Washington, D.C. 20549

 

FORM 10-K

 

ANNUAL REPORT

 

Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the Fiscal Year Ended September 30, 2003

 

1-8931

Commission File Number

 

CUBIC CORPORATION

Exact Name of Registrant as Specified in its Charter

 

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days.

 

Yes ý    No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K.

 

Yes ý    No o

 

Indicate by check mark whether the registrant is an accelerated filer.

 

Yes ý    No o

 

The aggregate market value of 16,039,954 shares of voting stock held by non-affiliates of the registrant is: $464,517,100 as of November 24, 2003, based on the closing stock price on that date.

 

Number of shares of common stock outstanding as of November 24, 2003 including shares held by affiliates is: 26,719,845 (after deducting 8,944,884 shares held as treasury stock).

 

 

Parts I and III incorporate information by reference from the Registrant’s definitive proxy statement which will be filed no later than 120 days after the close of the Registrant’s year-end, and no later than 30 days prior to the Annual Shareholders’ Meeting.

 

PART I

 

Item 1.           BUSINESS

 

GENERAL

 

CUBIC CORPORATION (“Cubic” or “the Company”), was incorporated in the State of California in 1949 and began operations in 1951.  In 1984, the Company moved its corporate domicile to the State of Delaware.

 

We design, develop, manufacture and install products which are mainly electronic in nature, such as:

 

Equipment for use in customized military range instrumentation, training and applications systems, communications and surveillance systems, HF and VHF/UHF surveillance receivers, transceivers and avionics systems.

 

Automated revenue collection systems, including contactless smart cards, passenger gates, central computer systems and ticket vending machines for mass transit networks, including rail systems and buses.

 

We also perform a variety of services, such as computer simulation training, distributed interactive simulation and development of military training doctrine, as well as field operations and maintenance. We also manufacture replacement parts for the products we produce.  In addition, we operate a corrugated paper converting facility through our subsidiary, Consolidated Converting Company.

 

Our sales have grown over the past five years from $414 million in 1998 to $634 million in 2003, a compound annual growth rate of about 9 percent. This sales growth was fueled by strategic acquisitions we made in the mid-nineties and by key contract wins in recent years in both the defense and transportation systems segments. We also achieved the highest level of net income in our history in fiscal 2003 due to significant operating profit improvements in the defense segment and continued strong operating profits in the transportation systems segment. The operating profit improvements in 2003 were augmented by gains from the sale of real estate that was no longer needed in the business.

 

During fiscal year 2003, approximately 44 percent of our total business was conducted, either directly or indirectly, with various agencies of the United States government.  Most of the remainder of our revenue was from local, regional and foreign governments or agencies.

 

Cubic’s internet address is www.Cubic.com. The content on our website is available for information purposes only. It should not be relied upon for investment purposes, nor is it incorporated by reference into this Form 10-K. We make available free of charge on or through our Internet website under the heading “Investor relations,” our reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file such material with the Securities and Exchange Commission.

 

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BUSINESS SEGMENTS

 

Information regarding the amounts of revenue, operating profit and loss and identifiable assets attributable to each of our industry segments, is set forth in Note 13 to the Consolidated Financial Statements for the year ended September 30, 2003. Additional information regarding the amounts of revenue and operating profit and loss attributable to major classes of products and services is set forth in Management’s Discussion and Analysis which follows at Item 7 of this filing.

 

DEFENSE

 

Cubic’s defense business segment operates as the Cubic Defense Applications (CDA) group. Continuing the strategic realignment begun in fiscal 2002, CDA consolidated its division profit centers into three market-focused business units in fiscal 2003:  Training Systems, Mission Support, and Communications and Electronics.  CDA’s products include customized military range instrumentation systems, tactical engagement simulation systems, communications and surveillance systems, HF and UHF/VHF surveillance receivers, transceivers and avionics systems.  Services provided by CDA include training mission support, computer simulation training, distributed interactive simulation, development of military training doctrine and field operations and maintenance.  The group markets its capabilities directly to various U. S. government departments and agencies and foreign governments.  In addition, CDA contracts or teams frequently with other leading defense suppliers.

