ | 447 | ||||||
| $300 million notes, due December 2040 | 5.95 | % | 6.03 | % | 216 | 216 | ||||||||
| Senior secured term loans: | ||||||||||||||
| $690 million Term Loan A, due August 2023 | 3.31 | % | 3.74 | % | 581 | 617 | ||||||||
| $310 million Term Loan A, due August 2023 | 3.31 | % | 3.76 | % | 242 | 258 | ||||||||
| $1,131 million Term Loan B, due August 2025 | 3.56 | % | 3.91 | % | 1,075 | 1,085 | ||||||||
| Senior unsecured notes: | ||||||||||||||
| $250 million notes, due July 2032 | 7.13 | % | 7.43 | % | 247 | 246 | ||||||||
| $300 million notes, due July 2033 | 5.50 | % | 5.88 | % | 158 | 158 | ||||||||
| Notes payable and finance leases due on various dates through fiscal 2022 | 2.85%-5.49% | Various | 15 | 97 | ||||||||||
| Total long-term debt | 2,986 | 3,124 | ||||||||||||
| Less: current portion | (61 | ) | (72 | ) | ||||||||||
| Total long-term debt, net of current portion | $ | 2,925 | $ | 3,052 |
| (1) | The carrying amounts of the senior secured term loans and notes and unsecured notes as of January 3, 2020, and December 28, 2018, include the remaining principal outstanding of $3,004 million and $3,073 million, respectively, less total unamortized debt discounts and deferred debt issuance costs of $35 million and $43 million, respectively, and a $2 million asset and a $3 million liability, respectively, related to the fair value of the interest rate swaps (see "Note 15—Derivative Instruments"). |
Senior Term Loans and Notes
In February 2017, Leidos amended the terms of its senior secured $1.1 billion Term Loan B. As a result, the margin on Term Loan B was reduced by 50 basis points to 2.25%. In August 2017, Leidos amended its senior secured term loans and revolving credit facility agreements. These amendments reduced the applicable margins for the revolving credit facility and Term Loans A and B each by 25 basis points. The amendments also include a collateral suspension provision that will permit the secured credit agreements to become unsecured under certain circumstances.
In March 2018, Leidos amended the terms of its senior secured $1.1 billion Term Loan B. As a result, the margin on Term Loan B was reduced by 25 basis points to 1.75%. The repricing of the term loan became effective March 15, 2018.
In August 2018, Leidos amended its senior secured term loans and revolving credit facility agreements. These amendments modified the margin range for the revolving credit facility and Term Loan A loans and extended their maturity dates by one year to August 2023. The amendments also extended the maturity date of Term Loan B by two years to August 2025 and delayed the scheduled increase in quarterly principal payments for Term Loan A by one year to March 2021. Additionally, the senior secured leverage ratio calculation was amended and excludes the lesser of $350 million and the Company's unrestricted cash and cash equivalents.
In November 2018, Leidos amended the terms of its senior secured $310 million Term Loan A and $1.1 billion Term Loan B. As a result, this transaction assigned the remaining Leidos Innovations Corporation term loan debts to Leidos, Inc. No other terms of the original or amended Term Loan A or Term Loan B loan agreements were changed.
The interest rate on the Company's senior secured term loans is determined based on the LIBOR rate plus a margin. During the periods presented, the margin for the Term Loan A loans ranged from 1.25% to 2.00%, depending on the Company's senior secured leverage ratio, and is computed on a quarterly basis. At January 3, 2020, the current margin on Term Loan A was 1.50% and the margin on Term Loan B was 1.75%.
Leidos Holdings, Inc. Annual Report - 81
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During fiscal 2019, 2018 and 2017, the Company made $80 million, $59 million, and $209 million of principal payments, respectively, on its long-term debt. This activity included $69 million, $46 million, and $76 million of principal payments on its senior secured term loans during fiscal 2019, 2018 and 2017, respectively. In April 2018, the Company made a required debt prepayment of $10 million on its senior secured term loans. The prepayment was a result of the annual excess cash flow calculation for fiscal 2017. In addition to the principal payments above, the Company prepaid $130 million of its senior secured term loans during fiscal 2017.
Principal payments are made quarterly on the Company's variable rate senior secured term loans, with the majority of the principal due at maturity. Interest on the variable rate senior secured term loans is payable on a periodic basis, which must be at least quarterly. Interest on the senior fixed rate secured notes and unsecured notes is payable on a semi-annual basis with principal payments due at maturity.
In connection with the fiscal 2018 and fiscal 2017 amendments, the Company incurred $8 million and $4 million of debt issuance costs, respectively, related to the senior secured term loans and revolving credit facility, which were recorded as an offset against the carrying value of debt and capitalized within "Other assets" in the consolidated balance sheets, respectively. Amortization for the senior secured term loans and notes, unsecured notes and revolving credit facility was $10 million for fiscal 2019 and 2018 and $13 million for fiscal 2017.
The senior secured term loans and notes, unsecured notes and revolving credit facility are fully and unconditionally guaranteed by intercompany guarantees. The senior secured term loans and notes and unsecured notes contain certain customary restrictive covenants, including among other things, restrictions on the Company's ability to create liens and enter into sale and leaseback transactions under certain circumstances. The Company was in compliance with all covenants as of January 3, 2020.
Future minimum payments of debt are as follows:
| Fiscal Year Ending | ||||
| (in millions) | ||||
| 2020 | $ | 519 | ||
| 2021 | 103 | |||
| 2022 | 102 | |||
| 2023 | 619 | |||
| 2024 | 11 | |||
| 2025 and thereafter | 1,667 | |||
| Total principal payments | 3,021 | |||
| Less: unamortized debt discount and issuance costs | (35 | ) | ||
| Total long-term debt | $ | 2,986 |
On December 17, 2019, the Company obtained debt financing commitments from various financial institutions in connection with its entry into a Purchase Agreement with Dynetics. The lenders have provided commitments in an amount up to $4.4 billion in the aggregate, consisting of a $1.65 billion senior unsecured 364-day bridge loan facility to support the Dynetics acquisition (the "Dynetics Bridge Facility") and a $2.75 billion senior unsecured 364-day bridge loan facility to support the refinancing of certain credit facilities (the "Refinancing Bridge Facility"). In January 2020, the Company entered into various debt transactions (see "Note 27—Subsequent Events").
As the Company has the ability to consummate and intends to refinance its existing debt, the carrying value of the $450 million senior secured notes maturing in December 2020 has not been reclassified into the current portion of long-term debt and was reflected within “Long-term debt, net of current portion” as of January 3, 2020.
Revolving Credit Facility
Leidos, Inc. has a revolving credit facility providing up to $750 million in secured borrowing capacity at interest rates determined based upon the LIBOR rate plus a margin that is subject to step-down provisions based on the Company's senior secured leverage ratio. The Company refinanced this credit facility during January 2020 (see "Note 27—Subsequent Events"). During fiscal 2019 and 2018, there were no borrowings under the credit facility.
Leidos Holdings, Inc. Annual Report - 82
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The credit agreements contain certain customary representations and warranties, as well as certain affirmative and negative covenants. The financial covenants define the debt-to-EBITDA ratio that the Company needs to maintain at the end of each quarter. The Company maintains a ratio of total senior secured debt, including borrowings under this credit facility, minus the lesser of $350 million and the Company's unrestricted cash and cash equivalents, to the trailing four quarters of EBITDA (adjusted for certain items as defined in the credit facility) of not more than 3.75 subsequent to February 16, 2019. The Company was in compliance with these financial covenants as of January 3, 2020.
Other covenants in the credit facility restrict certain of the Company's activities, including, among other things, its ability to create liens, dispose of certain assets and merge or consolidate with other entities. The credit facility also contains certain customary events of default, including, among others, defaults based on certain bankruptcy and insolvency events, nonpayment, cross-defaults to other debt, breach of specified covenants, Employee Retirement Income Security Act events, material monetary judgments, change of control events and the material inaccuracy of the Company’s representations and warranties.
Notes Payable
During fiscal 2018, the Company recognized a $79 million note payable related to the sale and leaseback arrangement of its San Diego, CA properties (see "Note 12—Property, Plant and Equipment" for further information). Upon adoption of ASC 842, the transaction qualified as a sale-leaseback and consequently the debt was reclassified into retained earnings as a cumulative effect adjustment.
