filings.toolsItem 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis of Leidos Holdings, Inc.'s ("Leidos") financial condition, results of operations and quantitative and qualitative disclosures about business environment and trends and market risk should be read in conjunction with the consolidated financial statements and related notes.
Unless indicated otherwise, references in this report to “we,” “us” and “our” refer collectively to Leidos and its consolidated subsidiaries.
The following discussion contains forward-looking statements, including statements regarding our intent, belief or current expectations with respect to, among other things, trends affecting our financial condition or results of operations, backlog, initiatives, our industry, the impact of our merger and acquisition activity, government budgets and spending, our business contingency plans and our ability to recover certain costs through the Coronavirus Aid, Relief and Economic Security Act ("CARES Act"). Such statements are not guarantees of future performance and involve risks and uncertainties, including uncertainties relating to the coronavirus pandemic ("COVID-19") and the actions taken by authorities and us to respond, and actual results may differ materially from those in the forward-looking statements as a result of various factors (see “Forward-Looking Statement Risks” within this Annual Report on Form 10-K). Factors that could cause or contribute to these differences include those discussed below and elsewhere in this Annual Report on Form 10-K, particularly in “Risk Factors" and "Business Environment and Trends.” Due to such uncertainties and risks, you are cautioned not to place undue reliance on such forward-looking statements, which speak only as of the date hereof. We do not undertake any obligation to update these factors or to publicly announce the results of any changes to our forward-looking statements due to future events or developments.
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PART II
Overview
We are a FORTUNE 500® science, engineering and information technology company that provides services and solutions in the defense, intelligence, homeland security, civil and health markets, both domestically and internationally. We bring domain-specific capabilities and innovations to customers in each of these markets by leveraging five technical core competencies: digital modernization, cyber operations, mission software systems, integrated systems and mission operations. Our customers include the U.S. Department of Defense ("DoD"), the U.S. Intelligence Community, the U.S. Department of Homeland Security, the Federal Aviation Administration, the Department of Veterans Affairs and many other U.S. civilian, state and local government agencies as well as foreign government agencies. Less than 10% of our revenues and tangible long-lived assets are generated by or owned by entities located outside of the United States. We operate in three reportable segments: Defense Solutions, Civil and Health. Additionally, we separately present the unallocable costs associated with corporate functions as Corporate.
Effective the beginning of fiscal 2020, certain contracts were reassigned from the Civil reportable segment to the Defense Solutions reportable segment. Prior year segment results have been recast to reflect this change.
For additional information regarding our reportable segments, see “Business” in Part I and "Note 23—Business Segments" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K.
Our significant initiatives include the following:
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achieving annual revenue growth through internal collaboration and better leveraging of key differentiators across our company and the deployment of resources and investments into higher growth markets;
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increasing headcount and internal direct labor content on our contract portfolio;
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continued improvement in our back office infrastructure and related business processes for greater effectiveness and efficiency across all business functions; and
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disciplined deployment of our cash resources and use of our capital structure to enhance shareholder value while retaining an appropriate amount of financial leverage.
Sales Trend. For fiscal 2020, revenues increased $1.2 billion, or 11%, compared to fiscal 2019, primarily due to revenues related to the acquisitions of Dynetics, Inc. ("Dynetics") and L3Harris Technologies' security detection and automation businesses ("the SD&A Businesses"), program wins and a net increase in volumes on certain programs. This was partially offset by the completion of certain contracts, negative impacts on certain contracts due to COVID-19 and the impact of the sale of our commercial cybersecurity and health staff augmentation businesses in the prior year. For fiscal 2019, revenues increased $900 million, or 9%, compared to fiscal 2018, primarily due to program wins and a net increase in program volumes, partially offset by programs ended and the impact of the sale of our commercial cybersecurity and health staff augmentation businesses. See "Results of Operations" below for discussion of our individual segment results.
Operating Expenses and Income Trend. For fiscal 2020, operating expenses increased by $1.1 billion, or 11%, compared to fiscal 2019. Operating margin for fiscal 2020 was 8.1% compared to 8.2% for fiscal 2019. Operating income was $998 million, an $86 million increase compared to fiscal 2019. The increase in operating income was primarily attributable to program wins, income related to the acquisitions of Dynetics and the SD&A Businesses and a net gain recognized upon the receipt of proceeds related to the VirnetX, Inc. ("VirnetX") legal matter. This was partially offset by negative impacts on certain contracts due to COVID-19, a net gain recognized in the prior year upon the receipt of the Greek arbitration award and increases in acquisition and integration costs and amortization expenses primarily associated with our current year acquisitions.
For fiscal 2019, operating expenses increased by $737 million, or 8%, compared to fiscal 2018. Operating margin for fiscal 2019 was 8.2% compared to 7.3% for fiscal 2018. Operating income was $912 million, a $163 million increase compared to fiscal 2018. The increases in operating margin and operating income were primarily attributable to the receipt of the Greek arbitration award, favorable program mix, decreases in acquisition, integration and restructuring costs and lower amortization of intangible assets.
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PART II
From a macroeconomic perspective, our industry is under general competitive pressures associated with spending from our largest customer, the U.S. government, and requires a high level of cost management focus to allow us to remain competitive. Although the Administration has not indicated a desire to reduce spending in the defense and homeland security sectors, the likelihood, extent and duration of current spending levels in these areas remains unclear. We continue to review our cost structure against our anticipated sales and undertake cost management actions and efficiency initiatives where necessary.