 

Training Systems

 

Our Training Systems Business Unit (TSBU) is a pioneer and market leader in the design and production of instrumented training systems for military customers.  These systems generally permit training in actual air and land combat environments, with weapons and other effects simulated by electronic and/or laser technology.  The systems also enable the collection (based on Global Positioning System technology) and analysis of behavior and event data for determination of combat effectiveness and lessons learned.  As such, the systems generally have a high degree of communications and software sophistication.

 

TSBU’s business is organized into Air Combat Training, Land Combat Training, Tactical Engagement Simulation, and Simulation Systems.  In Air Combat Training, Cubic was the initial developer and supplier of Air Combat Maneuvering Instrumentation (ACMI) capability during the Vietnam War and continues to lead that market with the competitive award in 2003 of a 10-year, $525 million indefinite delivery, indefinite quantity (IDIQ) contract to provide upgraded air combat training capability to the U. S. Air Force, Navy and Marine Corps.  The latest ACMI systems permit forces to train on either a fixed geographic range or in a “rangeless” environment.  Many other nations employ Cubic’s ACMI systems.

 

TSBU’s Land Combat Training involves systems analogous to air ranges for ground force training.  TSBU provided turnkey systems to instrument two of the three U. S. Army training centers in past years at Fort Polk, LA (Joint Readiness Training Center – JRTC) and Hohenfels, Germany (Combat Maneuver Training Center – CMTC).  Last year, the group completed the second of two similar ranges, in the U. K. and Canada, for the British Army.  Early in 2003, TSBU was awarded separate contracts by Canada ($92 million) and Australia ($46 million) for land combat training centers in those nations.  To meet new customer demand for mobile instrumented training, TSBU has also developed a transportable, deployable system now being fielded by the U. S. Army.

 

Laser-based Tactical Engagement Simulation systems, generally known as MILES (Multiple Integrated Laser Engagement Simulators), are used at combat training centers (CTC) and in other training environments to permit weapons to be used realistically, registering hits or kills, without live ammunition.  TSBU supplies MILES equipment as part of CTC contracts and as an independent product line.  Cubic MILES systems are being heavily utilized by U. S. Army and Marine Corps forces, as well as Air Force security forces, other U. S. agencies and many international customers.  We produce MILES equipment in the U. S. and at our New Zealand-based subsidiary, Oscmar International.

 

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TSBU’s newest segment, Simulation Systems, is the result of acquiring ECC International Corporation at the end of fiscal 2003.  Simulation Systems produces virtual training systems, employing actual or realistic weapons and systems together with visual imagery to simulate actual battlefield or other environments.

 

Mission Support Services

 

CDA’s Mission Support Business Unit (MSBU), along with the separate Analysis & Learning Technology Division (ALTD), is a leading provider of tactical knowledge-based services to the U. S. Government and allied nations, with an emphasis on military training.  MSBU/ALTD consist of nearly 2,500 people located at 64 sites in 26 states and 18 other nations.  The unit’s personnel serve with their clients in their actual environment and prepare forces through comprehensive training, education and exercises to meet the full scope of their missions, from large scale combat operations, to special operations, peacekeeping or humanitarian assistance operations worldwide.  The units plan, prepare, execute and document realistic and focused mission rehearsal exercises (live and computer-based) as final preparation of forces prior to their deployment to mission areas.  In addition, the units provide high level consultation and advisory services to the governments and militaries of allied nations.  U. S. government contracts are typically awarded on a competitive basis with options for multiple years.  In this competitive market, MSBU/ALTD are viewed as premier service providers and formidable competitors.  They typically compete as prime contractors to the government, but also team with other companies depending on the skills required.  Much of the business unit’s early work centered on battle command simulation and training, in which military commanders are taught to make correct decisions in battle situations.  More recently, the business base has broadened to include live training support, distance learning, weapons effects modeling, intelligence analysis and military force modernization.