During fiscal 2017, the Company recognized $21 million of notes payable related to secured borrowings associated with certain contracts within its commercial energy business.
Note 17—Accumulated Other Comprehensive Loss
Changes in the components of accumulated other comprehensive loss were as follows:
| Foreign currency translation adjustments | Unrecognized gain (loss) on derivative instruments | Pension adjustments | Total accumulated other comprehensive loss | |||||||||||||
| (in millions) | ||||||||||||||||
| Balance at December 30, 2016 | $ | (7 | ) | $ | 10 | $ | (7 | ) | $ | (4 | ) | |||||
| Other comprehensive income | 36 | 10 | 9 | 55 | ||||||||||||
| Taxes | (12 | ) | (6 | ) | — | (18 | ) | |||||||||
| Balance at December 29, 2017 | 17 | 14 | 2 | 33 | ||||||||||||
| Cumulative adjustments related to ASU adoptions | 3 | 10 | (4 | ) | 9 | |||||||||||
| Balance at December 30, 2017 | 20 | 24 | (2 | ) | 42 | |||||||||||
| Other comprehensive loss | (65 | ) | (7 | ) | (1 | ) | (73 | ) | ||||||||
| Taxes | 4 | 3 | — | 7 | ||||||||||||
| Reclassification from accumulated other comprehensive loss | — | (6 | ) | — | (6 | ) | ||||||||||
| Balance at December 28, 2018 | (41 | ) | 14 | (3 | ) | (30 | ) | |||||||||
| Other comprehensive income (loss) | 5 | (55 | ) | (1 | ) | (51 | ) | |||||||||
| Taxes | 3 | 15 | — | 18 | ||||||||||||
| Reclassification from accumulated other comprehensive loss | — | (7 | ) | — | (7 | ) | ||||||||||
| Balance at January 3, 2020 | $ | (33 | ) | $ | (33 | ) | $ | (4 | ) | $ | (70 | ) |
Reclassifications for unrecognized gain (loss) on derivative instruments are associated with outstanding debt and are recorded in "Interest expense, net" on the consolidated statements of income. See "Note 15—Derivative Instruments" for more information on the Company's interest rate swap agreements.
Leidos Holdings, Inc. Annual Report - 83
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Reclassifications for pension adjustments are recorded in "Selling, general and administrative expenses" on the consolidated statements of income.
Note 18—Composition of Certain Financial Statement Captions
| Balance Sheet | January 3, 2020 | December 28, 2018 | ||||||
| (in millions) | ||||||||
| Other current assets: | ||||||||
| Transition costs and project assets(1) | $ | 98 | $ | 145 | ||||
| Pre-contract costs | 6 | 41 | ||||||
| Other(2) | 306 | 357 | ||||||
| $ | 410 | $ | 543 | |||||
| Other assets: | ||||||||
| Transition costs and project assets(1) | $ | 207 | $ | 22 | ||||
| Equity method investments(3) | 19 | 26 | ||||||
| Other(2) | 200 | 134 | ||||||
| $ | 426 | $ | 182 | |||||
| Accounts payable and accrued liabilities: | ||||||||
| Accrued liabilities | $ | 822 | $ | 650 | ||||
| Accounts payable | 592 | 547 | ||||||
| Deferred revenue | 400 | 276 | ||||||
| Other(2)(4) | 23 | 18 | ||||||
| $ | 1,837 | $ | 1,491 | |||||
| Accrued payroll and employee benefits: | ||||||||
| Accrued vacation | $ | 232 | $ | 225 | ||||
| Salaries, bonuses and amounts withheld from employees’ compensation | 203 | 248 | ||||||
| $ | 435 | $ | 473 |
(1) During the year ended January 3, 2020 and December 28, 2018, the Company recognized $417 million and $146 million, respectively, of amortization related to its transition costs and project assets.
(2) Balance represents items that are not individually significant to disclose separately.
(3) Balances are net of $25 million and $29 million of dividends received during fiscal 2019 and fiscal 2018, respectively, that were recorded in cash flows provided by operating activities of continuing operations on the consolidated statements of cash flows.
(4) During the year ended January 3, 2020, the Company combined "Dividends payable and "Income taxes payable" with "Accounts payable and accrued liabilities" on the consolidated balance sheets. As a result, the prior year activity has been reclassified to conform with the current year presentation.
| Year Ended | ||||||||||||
| Income Statement | January 3, 2020 | December 28, 2018 | December 29, 2017 | |||||||||
| (in millions) | ||||||||||||
| Interest expense, net: | ||||||||||||
| Interest expense | $ | (147 | ) | $ | (145 | ) | $ | (148 | ) | |||
| Interest income | 14 | 7 | 8 | |||||||||
| $ | (133 | ) | $ | (138 | ) | $ | (140 | ) | ||||
| Other income (expense), net | ||||||||||||
| Gain on sale of businesses | $ | 88 | $ | — | $ | — | ||||||
| Promissory note impairment | — | — | (33 | ) | ||||||||
| (Loss) gain on foreign currencies | (1 | ) | 2 | 5 | ||||||||
| Other (expense) income, net | — | (3 | ) | 2 | ||||||||
| $ | 87 | $ | (1 | ) | $ | (26 | ) |
Leidos Holdings, Inc. Annual Report - 84
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 19—Earnings Per Share ("EPS")
Basic EPS is computed by dividing net income attributable to Leidos common stockholders by the basic weighted average number of shares outstanding. Diluted EPS is calculated to give effect to all potentially dilutive common shares that were outstanding during the reporting period. The dilutive effect of outstanding equity-based compensation awards is reflected in diluted EPS by application of the treasury stock method, only in periods in which such effect would have been dilutive for the period.
The Company issues unvested stock awards that have forfeitable rights to dividends or dividend equivalents. These stock awards are dilutive common share equivalents subject to the treasury stock method.
The weighted average number of shares used to compute basic and diluted EPS attributable to Leidos stockholders were:
| Year Ended | |||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | |||||||
| (in millions) | |||||||||
| Basic weighted average number of shares outstanding | 143 | 151 | 152 | ||||||
| Dilutive common share equivalents—stock options and other stock awards | 2 | 2 | 2 | ||||||
| Diluted weighted average number of shares outstanding | 145 | 153 | 154 |
Anti-dilutive stock-based awards are excluded from the weighted average number of shares outstanding used to compute diluted EPS. For fiscal 2019 and 2017, there were no significant anti-diluted equity awards. For fiscal 2018, there was 1 million of outstanding stock options and vesting stock awards that were anti-dilutive.
Share Repurchases
In the third quarter of fiscal 2019, the Company entered into an Accelerated Share Repurchase ("ASR") agreement with a financial institution to repurchase shares of its outstanding common stock. During the quarter ended September 27, 2019, the Company paid $200 million to the financial institution and received 2.4 million shares related to the ASR agreement. The total number of shares that the Company received under the ASR agreement was based on the volume-weighted-average-price of $84.25 per share for the period August 1, 2019 to September 25, 2019. The purchases were recorded to "Additional paid-in capital" in the consolidated balance sheets. All shares delivered were immediately retired.
In the first quarter of fiscal 2019, the Company entered into an ASR agreement with a financial institution to repurchase shares of its outstanding common stock. During the quarter ended March 29, 2019, the Company paid $200 million to the financial institution and received an initial delivery of 2.6 million shares. In April 2019, the Company received the final delivery of 0.6 million shares related to the ASR agreement. The total number of shares that the Company received under the ASR agreement was based on the volume-weighted-average-price of $63.52 per share for the period February 21, 2019 to April 29, 2019. The purchases were recorded to "Additional paid-in capital" in the consolidated balance sheets. All shares delivered were immediately retired.
In the fourth quarter of fiscal 2018, the Company entered into an uncollared ASR agreement with a financial institution to repurchase shares of its outstanding common stock. The Company paid $250 million to the financial institution and received an initial and final delivery of 3.3 million and 0.7 million shares, respectively. The purchase was recorded to "Additional paid-in capital" in the consolidated balance sheets. All shares delivered were immediately retired.