COVID-19
The COVID-19 pandemic is affecting major economic and financial markets, and effectively all industries and governments are facing challenges, which has resulted in a period of business disruption, the length and severity of which cannot be predicted. The pandemic has resulted in significant travel restrictions, government orders to “shelter-in-place”, quarantine restrictions and significant disruption of the financial markets. We have acted to protect the health and safety of our employees, comply with workplace health and safety regulations and work with our customers to minimize disruptions. The pandemic has impacted each of our groups, primarily in access to customer sites, travel restrictions, limitations of remote work and COVID-19 related costs.
Consistent with federal, state and local guidance, we perform work that is essential to support the critical infrastructure of the United States, the Defense Industrial Base and healthcare sector, and we continue to operate in support of our customers. We have taken steps to support increased teleworking and safe workplace environments. We have some minor business operations that are not designated as critical infrastructure and therefore have been required to operate in minimal conditions.
For fiscal 2020, COVID-19 adversely impacted revenues by approximately $198 million and impacted operating income by approximately $96 million as compared to prior year results. The full extent of the impact of the COVID-19 pandemic on our operational and financial performance, including our ability to execute on programs in the expected timeframe, will depend on future developments, including the duration and spread of the pandemic and the distribution and efficacy of vaccines, all of which are uncertain and cannot be predicted. While we have been able to make some recoveries, the ultimate timing and amount of recoveries remain uncertain as they will depend on a range of government actions, including each government agency and/or contracting officer's implementation of the authority granted in Section 3610 of the CARES Act, a $2 trillion coronavirus response bill providing widespread emergency relief, including the availability of funds. As a result of Congress passing government fiscal year ("GFY") 2021 appropriations, the relief from the CARES Act has been extended until March 31, 2021.
We have experienced delays, and expect to continue experiencing delays, on certain contracts as a result of standby leave absences, which has caused a portion of our contracts to be less profitable. Within our Health segment we saw recoveries in the fourth quarter of fiscal 2020 and continue to expect to see further recoveries in fiscal 2021. Our Defense Solutions reportable segment experienced less of a negative impact in the fourth quarter of fiscal 2020 than in previous quarters. We also experienced lower indirect expenditures for fiscal 2020 as a result of COVID-19 which partially offset the operating income impact on our programs. We are seeking reimbursement of some of the COVID-19 related costs under our U.S. government contracts through a combination of equitable adjustments to the contract prices and reimbursement of the costs under Section 3610, which allows, but does not require, federal agencies to reimburse contractors at the minimum applicable contract billing rate for costs arising from certain paid leave, including sick leave, a contractor provides to keep its employees or subcontractors in a ready state, including to protect the life and safety of government and contractor personnel. Reimbursement of any costs under Section 3610 increases sales, but does not include a profit or fee and has the effect of reducing our margins. Standby cost increases, including costs for employees whose jobs cannot be performed remotely, may not be fully recoverable under our contracts, particularly fixed-price contracts. We also have no assurance that Congress will appropriate funds to cover the reimbursement of defense contractors authorized by the CARES Act, which could reduce funds available for recovery of these costs or for other U.S. government defense priorities.
The CARES Act also enabled us to defer payment of the employer portion of social security taxes. As of January 1, 2021, we deferred $123 million of employer social security tax payments and received $12 million from the Employee Retention Credit.
We have taken measures to protect the health and well-being of our workforce and are working with our customers to minimize the delay and disruption of the award and performance on our contracts. Many of our employees continue to work remotely while our offices remain open with limited capacity.
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PART II
Business Environment and Trends
U.S. Government Markets
In fiscal 2020, we generated approximately 87% of our total revenues from contracts with the U.S. government, either as a prime contractor or a subcontractor to other contractors engaged in work for the U.S. government. Revenues under contracts with the DoD and U.S. Intelligence Community, including subcontracts under which the DoD or the U.S. Intelligence Community is the ultimate purchaser, represented approximately 49% of our total revenues for fiscal 2020. Accordingly, our business performance is affected by the overall level of U.S. government spending, especially national security, homeland security and intelligence spending, and the alignment of our service and product offerings and capabilities with current and future budget priorities of the U.S. government.
On February 10, 2020, the President submitted the GFY 2021 budget proposal to Congress, which included discretionary spending levels for defense and non-defense programs of $741 billion and $590 billion, respectively. Shortly after the budget release, Congress and the Administration shifted their collective attention to mitigating the impact of COVID-19.
Prior to the beginning of GFY 2021, Congress passed a continuing resolution ("CR") that was enacted on October 1, 2020 to provide temporary funding for government operations at GFY 2020 enacted levels until December 11, 2020. A series of short-term CRs were subsequently passed to extend temporary funding until the passage of GFY 2021 appropriations. On December 20, 2020, Congress reached agreement on a comprehensive GFY 2021 Appropriations Package, and on December 27, 2020, the President signed the $1.4 trillion appropriations deal.
With the enactment of GFY 2021 spending levels, attention now turns to additional COVID-19 relief. Immediately following that effort will be submission of a GFY 2021 supplemental aimed at economic recovery. Completing action on these proposals may delay the President's GFY 2022 budget request, which is not expected to be submitted to Congress until late April or early May.
Trends in the U.S. government contracting process, including a shift towards multiple-awards contracts, in which certain contractors are preapproved using indefinite-delivery/indefinite-quantity ("IDIQ") and U.S. General Services Administration ("GSA") contract vehicles, have increased competition for U.S. government contracts, reduced backlogs by shortening periods of performance on contracts and increased pricing pressure. We expect that a majority of the business that we seek in the foreseeable future will be awarded through a competitive bidding process. For more information on these risks and uncertainties, see “Risk Factors” in Part I of this Annual Report on Form 10-K.
International Markets
Sales to customers in international markets represented 8% of total revenues for fiscal 2020. Our international customers include foreign governments and their agencies. Our international business increases our exposure to international markets and the associated international regulatory, foreign currency exchange rate and geopolitical risks.