 

Principal MSBU programs include providing mission support services to two of the Army’s major combat training centers, the Joint Readiness Training Center (JRTC), as prime contractor, and the National Training Center (NTC), as a subcontractor.  These services include planning, executing and documenting large scale exercises aimed at stressing U. S. forces in situations as close to actual combat as possible.

 

At U. S. Joint Forces Command, Cubic supports and helps manage all aspects of the operations of the Joint Warfighting Center (JWFC).  On the Marine Air Ground Task Force Training Systems Support (MTSS) contract, Cubic provides “cradle-to-grave” training and exercise support to U. S. Marine forces worldwide, including real-world mission rehearsals.  We have planned and executed virtually all USMC simulation-based exercises worldwide since 1998, directly preparing Marines for combat operations.

 

Cubic initiated and has continued to operate the Korea Battle Simulation Centers (KBSC) since their inception in 1991.  KBSC prepares U. S. forces in Korea to deal with situations which may develop in their area of responsibility and includes the world’s largest and most complex training exercise, the annual ULCHI FOCUS LENS.

 

At the U. S. Army I Corps Battle Simulation Center, Cubic provides all technical and operational expertise necessary to support worldwide training, exercises, evaluations and mission rehearsals for I Corps active and reserve component units, the new Stryker brigades, other services and joint organizations.

 

Cubic supports the Defense Threat Reduction Agency (DTRA) with technology-based engineering and other services necessary to accomplish DTRA’s mission of predicting and defeating the effects of chemical, biological, radiological, nuclear and high explosive weapons.  Cubic supports DTRA with modeling and simulations to assess and predict the effects of such weapons in combat and other environments, as well as the training of U. S. forces, first responders, and other users of DTRA products.

 

ALTD has multiple contracts with government agencies for development and deployment of distance learning tools and programs to improve the quality and reach of training and education initiatives for large organizations.  ALTD’s principal business is in providing specialized teams of military experts to advise the governments and militaries of the nations of the former Warsaw Pact and Soviet Union in the transformation of their militaries to a NATO environment.  These very broad force modernization contracts entail both sweeping vision and minute detail, involving both the nations’ strategic foundation and the detailed planning

 

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of all aspects of reform.

 

In addition to providing contractor logistics support for CDA’s product divisions, MSBU’s Worldwide Technical Services Division operates and maintains a wide variety of flight simulation and other facilities worldwide for U. S. forces under multiple long term contracts.

 

Communications & Electronics

 

Our Communications and Electronics Business Unit (CEBU) is a supplier of secure data links, intelligence receivers, high power RF amplifiers and search and rescue avionics systems to the U. S. military, other agencies and allied nations.  CEBU’s products support the strong military trend toward network-centric warfare and modernization initiatives.  The unit has long supplied the air/ground secure data link for the U. S. Army/Air Force Joint STARS system and supplies the principal datalink for the United Kingdom’s ASTOR program.  Capitalizing on a multi-year internal R&D program, CEBU won a competitive contract in fiscal 2003 to develop and produce the next-generation Common Data Link Subsystem (CDLS) for the U. S. Navy.  CDLS is planned for installation on major surface ships of the U. S. fleet.  Smaller, tactical versions of our Common Data Link are strong candidates for new military platforms, such as Unmanned Aerial Vehicles (UAV), which require high performance in a small package.  A principal opportunity in this area is the United Kingdom’s new Watchkeeper UAV program.

 

CEBU’s Personnel Locator System (PLS) is standard equipment on U.S. aircraft with a search-rescue mission.  We received initial orders for an upgraded PLS which has been redesigned to interface with all modern search and rescue system standards, thus positioning us for major platform upgrades expected over the next 3 years.