During fiscal 2019 and 2018, the Company also made open market repurchases of its common stock for an aggregate purchase price of $25 million and $167 million, respectively. All shares repurchased were immediately retired. There were no open market repurchases during fiscal 2017.
Leidos Holdings, Inc. Annual Report - 85
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 20—Stock-Based Compensation
Plan Summaries
As of January 3, 2020, the Company had stock-based compensation awards outstanding under the following plans: the 2017 Omnibus Incentive Plan, 2006 Equity Incentive Plan, as amended, and the 2006 Employee Stock Purchase Plan, as amended ("ESPP"). Leidos issues new shares upon the issuance of the vesting of stock units or exercising of stock options under these plans.
In fiscal 2017, stockholders approved the 2017 Omnibus Incentive Plan which provides the Company and its affiliates' employees, directors and consultants the opportunity to receive various types of stock-based compensation awards, such as stock options, restricted stock units and performance-based awards, as well as cash awards. The Company grants service-based awards that generally vest or become exercisable 25% a year over four years or cliff vest in three years. As of January 3, 2020, 4.4 million shares of Leidos' stock were reserved for future issuance under the 2017 Omnibus Incentive Plan and the 2006 Equity Incentive Plan.
The Company offers eligible employees the opportunity to defer restricted stock units into an equity-based deferred equity compensation plan, the Key Executive Stock Deferral Plan ("KESDP"). Prior to 2013, the Company offered an additional opportunity for deferrals into the Management Stock Compensation Plan ("MSCP"). Benefits from these plans are payable in shares of Leidos' stock that are held in a trust for the purpose of funding shares to the plans' participants. Restricted stock units deferred under the KESDP are counted against the total shares available for future issuance under the 2017 Omnibus Incentive Plan. All awards under the MSCP are fully vested and the plan does not provide for a maximum number of shares available for future issuance.
The Company's ESPP allows eligible employees to purchase shares of Leidos' stock at a discount of up to 15% of the fair market value on the date of purchase. During the first half of fiscal 2018 and 2017, the discount was 5% of the fair market value on the date of purchase, thereby resulting in the ESPP being non-compensatory. Effective the second half of fiscal 2018, the Company increased the discount to 10% of the fair market value on the date of purchase, resulting in the ESPP being compensatory. During fiscal 2019, 2018 and 2017, $25 million, $11 million and $10 million, respectively, was received from ESPP plan participants for the issuance of Leidos' stock. A total of 4.2 million shares remain available for future issuance under the ESPP.
Stock-based compensation and related tax benefits recognized under all plans were as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Total stock-based compensation expense | $ | 52 | $ | 44 | $ | 43 | ||||||
| Tax benefits recognized from stock-based compensation | 13 | 11 | 17 |
Stock Options
Stock options are granted with exercise prices equal to the fair market value of Leidos' common stock on the date of grant and for terms not greater than ten years. Stock options have a term of seven years and a vesting period of four years, except for stock options granted to the Company's outside directors, which have a vesting period of the earlier of one year from grant date or the next annual meeting of stockholders following grant date.
The fair value of the Company's stock option awards is estimated on the date of grant using the Black-Scholes-Merton option-pricing model. The fair value of the Company's stock option awards to employees are expensed on a straight-line basis over the vesting period of four years, except for stock options granted to the Company's outside directors, which is recognized over the vesting period of one year or less.
During fiscal 2017, the Company ceased the usage of peer group volatility, as an input into its blended approach to measure expected volatility, and increased the reliance on historical volatility. The revised blended approach includes the Company's weighted average historical and implied volatilities. The Company continued the use of this approach during fiscal 2018 and fiscal 2019.
Leidos Holdings, Inc. Annual Report - 86
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The risk-free rate is derived using the yield curve of a zero-coupon U.S. Treasury bond with a maturity equal to the expected term of the stock option on the grant date. During fiscal 2017 and fiscal 2018, Leidos utilized the simplified method for the expected term, which represented an appropriate period of time that the options granted were expected to remain outstanding between the weighted-average vesting period and end of the respective contractual term. Upon re-examining the Company's exercise history, the methodology used to calculate the expected term changed in fiscal 2019. Based on actual historical settlement data, the midpoint scenario is utilized with a one-year grant date filter assumption for outstanding options. The Company uses historical data to estimate forfeitures and was derived in the same manner as in the prior years presented.
The weighted average grant-date fair value and assumptions used to determine fair value of stock options granted for the periods presented were as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| Weighted average grant-date fair value | $ | 11.89 | $ | 13.85 | $ | 11.53 | ||||||
| Expected term (in years) | 4.4 | 4.7 | 4.7 | |||||||||
| Expected volatility | 24.3 | % | 26.6 | % | 29.7 | % | ||||||
| Risk-free interest rate | 2.4 | % | 2.6 | % | 1.9 | % | ||||||
| Dividend yield | 2.2 | % | 2.0 | % | 2.5 | % |
Stock option activity for each of the periods presented was as follows:
| Shares of stock under stock options | Weighted average exercise price | Weighted average remaining contractual term | Aggregate intrinsic value | ||||||||||
| (in millions) | (in years) | (in millions) | |||||||||||
| Outstanding at December 30, 2016 | 3.3 | $ | 29.77 | 4.1 | $ | 70 | |||||||
| Options granted | 0.5 | 53.51 | |||||||||||
| Options forfeited or expired | (0.2 | ) | 35.72 | ||||||||||
| Options exercised | (0.8 | ) | 27.23 | 23 | |||||||||
| Outstanding at December 29, 2017 | 2.8 | $ | 34.38 | 3.9 | $ | 86 | |||||||
| Options granted | 0.4 | 63.75 | |||||||||||
| Options forfeited or expired | (0.2 | ) | 49.65 | ||||||||||
| Options exercised | (0.6 | ) | 30.40 | 24 | |||||||||
| Outstanding at December 28, 2018 | 2.4 | $ | 39.41 | 3.8 | $ | 36 | |||||||
| Options granted | 0.5 | 63.61 | |||||||||||
| Options forfeited or expired | — | 58.08 | |||||||||||
| Options exercised | (0.5 | ) | 30.86 | 21 | |||||||||
| Outstanding at January 3, 2020 | 2.4 | 46.04 | 3.8 | 128 | |||||||||
| Exercisable at January 3, 2020 | 1.4 | $ | 37.04 | 2.7 | $ | 89 | |||||||
| Vested and expected to vest in the future as of January 3, 2020 | 2.4 | $ | 45.80 | 3.8 | $ | 126 |
As of January 3, 2020, there was $6 million of unrecognized compensation cost, net of estimated forfeitures, related to stock options, which is expected to be recognized over a weighted-average period of 1.9 years. Tax benefits from stock options exercised for fiscal 2019, 2018 and 2017 were $5 million, $6 million and $7 million respectively.
Restricted Stock Units and Awards
Compensation expense is measured at the grant date fair value and generally recognized over the vesting period of either three to four years based upon required service conditions and in some cases revenue or EPS-based performance conditions.
Leidos Holdings, Inc. Annual Report - 87
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Restricted stock units and awards activity for each of the periods presented was as follows:
| Shares of stock under stock awards | Weighted average grant- date fair value | ||||||
| (in millions) | |||||||
| Unvested stock awards at December 30, 2016 | 2.5 | $ | 40.39 | ||||
| Awards granted | 0.8 | 53.91 | |||||
| Awards forfeited | (0.3 | ) | 45.89 | ||||
| Awards vested | (1.0 | ) | 41.02 | ||||
| Unvested stock awards at December 29, 2017 | 2.0 | $ | 44.96 | ||||
| Awards granted | 0.6 | 64.05 | |||||
| Awards forfeited | (0.2 | ) | 42.67 | ||||
| Awards vested | (0.4 | ) | 44.60 | ||||
| Unvested stock awards at December 28, 2018 | 2.0 | $ | 50.85 | ||||
| Awards granted | 0.6 | 64.70 | |||||
| Awards forfeited | (0.1 | ) | 60.20 | ||||
| Awards vested | (1.1 | ) | 44.10 | ||||
| Unvested stock awards at January 3, 2020 | 1.4 | $ | 60.91 |
As of January 3, 2020, there was $37 million of unrecognized compensation cost, net of estimated forfeitures, related to restricted stock units, which is expected to be recognized over a weighted average period of 2.0 years. The fair value of restricted stock units that vested in fiscal 2019, 2018 and 2017, was $66 million, $22 million and $33 million, respectively. In addition, the fair value of dividend equivalents with respect to restricted stock units that vested in fiscal 2019 and 2018 was $1 million and in fiscal 2017 was $13 million.