Changes in international trade policies, including higher tariffs on imported goods and materials, may increase our procurement costs of certain IT hardware used both on our contracts and for internal use. However, we expect to recover certain portions of these higher tariffs through our cost-plus contracts. While we evaluate the impact of higher tariffs, currently, we do not expect tariffs to have a significant impact to our business.
Key Performance Measures
The primary financial performance measures we use to manage our business and monitor results of operations are revenue, operating income, cash flows from operations and diluted earnings per share. Bookings and backlog are also useful measures for management and investors to evaluate our performance and potential future revenues. In addition, we consider business performance by contract type to be useful to management and investors when evaluating our operating income and margin performance.
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PART II
Results of Operations
Our results of operations for the periods presented were as follows:
| Year Ended | 2020 to 2019 | 2019 to 2018 | ||||||||||||||||||||||||||||||||||||||||||
| January 1, 2021 | January 3, 2020 | December 28, 2018 | Dollar change | Percent change | Dollar change | Percent change | ||||||||||||||||||||||||||||||||||||||
| (dollars in millions) | ||||||||||||||||||||||||||||||||||||||||||||
| Revenues | $ | 12,297 | $ | 11,094 | $ | 10,194 | $ | 1,203 | 11 | % | $ | 900 | 9 | % | ||||||||||||||||||||||||||||||
| Cost of revenues | 10,560 | 9,546 | 8,690 | 1,014 | 11 | % | 856 | 10 | % | |||||||||||||||||||||||||||||||||||
| Selling, general and administrative expenses | 770 | 689 | 729 | 81 | 12 | % | (40) | (5) | % | |||||||||||||||||||||||||||||||||||
| Bad debt expense and recoveries | (68) | (40) | — | (28) | 70 | % | (40) | (100) | % | |||||||||||||||||||||||||||||||||||
| Acquisition, integration and restructuring costs | 39 | 5 | 37 | 34 | NM | (32) | (86) | % | ||||||||||||||||||||||||||||||||||||
| Asset impairment charges | 12 | — | 7 | 12 | 100 | % | (7) | (100) | % | |||||||||||||||||||||||||||||||||||
| Equity earnings of non-consolidated subsidiaries | (14) | (18) | (18) | 4 | (22) | % | — | — | % | |||||||||||||||||||||||||||||||||||
| Operating income | 998 | 912 | 749 | 86 | 9 | % | 163 | 22 | % | |||||||||||||||||||||||||||||||||||
| Non-operating expense, net | (217) | (46) | (139) | (171) | NM | 93 | (67) | % | ||||||||||||||||||||||||||||||||||||
| Income before income taxes | 781 | 866 | 610 | (85) | (10) | % | 256 | 42 | % | |||||||||||||||||||||||||||||||||||
| Income tax expense | (152) | (196) | (28) | 44 | (22) | % | (168) | NM | ||||||||||||||||||||||||||||||||||||
| Net income | 629 | 670 | 582 | (41) | (6) | % | 88 | 15 | % | |||||||||||||||||||||||||||||||||||
| Less: net income attributable to non-controlling interest | 1 | 3 | 1 | (2) | (67) | % | 2 | 200 | % | |||||||||||||||||||||||||||||||||||
| Net income attributable to Leidos common stockholders | $ | 628 | $ | 667 | $ | 581 | $ | (39) | (6) | % | $ | 86 | 15 | % | ||||||||||||||||||||||||||||||
| Operating income margin | 8.1 | % | 8.2 | % | 7.3 | % |
NM - Not meaningful
Segment and Corporate Results
| Year Ended | 2020 to 2019 | 2019 to 2018 | ||||||||||||||||||||||||||||||||||||||||||
| Defense Solutions | January 1, 2021 | January 3, 2020 | December 28, 2018 | Dollar change | Percent change | Dollar change | Percent change | |||||||||||||||||||||||||||||||||||||
| (dollars in millions) | ||||||||||||||||||||||||||||||||||||||||||||
| Revenues | $ | 7,341 | $ | 6,300 | $ | 5,778 | $ | 1,041 | 17 | % | $ | 522 | 9 | % | ||||||||||||||||||||||||||||||
| Operating income | 506 | 471 | 402 | 35 | 7 | % | 69 | 17 | % | |||||||||||||||||||||||||||||||||||
| Operating income margin | 6.9 | % | 7.5 | % | 7.0 | % |
The increase in revenues for fiscal 2020 as compared to fiscal 2019 was primarily attributable to $937 million of revenues related to the acquisition of Dynetics, program wins and a net increase in materials volume on certain programs. This was partially offset by the completion of certain contracts and approximately $51 million of negative impacts from reduced volume on certain contracts due to COVID-19.
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PART II
The increase in revenues for fiscal 2019 as compared to fiscal 2018 was primarily attributable to new awards and a net increase in program volumes, partially offset by the completion of certain contracts and adverse exchange rate movements in the Australian dollar and British pound when compared to the U.S. dollar.
The increase in operating income for fiscal 2020 as compared to fiscal 2019 was primarily attributable to income related to the acquisition of Dynetics, program wins and lower indirect expenditures. This was partially offset by a net decrease in volumes on certain programs, including approximately $28 million of negative impacts on certain contracts due to COVID-19, and higher amortization of intangible assets related to the acquisition of Dynetics.