 

CEBU has also begun to successfully leverage its communications products portfolio to move into larger subsystem and system level programs in the areas of communications intercept and jamming (Electronic Warfare) and communications intelligence.  We have been awarded contracts by the US Army and Navy for the initial development of these systems which should evolve to production follow-on and open the door for new opportunities within these commands.

 

Raw Materials:

 

The principal raw materials used by the defense segment are sheet aluminum and steel, copper electrical wire, and composite products.  A significant portion of the segment’s end product is composed of purchased electronic components and subcontracted parts and supplies. These items are primarily procured from commercial sources.  In general, supplies of raw materials and purchased parts are presently adequate to meet the requirements of the segment.

 

Backlog:

 

Funded sales backlog of the defense segment at September 30, 2003 was $388 million compared to $232 million at September 30, 2002.  Total backlog, including unfunded or unexercised customer orders, was $743 million at September 30, 2003 compared to $493 million at September 30, 2002. Approximately $484 million of the September 30, 2003 total backlog is not expected to be completed by September 30, 2004.

 

Competition:

 

CDA’s broad defense business portfolio means we compete with numerous companies, large and small, domestic and international.  In many cases, we have also teamed with these same companies on specific bid opportunities.  Well known CDA competitors include Lockheed Martin, Northrop Grumman, General Dynamics, Boeing, L3 Communications and SAIC.  While CDA is generally smaller than its usual competition, we believe our competitive advantages include past performance, incumbent relationships and the ability to rapidly focus technology and innovation to solve customer problems.

 

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Competition also exists among projects for funding in the defense budget.  While the U. S. defense budget has seen sharp increases in recent years, long-term growth will only occur in those segments which offer very high payoff and are consistent with warfighting priorities.  The U. S. defense market today can be characterized as highly dynamic, with priorities and funding shifting in reaction to, or anticipation of, world events much more rapidly than during the Cold War or since.  Overarching military priorities include lighter, faster, more lethal forces with the ability and training to rapidly adapt to new situations based on superior knowledge of the battle environment.  Superior knowledge is enabled by systems which rapidly collect, process and disseminate the right information to the right place at the right time, resulting in what DoD calls network-centric warfare.  Cubic’s training systems, training support and intelligence, surveillance and reconnaissance capabilities are well matched to these sustainable defense priorities.

 

TRANSPORTATION SYSTEMS

 

Cubic Transportation Systems is a leading turnkey solution provider of automated fare collection systems for public transport authorities worldwide.  We provide a range of services and systems solutions for the bus, bus rapid transit, light rail, commuter rail, heavy rail, ferry and parking markets.  These solutions and services include system design, central computer systems, equipment design and manufacturing, device-level software, integration, test, installation, warranty, maintenance, computer hosting services, call center services, card management and distribution services, financial clearing and settlement, multi-application support and outsourcing services.  In addition, Cubic designs, develops and manufactures its own technology components, such as smart card readers, magnetic ticket transports, and controller boards, for use within its suite of fare collection equipment consisting of on-bus solutions, access control solutions, vending solutions, retail and card issuing solutions, and mobile inspection and sales solutions.

 

Over the years, the transportation segment has been awarded over 400 projects in 40 major markets on 5 continents.  Active projects include London, New York / New Jersey region, Washington, D.C. / Baltimore / Virginia region, Los Angeles region, San Diego region, San Francisco, Minneapolis/St. Paul, Chicago, Houston, Atlanta, South Florida, Vancouver and Edmonton, Canada, Brisbane, Australia, Singapore, Bangkok, Thailand, and Scandinavia.

 

These programs provide a solid base of current business and the potential for additional future business as the systems are expanded.  In 1998, Transaction Systems Limited (TranSys), a joint venture company in which Cubic has a 37.5 percent ownership, was awarded a contract called “PRESTIGE” to privatize the London Transport fare collection system.  This 17-year contract, now in its sixth year, is the largest automated fare collection contract ever awarded.  Cubic’s share of the work, including all options exercised to date, exceeds $800 million over the 17-year life of the contract.