Performance-Based Stock Awards
The Company's performance-based stock awards vest and the stock is issued at the end of a three-year period based upon the achievement of specific performance criteria, with the number of shares ultimately awarded, if any, ranging up to 150% of the specified target awards. If performance is below the threshold level of performance, no shares will be issued.
For awards granted during fiscal 2019, 2018 and 2017, the target number of shares of stock granted under the awards will vest and the stock will be issued at the end of a three-year period based on a three-year cycle performance period and the actual number of shares to be issued will be based upon the achievement of the three-year cycle's performance criteria. Also, during fiscal 2019, 2018 and 2017, the Company granted performance-based awards with market conditions. These market conditions grants represent the target number of shares and the actual number of shares to be awarded upon vesting may be higher or lower depending upon the achievement of the relevant market conditions. The target number of shares granted under the market conditions grants will vest and the stock will be issued at the end of a three-year period based on the attainment of certain total shareholder return performance measures and the employee's continued service through the vest date.
Leidos Holdings, Inc. Annual Report - 88
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Performance-based stock award activity for each of the periods presented was as follows:
| Expected number of shares of stock to be issued under performance-based stock awards | Weighted average grant- date fair value | ||||||
| (in millions) | |||||||
| Unvested at December 30, 2016 | 0.4 | $ | 44.44 | ||||
| Awards granted | 0.2 | 57.94 | |||||
| Awards vested | (0.1 | ) | 42.85 | ||||
| Unvested at December 29, 2017 | 0.5 | $ | 50.34 | ||||
| Awards granted | 0.3 | 61.43 | |||||
| Awards forfeited | (0.1 | ) | 61.81 | ||||
| Awards vested | (0.2 | ) | 44.04 | ||||
| Unvested at December 28, 2018 | 0.5 | $ | 57.36 | ||||
| Awards granted | 0.2 | 66.92 | |||||
| Awards forfeited | — | 66.72 | |||||
| Awards vested | (0.1 | ) | 45.83 | ||||
| Unvested at January 3, 2020 | 0.6 | $ | 63.66 |
The weighted average grant date fair value for performance-based stock, excluding those with a market condition, during fiscal 2019, 2018 and 2017 was $62.66, $63.76 and $53.58, respectively. The weighted average grant date fair value for performance-based stock with market conditions that were granted during fiscal 2019, 2018 and 2017, was $72.53, $71.50 and $62.30, respectively, and was calculated using the Monte Carlo simulation.
The Monte Carlo simulation assumptions used for the periods presented were as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| Expected volatility | 22.02 | % | 25.37 | % | 27.19 | % | ||||||
| Risk free rate of return | 2.39 | % | 2.35 | % | 1.53 | % | ||||||
| Weighted average grant date stock price | $ | 62.66 | $ | 65.00 | $ | 53.73 |
As of January 3, 2020, there was $12 million of unrecognized compensation cost, net of estimated forfeitures, which is expected to be recognized over a weighted average period of 1.7 years. The fair value of performance-based stock awards that vested in fiscal 2019, 2018 and 2017 was $9 million, $13 million, and $4 million, respectively.
Note 21—Income Taxes
In December 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (“Tax Act”). The Tax Act made broad and complex changes to the U.S. tax code. As a result, the Company recorded a preliminary net tax benefit of $115 million in fiscal 2017, and in accordance with Staff Accounting Bulletin No.118, the company decreased its preliminary net tax benefit estimate by $4 million during fiscal 2018.
Leidos Holdings, Inc. Annual Report - 89
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Less than 10% of the Company's income before income taxes for fiscal 2019, 2018 and 2017 was earned outside of the United States. The provision for income taxes for the periods presented included the following:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Current: | ||||||||||||
| Federal and foreign | $ | 147 | $ | 54 | $ | 130 | ||||||
| State | 31 | 23 | 30 | |||||||||
| Deferred: | ||||||||||||
| Federal and foreign | 21 | (39 | ) | (141 | ) | |||||||
| State | (3 | ) | (10 | ) | 10 | |||||||
| Total | $ | 196 | $ | 28 | $ | 29 |
A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate to income before income taxes for the periods presented was as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Amount computed at the statutory federal income tax rate | $ | 182 | $ | 128 | $ | 138 | ||||||
| State income taxes, net of federal tax benefit | 22 | 10 | 31 | |||||||||
| Excess tax benefits from stock-based compensation | (11 | ) | (9 | ) | (12 | ) | ||||||
| Research and development credits | (11 | ) | (9 | ) | (7 | ) | ||||||
| Change in valuation allowance for deferred tax assets | 6 | (49 | ) | 7 | ||||||||
| Stock basis in subsidiary held for sale | 5 | (16 | ) | — | ||||||||
| Change in accruals for uncertain tax positions | 4 | 1 | — | |||||||||
| Dividends paid to employee stock ownership plan | (2 | ) | (2 | ) | (4 | ) | ||||||
| Impact of foreign operations | 2 | — | (4 | ) | ||||||||
| Taxable conversion of a subsidiary | — | (17 | ) | — | ||||||||
| Change in statutory federal tax rate | — | (10 | ) | (125 | ) | |||||||
| Capitalized transaction costs | — | — | 9 | |||||||||
| Other | (1 | ) | 1 | (4 | ) | |||||||
| Total | $ | 196 | $ | 28 | $ | 29 | ||||||
| Effective income tax rate | 22.6 | % | 4.6 | % | 7.4 | % |
The Company's effective tax rate for fiscal 2019 was favorably impacted primarily by excess tax benefits related to employee stock-based payment transactions and federal research tax credits, partially offset by an increase in valuation allowances arising from foreign withholding tax and an increase in taxes related to the sale of the commercial cybersecurity business.
The Company's effective tax rate for fiscal 2018 was favorably impacted primarily by a decrease in valuation allowances arising from the taxable conversion of a subsidiary and the utilization of capital losses, an increase in deferred tax assets related to stock basis of a subsidiary held for sale, excess tax benefits related to employee stock-based payment transactions and federal research tax credits.
The Company's effective tax rate for fiscal 2017 was favorably impacted primarily by the Tax Act's reduction of the federal corporate tax rate from 35% to 21% applied to the Company's fiscal 2017 year-end deferred tax balances and excess tax benefits related to employee stock-based payment transactions.
Leidos Holdings, Inc. Annual Report - 90
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Deferred income taxes are recorded for differences in the basis of assets and liabilities for financial reporting purposes and tax reporting purposes. Deferred tax assets (liabilities) were comprised of the following:
| January 3, 2020 | December 28, 2018 | |||||||
| (in millions) | ||||||||
| Operating lease liabilities | $ | 115 | $ | — | ||||
| Accrued vacation and bonuses | 54 | 48 | ||||||
| Reserves | 46 | 57 | ||||||
| Deferred compensation | 26 | 25 | ||||||
| Credits and net operating losses carryovers | 25 | 31 | ||||||
| Vesting stock awards | 18 | 20 | ||||||
| Accumulated other comprehensive loss | 12 | — | ||||||
| Deferred rent and tenant allowances | 4 | 18 | ||||||
| Investments | 2 | 18 | ||||||
| Deferred gain | — | 20 | ||||||
| Other | 9 | 13 | ||||||
| Total deferred tax assets | 311 | 250 | ||||||
| Valuation allowance | (20 | ) | (28 | ) | ||||
| Deferred tax assets, net of valuation allowance | 291 | 222 | ||||||
| Purchased intangible assets | $ | (339 | ) | $ | (326 | ) | ||
| Operating lease right-of-use assets | (103 | ) | — | |||||
| Deferred revenue | (17 | ) | (40 | ) | ||||
| Employee benefit contributions | (6 | ) | (4 | ) | ||||
| Accumulated other comprehensive income | — | (6 | ) | |||||
| Partnership interest | — | (2 | ) | |||||
| Other | (10 | ) | (14 | ) | ||||
| Total deferred tax liabilities | (475 | ) | (392 | ) | ||||
| Net deferred tax liabilities | $ | (184 | ) | $ | (170 | ) |
At January 3, 2020, the Company had state net operating losses of $77 million and state tax credits of $7 million. Both will begin to expire in fiscal 2020; however, the Company expects to utilize $24 million and $7 million of these state net operating losses and state tax credits, respectively. The Company also had foreign net operating losses of $44 million, which do not expire. The Company expects to utilize $9 million of these foreign net operating losses.