The increase in operating income for fiscal 2019 as compared to fiscal 2018 was primarily attributable to new awards, favorable program mix and the release of a contract reserve.
| Year Ended | 2020 to 2019 | 2019 to 2018 | ||||||||||||||||||||||||||||||||||||||||||
| Civil | January 1, 2021 | January 3, 2020 | December 28, 2018 | Dollar change | Percent change | Dollar change | Percent change | |||||||||||||||||||||||||||||||||||||
| (dollars in millions) | ||||||||||||||||||||||||||||||||||||||||||||
| Revenues | $ | 2,994 | $ | 2,796 | $ | 2,599 | $ | 198 | 7 | % | $ | 197 | 8 | % | ||||||||||||||||||||||||||||||
| Operating income | 280 | 231 | 235 | 49 | 21 | % | (4) | (2) | % | |||||||||||||||||||||||||||||||||||
| Operating income margin | 9.4 | % | 8.3 | % | 9.0 | % |
The increase in revenues for fiscal 2020 as compared to fiscal 2019 was primarily attributable to $243 million of revenues related to the acquisition of the SD&A Businesses and program wins. This was partially offset by the completion of certain contracts and approximately $65 million of negative impacts from reduced volume on certain contracts due to COVID-19.
The increase in revenues for fiscal 2019 as compared to fiscal 2018 was primarily attributable to a net increase in program volumes and new awards, partially offset by the impact of the sale of our commercial cybersecurity business of $74 million, the completion of certain contracts and lower net profit write-ups in the current year.
The increase in operating income for fiscal 2020 as compared to fiscal 2019 was primarily attributable to program wins, a decrease in bad debt expense and lower indirect expenditures, partially offset by the completion of certain contracts.
The decrease in operating income for fiscal 2019 as compared to fiscal 2018 was primarily attributable to lower net profit write-ups in fiscal 2019 and a net increase in bad debt expense on certain international contracts, partially offset by lower amortization of intangibles of $18 million, a net increase in program volumes and the impact of the sale of our commercial cybersecurity business of $7 million.
| Year Ended | 2020 to 2019 | 2019 to 2018 | ||||||||||||||||||||||||||||||||||||||||||
| Health | January 1, 2021 | January 3, 2020 | December 28, 2018 | Dollar change | Percent change | Dollar change | Percent change | |||||||||||||||||||||||||||||||||||||
| (dollars in millions) | ||||||||||||||||||||||||||||||||||||||||||||
| Revenues | $ | 1,962 | $ | 1,998 | $ | 1,817 | $ | (36) | (2) | % | $ | 181 | 10 | % | ||||||||||||||||||||||||||||||
| Operating income | 235 | 242 | 230 | (7) | (3) | % | 12 | 5 | % | |||||||||||||||||||||||||||||||||||
| Operating income margin | 12.0 | % | 12.1 | % | 12.7 | % |
The decrease in revenues for fiscal 2020 as compared to fiscal 2019 was primarily attributable to approximately $82 million related to the timing of program execution due to COVID-19, a $73 million impact from the sale of our health staff augmentation business in the prior year and the completion of certain contracts. This was partially offset by a net increase in volumes on certain programs, program wins and a $21 million impact from our acquisition of IMX Medical Management Services, Inc. ("IMX") in the prior year.
The increase in revenues for fiscal 2019 as compared to fiscal 2018 was primarily attributable to a net increase in program volumes, new awards and $18 million from our acquisition of IMX, partially offset by the completion of certain contracts and the impact of the sale of our health staff augmentation business of $78 million.
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PART II
The decrease in operating income for fiscal 2020 as compared to fiscal 2019 was primarily attributable to approximately $67 million of negative impacts from reduced volume on certain managed service contracts with fixed cost infrastructures that were impacted by COVID-19. This was partially offset by a net increase in volumes on certain programs and a $9 million impact from the sale of our health staff augmentation business in the prior year.
The increase in operating income for fiscal 2019 as compared to fiscal 2018 was primarily attributable to a net increase in program volumes, partially offset by reduced margins on awarded re-compete contracts.
| Year Ended | 2020 to 2019 | 2019 to 2018 | ||||||||||||||||||||||||||||||||||||||||||
| Corporate | January 1, 2021 | January 3, 2020 | December 28, 2018 | Dollar change | Percent change | Dollar change | Percent change | |||||||||||||||||||||||||||||||||||||
| (dollars in millions) | ||||||||||||||||||||||||||||||||||||||||||||
| Operating loss | $ | (23) | $ | (32) | $ | (118) | $ | 9 | (28) | % | $ | 86 | (73) | % |
The decrease in operating loss for fiscal 2020 as compared to fiscal 2019 was primarily attributable to an $81 million net gain recognized upon the receipt of proceeds related to the VirnetX legal matter and reduced indirect expenses due to COVID-19. This was partially offset by a $52 million net gain recognized in the prior year upon the receipt of the Greek arbitration award and a $29 million increase in acquisition, integration and restructuring costs primarily associated with the acquisitions of Dynetics and the SD&A Businesses.
The decrease in operating loss for fiscal 2019 as compared to fiscal 2018 was primarily attributable to the $52 million net gain recognized upon the receipt of the Greek arbitration award, lower acquisition, integration and restructuring costs of $32 million and an asset impairment charge of $7 million in the prior year.
Equity earnings of non-consolidated subsidiaries
We have certain non-controlling ownership interests in equity method investments. For fiscal 2020, 2019 and 2018, we recorded earnings of $16 million, $29 million and $28 million, respectively, from our equity method investments, partially offset by amortization of $2 million, $11 million and $10 million, respectively.
Non-Operating Expense, Net
Non-operating expense, net increased $171 million for fiscal 2020 as compared to fiscal 2019, primarily due to the $88 million gain recognized on the sale of our commercial cybersecurity business in the prior year, $36 million of debt discount and deferred financing costs written off and higher interest expense associated with increases in our long-term debt related to the financing of the acquisitions of Dynetics and the SD&A Businesses.
Non-operating expense, net decreased $93 million for fiscal 2019 as compared to fiscal 2018, primarily due to the $88 million gain recognized on the sale of our commercial cybersecurity business.