 

Industry Overview

 

Transport agencies, particularly those based in the U.S., rely heavily on federal, state and local government for subsidies in capital investments, including new procurements and/or upgrades of automated fare collection systems.  The average lifecycle for fare collection systems is 12 to 15 years.  Procurements tend to follow a long and strict competitive bid process where the lowest price bid typically wins.

 

The automated fare collection business is a niche market able to sustain only a relatively few number of suppliers.  Because of the long life expectancy of these systems and only a few companies able to supply them, there is increasing demand for open systems and commercial off-the-shelf products. This demand is evidenced by transit agency participation in industry standards initiatives to increase interoperability and to actively encourage more competition.

 

Furthermore, advances in communications, networking and security technologies are enabling interoperability of multiple modes of transportation within a single networked system as well as interoperability of multiple operators within a single networked system.  As such, there is a growing trend for regional ticketing systems, usually built around a large transit agency and including neighboring

 

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operators, all sharing a common regional smart card.  There is an emerging trend for other applications to be added to these regional systems to expand the utility of the smart card, offering higher value and incentives to the end users and lowering costs and creating new revenue streams for the regional system operators.  As a result, these regional systems have created opportunities for new levels of systems support and services including call center support, smart card production and distribution, financial clearing and settlement and multi-application support.  In some cases, operators are choosing to outsource the capital development, ongoing operations and commercialization of these regional ticketing systems.

 

Raw Materials:

 

Raw materials used in this segment include sheet steel, composite products, copper electrical wire and castings. A significant portion of the segment’s end product is composed of purchased electronic components and subcontracted parts and supplies. All of these items are procured from commercial sources.  In general, supplies of raw materials and purchased parts are presently adequate to meet the requirements of the segment.

 

Backlog:

 

Funded sales backlog of the transportation systems segment at September 30, 2003 was $620 million compared to $545 million at September 30, 2002.  Total backlog, including un-funded or unexercised customer orders, was $762 million at September 30, 2003 compared to $672 million at September 30, 2002. Approximately $544 million of the September 30, 2003 total backlog is not expected to be completed by September 30, 2004.

 

Competition:

 

We are one of several companies involved in providing automated fare collection systems solutions and services for public transport operators worldwide including Thales, Ascom, Scheidt & Bachmann and ERG.  In addition, there are many smaller local companies, particularly in European and Asian markets.  For large national tenders, it is common practice to form consortiums that include, in addition to the fare collection companies noted above, telecommunications, consulting and computer services companies including T-Systems, Siemens, Accenture, Metropolitan Transit Railway Corporation, Control Data Corporation, Computer Sciences Corporation and EDS.  These procurement activities are very competitive and require that we have highly skilled and experienced technical personnel to compete. We believe that our competitive advantages include intermodal and interagency regional integration expertise, technical skills, past contract performance, systems quality and reliability, experience in the industry and long-term customer relationships.

 

OTHER OPERATIONS

 

Consolidated Converting Company converts corrugated paper stock into pizza boxes and other food related corrugated products. Effective December 15, 2003 the subsidiary will no longer convert paper stock into toilet seat covers.

 

Raw Materials:

 

Raw materials used by Consolidated Converting Company consist of paper products which are procured from commercial sources.  In general, supplies of raw materials are presently adequate to meet the requirements of this business.  Paper shortages could delay completion, or result in the cancellation, of customer orders.

 

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Backlog:

 

Consolidated Converting Company had little sales backlog at September 30, 2003 and 2002. The business does not track sales backlog due to the short-term conversion of customer orders into sales and the absence of long-term contracts.