Our valuation allowance for deferred tax assets was $20 million and $28 million as of January 3, 2020 and December 28, 2018, respectively. The valuation allowance decreased by $8 million primarily due to the sale of the commercial cybersecurity business and releases related to the expected utilization of certain carryover attributes, partially offset by an increase related to foreign withholding taxes.
Leidos Holdings, Inc. Annual Report - 91
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Company's income tax balance sheet items are included in the accompanying consolidated balance sheets as follows:
| January 3, 2020 | December 28, 2018 | |||||||
| (in millions) | ||||||||
| Other current assets: | ||||||||
| Prepaid income taxes and tax refunds receivable | $ | 24 | $ | 43 | ||||
| Accounts payable and accrued liabilities: | ||||||||
| Income taxes payable | $ | 19 | $ | 3 | ||||
| Deferred tax liabilities | 184 | 170 | ||||||
| Other long-term liabilities: | ||||||||
| Unrecognized tax benefits | $ | 1 | $ | 3 |
The Company's unrecognized tax benefits are primarily related to certain recurring deductions customary for the Company’s industry. The changes in the unrecognized tax benefits, excluding $1 million of accrued interest and penalties for fiscal 2018 and 2017, were as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Unrecognized tax benefits at beginning of year | $ | 6 | $ | 10 | $ | 9 | ||||||
| Additions for tax positions related to current year | — | 3 | 2 | |||||||||
| Additions for tax positions related to prior years | 11 | — | 2 | |||||||||
| Reductions for tax positions related to prior years(1) | (1 | ) | (5 | ) | (2 | ) | ||||||
| Settlements with taxing authorities(1) | (11 | ) | (2 | ) | (1 | ) | ||||||
| Unrecognized tax benefits at end of year | $ | 5 | $ | 6 | $ | 10 | ||||||
| Unrecognized tax benefits that, if recognized, would affect the effective income tax rate | $ | 4 | $ | 6 | $ | 7 |
(1) Settlements with taxing authorities for fiscal 2018 and 2017 have been reclassified from "Reductions for tax positions related to prior years" to "Settlements with taxing authorities" to reflect the current year change in presentation.
At January 3, 2020, the balance of unrecognized tax benefits included liabilities for uncertain tax positions of $5 million, $1 million of which were classified as other long-term liabilities on the Company's consolidated balance sheets. At December 28, 2018, the balance of unrecognized tax benefits included liabilities for uncertain tax positions of $7 million, $3 million of which were classified as other long-term liabilities on the Company's consolidated balance sheets. At December 29, 2017, the balance of unrecognized tax benefits included liabilities for uncertain tax positions of $11 million, $7 million of which were classified as other long-term liabilities on the Company's consolidated balance sheets.
The Company files income tax returns in the United States and various state and foreign jurisdictions. The Company participates in the Internal Revenue Service (“IRS”) Compliance Assurance Process, a real-time audit of the Company's consolidated federal corporate income tax return. The IRS has examined the Company's consolidated federal income tax returns through the year ended December 29, 2017. With a few exceptions, as of January 3, 2020, the Company is no longer subject to state, local, or foreign examinations by the tax authorities for fiscal years ending on or before January 1, 2016.
Leidos Holdings, Inc. Annual Report - 92
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During the next 12 months, it is reasonably possible that resolution of reviews by taxing authorities, both domestic and international, could be reached with respect to $3 million of the Company's unrecognized tax benefits, depending on the timing of ongoing examinations, any litigation and expiration of statute of limitations, either because the Company's tax positions are sustained or because the Company agrees to their disallowance and pays the related income tax. While the Company believes it has adequate accruals for uncertain tax positions, the tax authorities may determine that the Company owes taxes in excess of recorded accruals or the recorded accruals may be in excess of the final settlement amounts agreed to by tax authorities.
Note 22—Retirement Plans
Defined Contribution Plans
The Company sponsors a defined contribution plan, the Leidos, Inc. Retirement Plan, which is both a 401(k) plan and an employee stock ownership plan in which most employees are eligible to participate. This plan allows eligible participants to contribute a portion of their income through payroll deductions and the Company may also make discretionary contributions. Company contributions were $105 million for fiscal 2019 and $94 million for fiscal 2018 and 2017.
Deferred Compensation Plans
The Company maintains three deferred compensation plans, the Keystaff Deferral Plan ("KDP"), the KESDP and the MSCP (the "Plans"), for the benefit of certain management or highly compensated employees or members of the Board of Directors. The deferred compensation plans allow eligible participants to elect to defer a portion of their salary, and all or a portion of certain bonuses, including restricted stock unit awards. Directors may also elect to defer their cash compensation in addition to their restricted stock unit awards. Deferred balances in the Plans are paid in lump sum or installments upon retirement, termination or the elected specified date.
The Company makes no contributions to the KDP but maintains participant accounts for deferred amounts and investments. The Company maintains a rabbi trust for the purpose of funding benefit payments to the KDP participants. Participants may allocate deferred salary and cash bonus amounts into a variety of designated investment options, with gains and losses based on the elected investment option performance with the participant assuming all risks related to future returns of their contributions.
Under the KESDP, eligible participants may also elect to defer in share units all or a portion of certain cash bonuses and restricted stock unit awards granted under the previous 2006 Equity Incentive Plan and the current 2017 Omnibus Incentive Plan (see "Note 20—Stock-Based Compensation"). Under the MSCP, restricted stock share units are fully vested and no further deferrals into the plan are made. The Company makes no contributions to the accounts of KESDP or MSCP participants. Benefits from the KESDP and MSCP are payable in shares of Leidos common stock held in a rabbi trust for the purpose of funding benefit payments to KESDP and MSCP participants.
Defined Benefit Plans
The Company sponsors a defined benefit pension plan in the United Kingdom for former employees on an expired customer contract. While benefits under the plan are frozen, the Company has continuing defined benefit pension obligations with respect to certain plan participants. In fiscal 2012, the Company sold certain components of its business, including the component of its business that contained this pension and employed the pension plan participants. Pursuant to the definitive sale agreement, the Company retained the assets and obligations of this defined benefit pension plan. As a result of retaining the pension obligation, the remaining immaterial components of ongoing pension expense, primarily interest costs and assumed return on plan assets subsequent to the sale, are recorded in continuing operations.
The projected benefit obligation as of January 3, 2020, and December 28, 2018, was $121 million and $103 million, respectively. The increase in the projected benefit obligation was primarily due to a loss resulting from changes in assumptions used in the valuation and adverse exchange rate movements in the British pound when compared to the U.S. dollar.
The fair value of plan assets as of January 3, 2020, and December 28, 2018, was $139 million and $115 million, respectively. The plan funding status was overfunded $18 million and $12 million as of January 3, 2020, and December 28, 2018, respectively, and included within "Other assets" on the consolidated balance sheets.
Leidos Holdings, Inc. Annual Report - 93
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Other
The Company also sponsors a defined benefit pension plan for employees working on one U.S. government contract. As part of the contractual agreement, the customer reimburses the Company for contributions made to the plan that are allowable under government contract cost accounting requirements. If the Company were to cease being the contractor as a result of a recompetition process, this defined benefit pension plan and related plan assets and liabilities would transfer to the new contractor. If the contract expires or is terminated with no transfer of the plan to a successor contractor, any amount by which plan liabilities exceed plan assets, as of that date, will be reimbursed by the U.S. government customer. Since the Company is not responsible for the current or future funded status of this plan, no assets or liabilities arising from its funded status are recorded in the Company's consolidated financial statements and no amounts associated with this plan are included in the defined benefit plan disclosures above.