Provision for Income Taxes
Our effective tax rate was 19.5%, 22.6% and 4.6% in fiscal 2020, 2019 and 2018, respectively. The effective tax rate for fiscal 2020 was favorably impacted primarily by federal research tax credits and excess tax benefits related to employee stock-based payment transactions, partially offset by taxes related to foreign operations.
The 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 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 the stock basis of a subsidiary held for sale, excess tax benefits related to employee stock-based payment transactions and federal research tax credits.
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PART II
Non-controlling Interest
We have an 88% controlling interest in Mission Support Alliance, LLC ("MSA"), a joint venture with Centerra Group, LLC, which is anticipated to end in early fiscal 2021. We also have a 53% controlling interest in Hanford Mission Integration Solutions, LLC ("HMIS"), the legal entity for the follow-on contract to MSA's contract and a joint venture with Centerra Group, LLC and Parsons Government Services, Inc. We include the financial results for MSA and HMIS in our consolidated financial statements. Net income attributable to non-controlling interest was $1 million for fiscal 2020 and 2018 and $3 million for fiscal 2019.
Bookings and Backlog
We had net bookings of $17.8 billion and $14.5 billion during fiscal 2020 and 2019, respectively. Net bookings represent the estimated amount of revenue to be earned in the future from funded and unfunded contract awards that were received during the year, net of any adjustments to previously awarded backlog amounts. We calculate net bookings as the year’s ending backlog, plus the year’s revenues, less the prior year’s ending backlog and any impacts from foreign currency or acquisitions and divestitures.
Backlog represents the estimated amount of future revenues to be recognized under negotiated contracts. We segregate our backlog into two categories as follows:
- Funded Backlog. Funded backlog for contracts with the U.S. government represents the value on contracts for which funding is appropriated less revenues previously recognized on these contracts. Funded backlog for contracts with non-U.S. government entities and commercial customers represents the estimated value on contracts, which may cover multiple future years, under which we are obligated to perform, less revenues previously recognized on the contracts.
*•*Negotiated Unfunded Backlog. Negotiated unfunded backlog represents estimated amounts of revenue to be earned in the future from contracts for which funding has not been appropriated and unexercised priced contract options. Negotiated unfunded backlog does not include unexercised option periods and future potential task orders expected to be awarded under IDIQ, GSA Schedule or other master agreement contract vehicles, 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 anticipated task orders.
The estimated value of our total backlog for the periods presented was as follows:
| January 1, 2021 | January 3, 2020 | |||||||||||||
| (in millions) | ||||||||||||||
| Defense Solutions: | ||||||||||||||
| Funded backlog | $ | 3,710 | $ | 3,063 | ||||||||||
| Negotiated unfunded backlog | 14,721 | 11,974 | ||||||||||||
| Total Defense Solutions backlog | $ | 18,431 | $ | 15,037 | ||||||||||
| Civil: | ||||||||||||||
| Funded backlog | $ | 1,398 | $ | 1,267 | ||||||||||
| Negotiated unfunded backlog | 7,051 | 2,978 | ||||||||||||
| Total Civil backlog | $ | 8,449 | $ | 4,245 | ||||||||||
| Health: | ||||||||||||||
| Funded backlog | $ | 1,486 | $ | 1,083 | ||||||||||
| Negotiated unfunded backlog | 3,546 | 3,725 | ||||||||||||
| Total Health backlog | $ | 5,032 | $ | 4,808 | ||||||||||
| Total: | ||||||||||||||
| Funded backlog | $ | 6,594 | $ | 5,413 | ||||||||||
| Negotiated unfunded backlog | 25,318 | 18,677 | ||||||||||||
| Total backlog | $ | 31,912 | $ | 24,090 |
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PART II
The change in backlog for the Defense Solutions and Civil reportable segments reflect $1,632 million and $574 million, respectively, of backlog acquired as a result of the acquisitions of Dynetics and the SD&A Businesses, respectively. (see "Note 6—Acquisitions" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K).
Bookings and backlog fluctuate from period to period depending on our success rate in winning contracts and the timing of contract awards, renewals, modifications and cancellations, as well as foreign currency movements. Contract awards may be negatively impacted by ongoing industry-wide delays in procurement decisions and budget cuts by the U.S. government as discussed in “Business Environment and Trends” in this Annual Report on Form 10-K.
We expect to recognize a substantial portion of our funded backlog as revenues within the next 12 months. However, the U.S. government may cancel any contract at any time through a termination for the convenience of the U.S. government. In addition, certain contracts with commercial or non-U.S. government customers may include provisions that allow the customer to cancel at any time. Most of our contracts have cancellation terms that would permit us to recover all or a portion of our incurred costs and fees for work performed.
Contract Types
Our earnings and profitability may vary materially depending on changes in the proportionate amount of revenues derived from each type of contract. For a discussion of the types of contracts under which we generate revenues, see “Business—Contract Types” in Part I of this Annual Report on Form 10-K. Revenues by contract type as a percentage of our total revenues for the periods presented were as follows:
| Year Ended | ||||||||||||||||||||
| January 1, 2021 | January 3, 2020 | December 28, 2018 | ||||||||||||||||||
| Cost-reimbursement and fixed-price-incentive-fee | 51 | % | 54 | % | 54 | % | ||||||||||||||
| Firm-fixed-price | 36 | % | 33 | % | 31 | % | ||||||||||||||
| Time-and-materials and fixed-price-level-of-effort | 13 | % | 13 | % | 15 | % | ||||||||||||||
| Total | 100 | % | 100 | % | 100 | % |
Liquidity and Capital Resources
Overview of Liquidity
As of January 1, 2021, we had $524 million in cash and cash equivalents. In January 2020, we entered into an unsecured revolving credit facility which can provide up to $750 million in additional borrowing, if required. This new credit facility replaced the previous secured credit facility with the same borrowing capacity. During fiscal 2020 and 2019, there were no borrowings outstanding under the credit facilities and we were in compliance with the related financial covenants.