 

Competition:

 

This business competes with concerns of varying size, including some very large companies. It is not possible to predict the extent of the competition which present or future activities will encounter, particularly since the market for this subsidiary’s products is subject to rapidly changing competitive conditions.

 

BUSINESS STRATEGY

 

Our objective is to consistently grow sales, improve profitability and deliver attractive returns on capital.  We intend to build on our position with U.S. and foreign governments as the leading ‘full spectrum” supplier of training systems and mission support services, grow our niche position as a supplier of network centric technologies for communications systems and products, and maintain our position as the number one provider of integrated intermodal regional transit fare collection systems to transit authorities worldwide. Our strategies to achieve these objectives include:

 

Leverage Long-Term Relationships

 

We seek to maintain long term relationships with our customers through repeat business by continuing to achieve high levels of performance on our existing contracts.  By achieving this goal we can leverage our returns through repeat business with existing customers and expand our market through sales of similar systems at “good value” to additional customers.

 

An example of this in our defense segment is the recent competitive award of a contract to provide the next generation U.S. air combat training systems for the next 10 years.  Since pioneering this technology in the 1970’s we have played a significant role in developing this key training technology for U.S. and foreign militaries.  Our earlier air combat training work gave us the credibility and much of the technology to diversify into providing similar capability for ground forces and to accelerate the expansion of our training service offerings.

 

 In our transportation segment we have had a relationship with the Washington Metropolitan Area Transportation Authority (WMATA) for 30 years, since we first implemented their magnetic ticketing system, and have over the years installed a complete back office system and over 4,000 pieces of equipment.  In 1999, we upgraded their system with SmarTripÒ, the first contactless smart card implementation in the U.S. and have since added other applications such as parking, security access and prepaid transit benefits to the system.  We are currently rolling out the SmarTripÒ system to 1,600 WMATA buses, to over 2,000 buses throughout the Baltimore and Northern Virginia region and to the regional rail system.  We are also supplying a point-of-sale distribution network and upgrading the central computer system to offer region-wide services and to interface to a third party operated customer service center. Similarly we are regionalizing integrated fare collection systems in London, New York and Southern California.

 

Maintain a Diversified Business Mix

 

We have a diverse mix of business in our defense and transportation systems segments. Approximately 44 percent of our sales are to the U.S. government, however, this represents a wide variety of product and service sales to many different U.S. government agencies. While 15% of our sales in 2003 and for the past several years came from the PRESTIGE contract in London, its share of total sales should decrease going forward as we expect growth in sales from other transit customers and in the defense segment.

 

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Our backlog increased in 2003 to $1.5 billion, the highest level in our history. The increase is significant not just because of the amount of the increase, but because of the makeup of the backlog. Our previous record high backlog was $1.2 billion in 1998. At that time the PRESTIGE contract represented 55 percent of our total backlog and defense was only 28 percent of the total. As of September 30, 2003, backlog was $300 million higher than in 1998 and PRESTIGE was only 24 percent of the total, with defense about half of the total. Therefore, not only has the backlog grown, but it has done so in a much broader manner, so we are not as reliant on a single contract or customer for our revenues.

 

We also seek a reasonable balance between systems and service work in both the defense and transportation segments. In aggregate, approximately 35% of our sales revenue in 2003 was from service type work. We believe that a strong base of service work helps to smooth the revenue fluctuations inherent in systems type work.

 

Pursue Strategic Acquisitions

 

Through selective strategic acquisitions we seek to expand our customer base, broaden our technical solutions, gain staffing resources and leverage our entry into related new markets. As an example, we recently acquired ECC International. This acquisition expanded our presence in the training market by adding virtual training, which complements our existing focus on live and constructive training.

 

OTHER MATTERS

 

We pursue a policy of seeking patent protection for our products, where deemed advisable, but do not regard ourselves as materially dependent on its patents for the maintenance of our competitive position.