Note 23—Supplementary Cash Flow Information and Restricted Cash
Supplementary cash flow information, including non-cash activities, for the periods presented was as follows:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Supplementary cash flow information: | ||||||||||||
| Cash paid for interest | $ | 172 | $ | 133 | $ | 133 | ||||||
| Cash paid for income taxes, net of refunds | 142 | 70 | 214 | |||||||||
| Non-cash investing activity: | ||||||||||||
| Fixed asset additions | $ | 27 | $ | — | $ | — | ||||||
| Non-cash financing activity: | ||||||||||||
| Real estate financing transaction | $ | — | $ | 65 | $ | — | ||||||
| Notes payable and capital lease obligations | — | — | 27 |
The following is a reconciliation of cash and cash equivalents, as reported within the consolidated balance sheets, to the total cash, cash equivalents and restricted cash, as reported within the consolidated statements of cash flows:
| January 3, 2020 | December 28, 2018 | |||||||
| (in millions) | ||||||||
| Cash and cash equivalents | $ | 668 | $ | 327 | ||||
| Restricted cash | 49 | 42 | ||||||
| Total cash, cash equivalents and restricted cash | $ | 717 | $ | 369 |
The restricted cash is recorded within "Other current assets" in the Company's consolidated balance sheets.
The restricted cash is primarily comprised of advances from customers that are restricted as to use for certain expenditures related to that customer's contract.
Leidos Holdings, Inc. Annual Report - 94
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 24—Business Segments
The Company's operations and reportable segments are organized around the customers and markets it serves. The Company defines its reportable segments based on the way the chief operating decision maker ("CODM"), currently its Chairman and Chief Executive Officer, manages the operations of the Company for purposes of allocating resources and assessing performance.
The Company's business is aligned into three reportable segments (Defense Solutions, Civil and Health). Additionally, the Company separately presents the unallocable costs associated with corporate functions as Corporate. Effective the beginning of fiscal 2019, the Company changed the composition of its Defense Solutions reportable segment to better align the operations within the reportable segment to the customers it serves. This resulted in the identification of new operating segments within Defense Solutions. In addition, certain contracts were reassigned between the Civil and Defense Solutions reportable segments. While this activity did not have a material impact on the Company's reportable segments, prior year segment results have been recast to reflect this change.
Defense Solutions is focused on rapidly deploying agile, cost-effective solutions to meet the ever-changing missions of the Company's customers in the areas of intelligence surveillance and reconnaissance, enterprise IT, integrated systems, cybersecurity and global services. Defense Solutions provides a diverse portfolio of national security solutions and systems for air, land, sea, space and cyberspace for the U.S. Intelligence Community, the DoD, military services, government agencies of U.S. allies abroad and other federal and commercial customers in the national security industry. The Company's solutions deliver innovative technology, large-scale intelligence systems, command and control platforms, data analytics, logistics and cybersecurity solutions, as well as intelligence analysis and operations support to critical missions around the world.
The Civil business is focused on seamlessly integrating and protecting physical, digital and data domains. By applying leading science, effective technologies and business acumen, the Company's talented employees help customers maximize their performance and take on the connected world with data-driven insights, improved efficiencies and technological advantages.
The Health business is focused on delivering effective and affordable solutions to federal and commercial customers that are responsible for the health and well-being of people worldwide including service members and veterans. These solutions enable customers to deliver on the health mission of providing high quality, cost effective care and are accomplished through the integration of information technology, engineering, health and life sciences, clinical insights and health policy. The capabilities the Health business provides are principally encapsulated by four major areas of activity: complex systems integration, managed health services, enterprise IT transformation and life sciences.
Corporate includes the operations of various corporate activities, certain corporate expense items that are not reimbursed by the Company's U.S. government customers and certain other expense items excluded from a reportable segment's performance.
Leidos Holdings, Inc. Annual Report - 95
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes business segment information for the periods presented:
| Year Ended | ||||||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | ||||||||||
| (in millions) | ||||||||||||
| Revenues: | ||||||||||||
| Defense Solutions | $ | 5,367 | $ | 4,966 | $ | 4,989 | ||||||
| Civil | 3,729 | 3,411 | 3,379 | |||||||||
| Health | 1,998 | 1,817 | 1,802 | |||||||||
| Total revenues | $ | 11,094 | $ | 10,194 | $ | 10,170 | ||||||
| Operating income (loss): | ||||||||||||
| Defense Solutions | $ | 407 | $ | 353 | $ | 312 | ||||||
| Civil | 295 | 284 | 221 | |||||||||
| Health | 242 | 230 | 228 | |||||||||
| Corporate | (32 | ) | (118 | ) | (202 | ) | ||||||
| Total operating income | $ | 912 | $ | 749 | $ | 559 | ||||||
| Amortization of intangible assets: | ||||||||||||
| Defense Solutions | $ | 60 | $ | 68 | $ | 108 | ||||||
| Civil | 67 | 87 | 132 | |||||||||
| Health | 46 | 46 | 41 | |||||||||
| Total amortization of intangible assets | $ | 173 | $ | 201 | $ | 281 |
The financial performance measures used to evaluate segment performance are revenues and operating income. As a result, "Interest expense, net," "Other income (expense), net," and "Income tax expense," as reported in the consolidated financial statements are not allocated to the Company's segments. Under U.S. government CAS, indirect costs including depreciation expense are collected in numerous indirect cost pools, which are then collectively allocated out to the Company’s reportable segments based on a representative causal or beneficial relationship of the costs in the pool to the costs in the base. While depreciation expense is a component of the allocated costs, the allocation process precludes depreciation expense from being specifically identified by the Company’s individual reportable segments. For this reason, depreciation expense by reportable segment has not been reported above.
Asset information by segment is not a key measure of performance used by the CODM.
Less than 10% of the Company's revenues and tangible long-lived assets are generated by or owned by entities outside of the United States. As such, additional financial information by geographic location is not presented.
The Company's revenues are largely attributable to prime contracts with the U.S. government or to subcontracts with other contractors engaged in work for the U.S. government. The percentages of total revenues for the U.S. government, its agencies and other customers comprising more than 10% of total revenues in any of the periods for the periods presented were as follows:
| Year Ended | |||||||||
| January 3, 2020 | December 28, 2018 | December 29, 2017 | |||||||
| U.S. Government | 87 | % | 85 | % | 84 | % | |||
| DoD and U.S. Intelligence Community | 48 | % | 48 | % | 48 | % | |||
| U.S. Army | 11 | % | 13 | % | 13 | % |
Leidos Holdings, Inc. Annual Report - 96
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 25—Contingencies
Legal Proceedings
MSA Joint Venture
On November 10, 2015, MSA received a final decision by the Department of Energy ("DoE") contracting officer for the Mission Support Contract concluding that certain payments to MSA by the DoE for the performance of IT services by Lockheed Martin Services, Inc. (“LMSI”) under a subcontract to MSA constituted alleged affiliate fees in violation of the FAR. Lockheed Martin Integrated Technology LLC (now known as Leidos Integrated Technology LLC) is a member entity of MSA. Subsequent to the contracting officer's final decision, MSA, LMSI and Lockheed Martin Corporation received notice from the U.S. Attorney's Office for the Eastern District of Washington that the U.S. government had initiated a False Claims Act investigation into the facts surrounding this dispute. On February 8, 2019, the Department of Justice filed a complaint in the United States District Court for the Eastern District of Washington against MSA, Lockheed Martin Corporation, Lockheed Martin Services, Inc. and a Lockheed Martin employee ("Defendants"). The complaint alleges violations of the False Claims Act, the Anti-Kickback Act, breach of contract with DoE, among other things. On January 13, 2020, the Defendants' motions to dismiss were granted in part and denied in part. Litigation will proceed for the False Claims Act and other common law claims, although the Anti-Kickback Act claim has been dismissed with prejudice. The U.S. Attorney's office had previously advised that a parallel criminal investigation was open, although no subjects or targets of the investigation had been identified. The U.S. Attorney's office has informed MSA that it has closed the criminal investigation.