At January 1, 2021 and January 3, 2020, we had outstanding debt of $4.7 billion and $3.0 billion, respectively. In January 2020, we entered into a Credit Agreement with certain financial institutions, which provided for a senior unsecured term loan facility in an aggregate principal amount of $1.9 billion (the "Term Loan Facility"). We used the proceeds of the Term Loan Facility and cash on hand 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.
Additionally, on January 17, 2020, we entered into a Bridge Credit Agreement with certain financial institutions, which provided for a senior unsecured 364-day bridge loan facility in an aggregate amount of $1.25 billion (the "Bridge Facility"). We used the proceeds of the Bridge Facility and cash on hand to fund the purchase of Dynetics.
In February 12, 2020, we entered into a senior unsecured delayed-draw term loan facility (the "Facility") providing for $1.0 billion of commitments from certain financial institutions in connection with the acquisition of the SD&A Businesses. On May 4, 2020, we completed our acquisition of the SD&A Businesses and drew on the Facility in an aggregate principal amount of $1.0 billion. The proceeds of the Facility and cash on hand were used to fund the purchase of the SD&A Businesses.
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On May 12, 2020, we issued and sold $500 million senior notes maturing in May 2023, $500 million senior notes maturing in May 2025 and $750 million senior notes maturing in May 2030 (collectively, the "Notes"). The proceeds from the Notes were used to repay all of the outstanding obligations in respect of principal, interest and fees under the Bridge Credit Agreement and to repay a portion of the outstanding loans under the Facility.
On June 18, 2020, we entered into a 364-day Term Loan Credit Agreement, which provided for a senior unsecured term loan facility in an aggregate principal amount of $300 million (the "Term Loan"). The proceeds of the Term Loan and cash on hand on were used to repay in full all indebtedness under, and discharge and release all guarantees existing in connection with the Facility.
On September 1, 2020, we retired our $450 million senior unsecured notes due December 2020. Cash on hand was used to repay in full all indebtedness under, and discharge and release all guarantees existing in connection with the notes.
On October 8, 2020, we issued and sold $1.0 billion aggregate principal amount of fixed-rate senior notes maturing in February 2031 (the "2031 Notes"). The proceeds from the 2031 Notes were used for general corporate purposes, including to repay all of the outstanding obligations in respect of principal, interest and fees under the 364-day Term Loan and to repay a portion of the outstanding loans under the five-year Term Loan Facility.
See "Note 15—Debt" for further details regarding the debt transactions noted above.
In addition to the refinancing activity noted above, we made principal payments on our long-term debt of $731 million, $80 million, and $59 million during fiscal 2020, 2019 and 2018, respectively. This activity included required principal payments on our term loans of $72 million, $69 million and $46 million during fiscal 2020, 2019 and 2018, respectively. In April 2018, we made a required debt prepayment of $10 million on our senior secured term loans. The prepayment was a result of the annual excess cash flow calculation clause in our August 2016 credit agreements. The notes outstanding as of January 1, 2021, contain financial covenants and customary restrictive covenants. We were in compliance with all covenants as of January 1, 2021.
We paid dividends of $196 million for fiscal 2020 and $198 million for fiscal 2019 and 2018.
During fiscal 2020, we sold $1,866 million of accounts receivable under accounts receivable purchase agreements and received proceeds of $1,864 million (see "Note 22—Supplementary Cash Flow Information and Restricted Cash").
We may from time to time seek to retire or purchase our outstanding debt through cash purchases in the open market, privately negotiated transactions or otherwise. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual restrictions and other factors. The amounts involved may be material.
Stock repurchases of Leidos common stock may be made on the open market or in privately negotiated transactions with third parties including through accelerated share repurchase ("ASR") agreements. Whether repurchases are made and the timing and actual number of shares repurchased depends on a variety of factors including price, corporate capital requirements, other market conditions and regulatory requirements. The repurchase program may be accelerated, suspended, delayed or discontinued at any time.
During fiscal 2020, 2019 and 2018, we made open market repurchases of our common stock for an aggregate purchase price of $67 million, $25 million and $167 million, respectively.
Additionally, during fiscal 2019 and 2018, we entered into ASR agreements with a financial institution, whereby we paid an aggregate of $400 million and $250 million, respectively, and received approximately 6 million and 4 million shares, respectively, of Leidos outstanding shares (see "Note 18—Earnings Per Share" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K). The purchases were recorded to "Additional paid-in capital" in the consolidated balance sheets. All shares delivered were immediately retired.
COVID-19 has negatively impacted the financial markets and may impact our liquidity; we will continue to assess our liquidity needs as the pandemic and efforts to deploy vaccines evolve.
For the next 12 months, we anticipate that we will be able to meet our liquidity needs, including servicing our debt, through cash generated from operations, available cash balances, sales of accounts receivable and, if needed, borrowings from our revolving credit facility.
Leidos Holdings, Inc. Annual Report - 48
PART II
Summary of Cash Flows
The following table summarizes cash flow information for the periods presented:
| Year Ended | ||||||||||||||||||||
| January 1, 2021 | January 3, 2020 | December 28, 2018 | ||||||||||||||||||
| (in millions) | ||||||||||||||||||||
| Net cash provided by operating activities | $ | 1,334 | $ | 992 | $ | 768 | ||||||||||||||
| Net cash (used in) provided by investing activities | (2,815) | 65 | (114) | |||||||||||||||||
| Net cash provided by (used in) financing activities | 1,451 | (709) | (707) | |||||||||||||||||
| Net (decrease) increase in cash, cash equivalents and restricted cash | $ | (30) | $ | 348 | $ | (53) |
Net cash provided by operating activities increased $342 million for fiscal 2020 as compared to fiscal 2019. The increase was primarily due to the timing of payroll payments, including the deferral of $123 million of tax payments under the CARES Act, and the receipt of $85 million of proceeds related to the VirnetX legal matter.