 

We do not engage in any significant business that is seasonal in nature. Because our revenues are generated primarily from work on contracts performed by our employees and subcontractors, first quarter revenues tend to be lower than the other three quarters due to our policy of providing many of our employees seven holidays in the first quarter, compared to one or two in each of the other quarters of the year. This is not necessarily a consistent pattern as it depends upon actual activities in any given year.

 

The cost of Company sponsored research and development (R&D) activities was $4.8 million, $8.4 million and $9.8 million in 2003, 2002, and 2001, respectively. We do not rely heavily on independent R&D, as most of our new product development occurs in conjunction with the performance of work on our contracts. The amount of contract required product development activity increased in 2003 to $46 million, compared to $41 million in 2002 and 2001; however, these costs are included in cost of sales as they are directly related to contract performance.

 

We comply with federal, state and local laws and regulations regarding discharge of materials into the environment and the handling and disposal of materials classed as hazardous and/or toxic. Such compliance has no material effect upon the capital expenditures, earnings or competitive position of the Company.

 

We employed approximately 4,700 persons at September 30, 2003.

 

Our domestic products and services are sold almost entirely by our employees.  Overseas sales are made either directly or through representatives or agents.

 

Typically our long-term contracts provide for progress or advance payments by our customers, which provide assistance in financing the working capital requirements on those contracts.  From time to time we also obtain third party financing to assist in working capital requirements.

 

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RISK FACTORS

 

The following are some of the factors we believe could cause our actual results to differ materially from expected and historical results.  Additional risks and uncertainties not presently known to us, or that we currently see as immaterial, may also harm our business.  If any of the risks or uncertainties described below or any such additional risks and uncertainties actually occur, our business, results of operations or financial condition could be materially and adversely affected.

 

We depend on government contracts for substantially all of our sales and the loss of government contracts or a delay or decline in funding of existing or future government contracts could adversely affect our sales and cash flows and our ability to fund our growth.

 

Our sales from contracts, directly or indirectly, with international and United States, state, regional and local governmental agencies represented more than 95 percent of our total sales in fiscal year 2003.  Although government agencies are subject to common budgetary pressures and other factors, many of our government customers exercise independent purchasing decisions.  Because of the concentration of business with governmental agencies, we are vulnerable to adverse changes in our sales, income and cash flows if a significant number of our government contracts or subcontracts or prospects are delayed or canceled for budgetary or other reasons.

 

The factors that could cause us to lose these contracts or could otherwise materially harm our business, prospects, financial condition or results of operations include:

 

•                  Re-allocation of government resources as the result of actual or threatened terrorism or hostile activities;

 

•                  budget constraints affecting government spending generally, or specific departments or agencies such as U.S. or foreign defense and transit agencies and regional transit agencies, and changes in fiscal policies or a reduction of available funding;

 

•                  changes in government programs or requirements or their timing;

 

•                  curtailment of government’s use of technology products and service providers;

 

•                  the adoption of new laws or regulations pertaining to government procurement;

 

•                  government appropriations delays or shutdowns;

 

•                  suspension or prohibition from contracting with any significant agency;

 

•                  impairment of our ability to provide third-party guarantees and letters of credit;

 

•                  impairment of our reputation or relationships with any significant government agency; and

 

•                  delays in the payment of our invoices by government payment offices.

 

Government spending priorities may change in a manner adverse to our businesses.

 

In the past, our businesses have been adversely affected by significant changes in government spending during periods of declining budgets.  A significant decline in overall spending, or the decision not to exercise options to renew contracts, or the loss of or substantial decline in spending on a large program in which we participate could materially adversely affect our business, prospects, financial condition or results of operations.  As an example, the U.S. defense and intelligence budgets generally, and spending in specific agencies with which we work, such as the Department of Defense, have declined from time to time for extended periods since the mid-1980s, resulting in program delays, program cancellations and a slowing of new program starts.  Although spending on defense-related programs by the U.S. government has recently increased, future levels of expenditures and authorizations for those programs may decrease, remain constant or shift to programs in areas where we do not currently provide products or services.