Since this issue first was raised by the DoE, MSA has asserted that the IT services performed by LMSI under a fixed-price/fixed-unit rate subcontract approved by the DoE meet the definition of a "commercial item" under the FAR and any profits earned on that subcontract are permissible. MSA filed an appeal of the contracting officer's decision with the Civilian Board of Contract Appeals ("CBCA"), which was stayed pending resolution of the False Claims Act matter. Subsequent to the filing of MSA's appeal, the contracting officer demanded that MSA reimburse the DoE in the amount of $64 million, which was his estimate of the profits earned during the period from 2010 to 2014 by LMSI. The DoE has deferred collection of $32 million of that demand, pending resolution of the appeal and without prejudice to MSA's position that it is not liable for any of the DOE's $64 million reimbursement claim. On December 10, 2019, MSA received a second final decision by the DoE contracting officer, estimating approximately $29 million in alleged unallowable profit and associated general and administrative costs during the period from 2015 to 2016 by LMSI. MSA filed an appeal of the second contracting officer's decision, which has been consolidated with the prior proceeding before the CBCA and stayed pending resolution of the False Claims Act matter. The DoE and MSA also executed an agreement to defer the entire amount of the disallowed costs from the second contracting officer's final decision until the CBCA proceedings are finally resolved. The Company has agreed to indemnify Jacobs Group, LLC and Centerra Group, LLC for any liability MSA incurs in this matter. Under the terms of the Separation Agreement, Lockheed Martin agreed to indemnify the Company for 100% of any damages in excess of $38 million up to $64 million, and 50% of any damages in excess of $64 million, with respect to claims asserted against MSA related to this matter.
At January 3, 2020, the Company had a liability of $39 million recorded in the consolidated balance sheets for this matter. The amount of possible loss ultimately incurred, if any, is subject to a range of complex factors and potential outcomes that remain to be determined, including information gathered during the course of litigation, pretrial and trial rulings and other litigation-related developments.
Leidos Holdings, Inc. Annual Report - 97
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Securities Litigation
Between February and April 2012, alleged stockholders filed three putative securities class actions against the Company and several former executives relating to the Company's contract to develop and implement an automated time and attendance and workforce management system for certain agencies of the City of New York ("CityTime"). One case was withdrawn and two cases were consolidated in the U.S. District Court for the Southern District of New York in In Re: SAIC, Inc. Securities Litigation. The consolidated securities complaint asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 based on allegations that the Company and individual defendants made misleading statements or omissions about the Company's revenues, operating income and internal controls in connection with disclosures relating to the CityTime project. The plaintiffs sought to recover from the Company and the individual defendants an unspecified amount of damages class members allegedly incurred by buying Leidos' stock at an inflated price. The District Court dismissed the plaintiffs' claims with prejudice and without leave to replead. The plaintiffs then appealed to the United States Court of Appeals for the Second Circuit, which issued an opinion affirming in part, and vacating in part, the District Court's ruling. The Company filed a petition for a writ of certiorari in the U.S. Supreme Court, which was granted on March 27, 2017. The District Court granted the Company's request to stay all proceedings, including discovery, pending the outcome at the Supreme Court. In September 2017, the parties engaged in mediation resulting in an agreement to settle all remaining claims for an immaterial amount to be paid by the Company. On October 2, 2019, the court granted preliminary approval of the proposed settlement. The amounts payable by the Company are covered by an insurance policy.
Greek Government Contract
In 2003, the Company entered into an FFP contract with the Hellenic Republic of Greece to provide a Command, Control, Communications, Coordination and Integration System. The Greek government disputed the contract balance owed to the Company and withheld payment. In 2013, the Company received an arbitral award by the International Chamber of Commerce. In 2017, the U.S. District Court granted an order to enforce the arbitration award and entered judgment in the Company's favor. The Company subsequently commenced enforcement proceedings against the Greek government. On September 10, 2019, the Company received $59 million on behalf of Leidos and its subcontractors, substantially, though not entirely, resolving the Company's claim.
Arbitration Proceeding
The Company is a party to an arbitration proceeding involving a claim by Lockheed Martin for indemnification for $56 million in taxes attributable to deferred revenue recognized as a result of the IS&GS Transactions. Based on the arguments advanced to date, the Company believes that the claim appears to be without merit and intends to vigorously defend itself in arbitration. The Company does not believe that a material loss is probable, and has therefore not recorded any liability for this matter.
Other
The Company is also involved in various claims and lawsuits arising in the normal conduct of its business, none of which, in the opinion of the Company's management, based upon current information, will likely have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows.
Other Contingencies
VirnetX, Inc.
On September 29, 2017, the federal trial court in the Eastern District of Texas entered a final judgment in the VirnetX v. Apple case referred to as the Apple I case. The court found that Apple willfully infringed the VirnetX patents at issue in the Apple I case and awarded enhanced damages, bringing the total award against Apple to over $343 million in pre-interest damages. The court subsequently awarded an additional sum of over $96 million for costs, attorneys' fees and interest, bringing the total award to VirnetX in the Apple I case to over $439 million. Apple appealed the judgment in the Apple I case with the U.S. Court of Appeals for the Federal Circuit and on January 15, 2019, the court affirmed the $439 million judgment. On August 1, 2019, the U.S. Court of Appeals for the Federal Circuit denied Apple's petition for panel and en banc rehearing, but Apple subsequently filed motions to stay and vacate the judgment, and for leave to file a second petition for rehearing. These motions were denied by the court on October 1, 2019. On December 27, 2019, Apple filed a petition in the Apple I matter for a writ of certiorari with the United States Supreme Court.
Leidos Holdings, Inc. Annual Report - 98
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
On April 10, 2018, a jury trial concluded in an additional patent infringement case brought by VirnetX against Apple, referred to as the Apple II case, in which the jury returned a verdict against Apple for infringement and awarded VirnetX damages in the amount of over $502 million. On April 11, 2018, in a second phase of the Apple II trial, the jury found Apple's infringement to be willful. On August 30, 2018, the federal trial court in the Eastern District of Texas entered a final judgment and rulings on post-trial motions in the Apple II case. The court affirmed the jury’s verdict of over $502 million and granted VirnetX’s motions for supplemental damages, a sunset royalty and royalty rate of $1.20 per infringing device, along with pre-judgment and post-judgment interest and costs. The court denied VirnetX’s motions for enhanced damages, attorneys’ fees and an injunction. The court also denied Apple’s motions for judgment as a matter of law and for a new trial. An additional sum of over $93 million for costs and pre-judgment interest was subsequently agreed upon pursuant to a court order, bringing the total award to VirnetX in the Apple II case to over $595 million. Apple filed an appeal of the judgment in the Apple II case with the U.S. Court of Appeals for the Federal Circuit, and on November 22, 2019, the Federal Circuit affirmed in part, reversed in part and remanded the Apple II case back to the District Court. The Federal Circuit affirmed that Apple infringed two of the patents at issue in the case, and ruled that Apple is precluded from making certain patent invalidity arguments. However, the Federal Circuit reversed the judgment that Apple infringed two other patents at issue, vacated the prior damages award in the Apple II case, and remanded the Apple II case back to the District Court for further proceedings regarding damages.
Under its agreements with VirnetX, the Company would receive 25% of the proceeds obtained by VirnetX after reduction for attorneys' fees and costs. However, the verdicts in these cases remain subject to appeal. In addition, the patents at issue in these cases are subject to U.S. Patent and Trademark Office post-grant inter partes review and/or reexamination proceedings and related appeals, which may result in all or part of these patents being invalidated or the claims of the patents being limited. Thus, no assurances can be given when or if the Company will receive any proceeds in connection with these jury awards. In addition, if the Company receives any proceeds, the Company is required to pay a royalty to the customer who paid for the development of the technology.
The Company does not have any assets or liabilities recorded in connection with this matter as of January 3, 2020.
Government Investigations and Reviews
The Company is routinely subject to investigations and reviews relating to compliance with various laws and regulations with respect to its role as a contractor to federal, state and local government customers and in connection with performing services in countries outside of the United States. Adverse findings could have a material effect on the Company's business, financial position, results of operations and cash flows due to its reliance on government contracts.