Net cash provided by operating activities increased $224 million for fiscal 2019 as compared to fiscal 2018. The increase was primarily due to more favorable timing of working capital changes including higher advance payments from customers, $59 million received for the Greek arbitration award and lower payments for integration and restructuring costs. These activities were partially offset by higher tax payments, the timing of interest payments and $60 million of proceeds received from the termination of interest rate swaps in the prior year.
Net cash used in investing activities increased $2,880 million for fiscal 2020 as compared to fiscal 2019. The increase was primarily due to $2,655 million of net cash paid related to the acquisitions of Dynetics and the SD&A Businesses, $178 million received in the prior year for the disposition of our commercial cybersecurity and health staff augmentation businesses, $96 million of proceeds received for the sale of real estate properties in the prior year and higher purchases of equipment and leasehold improvements associated with our new global headquarters. This was partially offset by $94 million of cash paid related to the acquisition of IMX in the prior year.
Net cash provided by investing activities increased $179 million for fiscal 2019 as compared to fiscal 2018. The increase was primarily due to $178 million of proceeds received for the dispositions of our commercial cybersecurity and health staff augmentation businesses, $96 million of proceeds received for the sale of real estate properties and $81 million of cash paid in the prior year related to our 2016 acquisition. These activities were partially offset by $94 million of cash paid related to the acquisition of IMX, higher purchases of property, equipment and software and lower proceeds from promissory notes.
Net cash provided by financing activities increased $2,160 million for fiscal 2020 as compared to fiscal 2019. The increase was primarily due to $7,225 million of proceeds received related to the refinancing and the issuance of new debt and higher stock repurchases in the prior year. This was partially offset by $4,925 million of principal repayments of outstanding debt and the retirement of the $450 million senior notes in the current year.
Net cash used in financing activities increased $2 million for fiscal 2019 as compared to fiscal 2018. The increase was primarily due to the timing of debt payments and higher stock repurchases, partially offset by $23 million of cash paid related to a tax indemnification in the prior year and the timing of issuances of stock.
Off-Balance Sheet Arrangements
We have outstanding performance guarantees and cross-indemnity agreements in connection with certain aspects of our business. We also have letters of credit outstanding principally related to performance guarantees on contracts and surety bonds outstanding principally related to performance and subcontractor payment bonds as described in "Note 25—Commitments" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K. These arrangements have not had, and management does not believe it is likely that they will in the future have, a material effect on our liquidity, capital resources, operations or financial condition.
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Contractual Obligations
The following table summarizes, as of January 1, 2021, our obligations to make future payments pursuant to certain contracts or arrangements and provides an estimate of the fiscal years in which these obligations are expected to be satisfied:
| Total | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 and thereafter | ||||||||||||||||||||||||||||||||||||||
| (in millions) | ||||||||||||||||||||||||||||||||||||||||||||
| Contractual obligations(1): | ||||||||||||||||||||||||||||||||||||||||||||
| Long-term debt (including current portion)(2) | $ | 6,115 | $ | 244 | $ | 245 | $ | 807 | $ | 335 | $ | 1,454 | $ | 3,030 | ||||||||||||||||||||||||||||||
| Operating lease obligations | 790 | 148 | 126 | 108 | 94 | 69 | 245 | |||||||||||||||||||||||||||||||||||||
| Finance lease obligations | 11 | 6 | 2 | 2 | — | — | 1 | |||||||||||||||||||||||||||||||||||||
| Other long-term liabilities(3) | 262 | 9 | 71 | 9 | 9 | 110 | 54 | |||||||||||||||||||||||||||||||||||||
| Total contractual obligations | $ | 7,178 | $ | 407 | $ | 444 | $ | 926 | $ | 438 | $ | 1,633 | $ | 3,330 |
(1)We have excluded purchase orders for services or products to be delivered pursuant to U.S. government contracts for which we are entitled to full recourse under normal contract termination clauses.
(2)Includes total interest payments on our outstanding debt. Interest payments represent $146 million, $148 million, $139 million, $142 million and $105 million of the balance for fiscal 2021, 2022, 2023, 2024 and 2025, respectively, and $651 million for fiscal 2026 and thereafter. The total interest payments on our outstanding term loan debt are calculated based on the stated variable rates of the notes as of January 1, 2021. The total interest payments on our outstanding senior unsecured notes are calculated based on the stated fixed rates.
(3)Other long-term liabilities were allocated by fiscal year as follows: liabilities under deferred compensation arrangements are based upon the average annual payments in prior years upon termination of employment by participants and other liabilities are based on the fiscal year that the liabilities are expected to be realized. The table above does not include income tax liabilities for uncertain tax positions of $4 million and $1 million of other tax liabilities, as we are not able to reasonably estimate the timing of payments in individual years due to uncertainties in the timing of audit outcomes and when settlements will become due. There is no obligation included for our foreign defined benefit pension plan, as the plan is overfunded as of January 1, 2021. For a discussion of potential changes in these pension obligations, see "Note 21—Retirement Plans" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K.
Guarantors and Issuers of Guaranteed Securities
Leidos, Inc. has fully and unconditionally guaranteed the obligations of Leidos under its $300 million notes due December 2040. Leidos has fully and unconditionally guaranteed the obligations of Leidos, Inc. under its $300 million notes due July 2033, $250 million notes due July 2032, the Notes and the 2031 Notes. The underlying subsidiaries of Leidos and Leidos Inc. do not guarantee these obligations.
We have entered into registration rights agreements, pursuant to which we agreed to use reasonable best efforts to file registration statements to permit the exchange of the Notes and the 2031 Notes and related guarantees for registered notes having terms substantially identical thereto, or in the alternative, the registered resale of the Notes and 2031 Notes and related guarantees under certain circumstances. See "Note 15—Debt" for further details.
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Summarized financial information for Leidos and Leidos Inc., net of eliminations, for the year ended January 1, 2021 was as follows (in millions):
Balance Sheet
| Total current assets | $ | 1,940 | ||||||
| Goodwill | 4,080 | |||||||
| Investments in consolidated subsidiaries | 4,254 | |||||||
| Other long-term assets | 1,419 | |||||||
| $ | 11,693 | |||||||
| Total current liabilities | $ | 2,001 | ||||||
| Long-term debt, net of current portion | 4,642 | |||||||
| Intercompany payables | 1,115 | |||||||
| Other long-term liabilities | 858 | |||||||
| Total liabilities | 8,616 | |||||||
| Total equity | 3,077 | |||||||
| $ | 11,693 |
Income Statement
| Revenues, net | $ | 8,736 | ||||||
| Operating income | 653 | |||||||
| Net income | 290 | |||||||
| Net income attributable to Leidos common stockholders | 290 |
Commitments and Contingencies
We are subject to a number of reviews, investigations, claims, lawsuits, other uncertainties and future obligations related to our business. For a discussion of these items, see "Note 12—Leases," "Note 24—Contingencies" and "Note 25—Commitments" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP"). The preparation of these financial statements in accordance with 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. Our estimates and assumptions have been prepared by management on the basis of the most current and best available information. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from these estimates under different assumptions and conditions.
We have identified the following accounting policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on our results of operations or financial condition.
-
Revenue Recognition
-
Goodwill and Intangible Assets
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Income Taxes
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Revenue Recognition
Our revenues from contracts with customers are from offerings including digital modernization, cyber operations, mission software systems, integrated systems and mission operations, primarily with the U.S. government and its agencies. We also serve various state and local governments, foreign governments and commercial customers.
We perform 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 ("CPFF"), cost-plus-award-fee, cost-plus-incentive-fee and fixed-price-incentive-fee contracts.
To determine the proper revenue recognition, we first evaluate whether we have 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. We also evaluate whether two or more contracts should be combined and accounted for as a single contract, including the task orders issued under an IDIQ award. In addition, we assess 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 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.
Most of our 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, we assess if the multiple promises should be accounted for as separate performance obligations or combined into a single performance obligation. We generally separate 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.
Our 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. We account 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. Any taxes collected or imposed when determining the transaction price are excluded.
Certain 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. We estimate variable consideration at the most probable amount that we expect 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.
We allocate 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 performance obligations is generally based on an expected cost-plus margin approach, in accordance with the FAR. For certain product sales, prices from other standalone sales are used. Substantially all of our contracts do not contain a significant financing component, which would require an adjustment to the transaction price of the contract.
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We recognize revenue on our service-based contracts primarily over time as there is continuous transfer of control to the customer over the duration of the contract as the promised services are performed. 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 for which we do not have an alternate use. Anticipated losses on service-based contracts are recognized when incurred (generally on a straight-line basis) over the contract term. In certain product sales, where the products have an alternate use, revenue is recognized at a point in time when the customer takes control of the asset usually denoted by possession and legal title.
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, an EAC of a performance obligation includes future losses estimated to be incurred on onerous contracts, as and when known. On certain other contracts, principally T&M, FP-LOE and CPFF, revenue is recognized using the right-to-invoice practical expedient as we are 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 we are not primarily responsible for fulfilling the promise to provide the goods or service to the customer, do not have inventory risk and do not have discretion in establishing the price for the goods or service, we recognize revenue on a net basis.
Goodwill and Intangible Assets
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. We recognize purchased intangible assets in connection with our business acquisitions at fair value on the acquisition date.
Goodwill and intangible assets, net collectively represent 60% and 58% of our total assets as of January 1, 2021 and January 3, 2020, respectively.
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. Our policy is to perform our annual goodwill impairment evaluation as of the first day of the fourth quarter of our fiscal year. During fiscal 2020 and 2019, we had seven and six reporting units, respectively, for the purpose of testing goodwill for impairment.
Estimating the fair value of a reporting unit and intangibles requires the exercise of significant judgment and assumptions including judgments about expected future cash flows, weighted-average cost of capital, discount rates and expected long-term growth rates. In some cases, we use discounted cash flow analyses, which are based on estimates of future sales, earnings and cash flows after considering such factors as general market conditions, customer budgets, existing firm and future orders, changes in working capital, long term business plans and recent operating performance. A significant change to these estimates and assumptions could cause the estimated fair values of our reporting units and intangible assets to decline and increase the risk of an impairment charge to earnings. 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.
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PART II
Income Taxes
We account 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.
We record net deferred tax assets to the extent we believe these assets will more likely than not be realized. In making such determination, we consider 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 we were to determine that we would be able to realize our deferred income tax assets in the future in excess of their net recorded amount or would no longer be able to realize our deferred income tax assets in the future as currently recorded, we 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.
We recognize 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. We recognize interest and penalties related to uncertain tax positions in our income tax expense.
Recently Adopted and Issued Accounting Pronouncements
For a discussion of these items, see "Note 2—Accounting Standards" of the notes to the consolidated financial statements contained within this Annual Report on Form 10-K.
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