As of January 3, 2020, indirect cost audits by the DCAA remain open for fiscal 2013 and subsequent fiscal years. Although the Company has recorded contract revenues based upon an estimate of costs that the Company believes will be approved upon final audit or review, the Company cannot predict the outcome of any ongoing or future audits or reviews and adjustments and, if future adjustments exceed the Company's estimates, its profitability would be adversely affected. As of January 3, 2020, the Company believes it has adequately reserved for potential adjustments from audits or reviews of contract costs.
In February 2019, the Company executed an external restructuring advance agreement with the DoD in accordance with provisions of the Defense Federal Acquisition Regulation Supplement, which allows the Company to recover certain specified external restructuring costs.
Note 26—Commitments
The Company has outstanding letters of credit of $66 million as of January 3, 2020, principally related to performance guarantees on contracts. The Company also has outstanding surety bonds with a notional amount of $57 million as of January 3, 2020, principally related to performance and subcontractor payment bonds on the Company's contracts. The value of the surety bonds may vary due to changes in the underlying project status and/or contractual modifications. The outstanding letters of credit and surety bonds have various terms with the majority expiring over the next three fiscal years.
Leidos Holdings, Inc. Annual Report - 99
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Reston, VA Lease Agreement
On January 24, 2018, the Company entered into a lease agreement with its current lessor for office space in a building to be constructed to function as the Company's new corporate headquarters in Reston, VA (see "Note 13—Leases").
Gaithersburg, MD Lease Agreement
On December 31, 2018, the Company closed the sale and leaseback agreement relating to its land and building in Gaithersburg, MD (see "Note 12—Property, Plant and Equipment").
San Diego, CA Lease Agreement
On December 28, 2018, the Company closed the sales and leaseback agreement relating to two buildings and the adjacent land in San Diego, CA (see "Note 12—Property, Plant and Equipment").
Note 27—Subsequent Events
Debt Financing
On January 17, 2020 (the “Closing Date"), the Company entered into a Credit Agreement (the “Credit Agreement”) with certain financial institutions, which provides for a senior unsecured term loan A facility in an aggregate principal amount of $1.9 billion (the “Term Loan Facility”) and a $750 million senior unsecured revolving facility (the “Revolving Facility” and, together with the Term Loan Facility, the “Credit Facilities”). As a result of the Credit Agreement, the Refinancing Bridge Facility was terminated without being funded. The Credit Facilities will mature five years from the Closing Date, subject to up to two additional one year extensions.
The Company used the proceeds of the Term Loan Facility and cash on hand on the Closing Date to repay in full all indebtedness, and terminate all commitments, under, and discharge and release all guarantees and liens existing in connection with the Credit Agreements entered into in August 2016 ("the Terminated Credit Agreements"). The obligations under the Credit Agreement are guaranteed by intercompany guarantees. As a result of the termination of the liens under the Terminated Credit Agreements, the liens securing the Company’s outstanding $450 million notes due 2020 and $300 million notes due 2040 were also released and such notes are now the Company’s senior unsecured obligations.
Borrowings under the Credit Agreement bear interest at a rate determined, at the Company's option, based on either an alternate base rate or a LIBOR rate plus, in each case, an applicable margin that varies depending on the credit rating of the Borrower.
Sale of Accounts Receivable
During 2019, the Company entered into a Master Accounts Receivable Purchase Agreement with a financial institution which provides the Company the election to sell accounts receivable, at a discount, up to a maximum of $200 million. This agreement is an uncommitted facility with no expiration date.
On January 28, 2020, the Company sold $200 million of accounts receivable under the agreement and received proceeds of $200 million on January 30, 2020.
Dynetics Acquisition
On January 31, 2020 (the "Acquisition Date"), the Company completed the acquisition of Dynetics. The Company purchased all of the issued and outstanding shares of common stock of Dynetics for $1.65 billion in cash.
In connection with the acquisition of Dynetics, the Company entered into a Bridge Credit Agreement with certain financial institutions, which provides for a senior unsecured 364-day bridge loan facility in an aggregate principal amount of $1.25 billion (the "Bridge Facility"). The Bridge Facility will mature 364 days after the Acquisition Date.
The Company used the proceeds of the Bridge Facility and cash on hand on the Acquisition Date to fund the purchase of Dynetics and repay in full all third party indebtedness of Dynetics, terminate all commitments thereunder and discharge and release all existing guarantees and liens.
Borrowings under the Bridge Credit Agreement bear interest at a rate determined, at the Company's option, based on either an alternate base rate or a LIBOR rate plus, in each case, an applicable margin that varies depending on the credit rating of the Borrower, subject to increases at 90, 180 and 270 days after the Acquisition Date.
Leidos Holdings, Inc. Annual Report - 100
LEIDOS HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
L3Harris Transaction
On February 3, 2020, the Company entered into a definitive agreement to acquire L3Harris' security detection and automation businesses for cash consideration of $1.0 billion, subject to net working capital adjustments, if any. L3Harris' security detection and automation businesses provide airport and critical infrastructure screening products, automated tray return systems and other industrial automation products. The transaction is expected to close by the end of the second quarter of fiscal 2020.
On February 12, 2020, the Company obtained a debt financing commitment of $1.0 billion from certain financial institutions in connection with the L3Harris transaction. The maturity date will be two years from the funding date if the Company draws on this commitment.
Leidos Holdings, Inc. Annual Report - 101
PART II
Selected Quarterly Financial Data (Unaudited)
Selected financial data (unaudited) for the periods presented was as follows:
| Three Months Ended | ||||||||||||||||
| March 29, 2019 | June 28, 2019 | September 27, 2019 | January 3, 2020 | |||||||||||||
| (in millions, except per share amounts) | ||||||||||||||||
| Fiscal 2019*(1)* | ||||||||||||||||
| Revenues | $ | 2,577 | $ | 2,728 | $ | 2,835 | $ | 2,954 | ||||||||
| Operating income | 192 | 210 | 249 | 261 | ||||||||||||
| Net income | 189 | 138 | 162 | 181 | ||||||||||||
| Net income attributable to Leidos common stockholders | 189 | 136 | 161 | 181 | ||||||||||||
| Basic earnings per share attributable to Leidos common stockholders(3) | $ | 1.30 | $ | 0.94 | $ | 1.13 | $ | 1.27 | ||||||||
| Diluted earnings per share attributable to Leidos common stockholders(3) | 1.29 | 0.93 | 1.11 | 1.26 | ||||||||||||
| Three Months Ended | ||||||||||||||||
| March 30, 2018 | June 29, 2018 | September 28, 2018 | December 28, 2018 | |||||||||||||
| (in millions, except per share amounts) | ||||||||||||||||
| Fiscal 2018*(2)* | ||||||||||||||||
| Revenues | $ | 2,443 | $ | 2,529 | $ | 2,575 | $ | 2,647 | ||||||||
| Operating income | 159 | 199 | 203 | 188 | ||||||||||||
| Net income | 102 | 145 | 147 | 188 | ||||||||||||
| Net income attributable to Leidos common stockholders | 102 | 144 | 147 | 188 | ||||||||||||
| Basic earnings per share attributable to Leidos common stockholders(3) | $ | 0.67 | $ | 0.95 | $ | 0.97 | $ | 1.27 | ||||||||
| Diluted earnings per share attributable to Leidos common stockholders(3) | 0.66 | 0.94 | 0.96 | 1.25 |
| (1) | The fiscal 2019 quarterly results include a preliminary gain on sale of $88 million in the first quarter related to the divestiture of the Company's commercial cybersecurity business, a $54 million gain recognized upon the receipt of the Greek arbitration award and bad debt expense of $19 million in the third quarter and $7 million of bad debt expense recoveries in the fourth quarter. |
| (2) | The fiscal 2018 quarterly results include acquisition, integration and restructuring costs of $17 million, $8 million, $7 million, and $5 million in the first, second, third, and fourth quarter, respectively. The fiscal 2018 first quarter results include a $7 million tangible asset impairment charge. |
| (3) | Earnings per share are computed independently for each of the quarters presented and therefore may not sum to the totals for fiscal 2019 and 2018. |
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