 

Even though our contract periods of performance for a program may exceed one year, Congress must usually approve funds for a given program each fiscal year and may significantly reduce funding of a

 

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program in a particular year.  Significant reductions in these appropriations or the amount of new defense contracts awarded may affect our ability to complete contracts, obtain new work and grow our business.  Congress does not always enact spending bills by the beginning of the new fiscal year.  Such delays leave the affected agencies under-funded which delays their ability to contract.  Future delays and uncertainties in funding could impose additional business risks on us.

 

Our contracts with government agencies may be terminated or modified prior to completion, which could adversely affect our business.

 

Government contracts typically contain provisions and are subject to laws and regulations that give the government agencies rights and remedies not typically found in commercial contracts, including providing the government agency with the ability to unilaterally:

 

•                  terminate our existing contracts;

 

•                  reduce the value of our existing contracts;

 

•                  modify some of the terms and conditions in our existing contracts;

 

•                  suspend or permanently prohibit us from doing business with the government or with any specific government agency;

 

•                  control and potentially prohibit the export of our products;

 

•                  cancel or delay existing multi-year contracts and related orders if the necessary funds for contract performance for any subsequent year are not appropriated;

 

•                  decline to exercise an option to extend an existing multi-year contract; and

 

•                  claim rights in technologies and systems invented, developed or produced by us.

 

Most U.S. government agencies can terminate their contracts with us for convenience, and in that event we generally may recover only our incurred or committed costs, settlement expenses and profit on the work completed prior to termination.  If an agency terminates a contract with us for default, we are denied any recovery, and may be liable for excess costs incurred by the agency in procuring undelivered items from an alternative source.  We may receive show-cause or cure notices under contracts that, if not addressed to the agency’s satisfaction, could give the agency the right to terminate those contracts for default or to cease procuring our services under those contracts.

 

In the event that any of our contracts were to be terminated or adversely modified, there may be significant adverse effects on our revenues, operating costs and income that would not be recoverable.

 

Failure to retain existing contracts or win new contracts under competitive bidding processes may adversely affect our revenue.

 

We obtain most of our contracts through a competitive bidding process, and substantially all of the business that we expect to seek in the foreseeable future likely will be subject to a competitive bidding process.  Competitive bidding presents a number of risks, including:

 

•                  the need to compete against companies or teams of companies with more financial and marketing resources and more experience in bidding on and performing major contracts than we have;

 

•                  the need to compete against companies or teams of companies that may be long-term, incumbents for a particular contract for which we are competing and that have, as a result, greater domain expertise and better customer relations;

 

•                  the need to compete to retain existing contracts that have in the past been awarded to us on a sole-source basis;

 

•                  the expense and delay that may arise if our competitors protest or challenge new contract awards;

 

•                  the need to bid on programs in advance of the completion of their design, which may result in unforeseen technological difficulties, cost overruns or both;

 

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•                  the substantial cost and managerial time and effort, including design, development and marketing activities, necessary to prepare bids and proposals for contracts that may not be awarded to us;

 

•                  the need to develop, introduce, and implement new and enhanced solutions to our customers’ needs;

 

•                  the need to locate and contract with teaming partners and subcontractors; and

 

•                  the need to accurately estimate the resources and cost structure that will be required to perform any fixed-price contract that we are awarded.

 

We may not be afforded the opportunity to bid on contracts that are held by other companies and are scheduled to expire if the agency determines to extend the existing contract.  If we are unable to win contracts that are awarded through the competitive bidding process, we may not be able to operate in the market for services that are provided under those contracts for a number of years.  If we win a contract, upon expiration, if the customer requires further services of the type provided by the contract, there is frequently a competitive rebidding process and there can be no assurance that we will win any particular bid, or that we will be able to replace business lost upon expiration or completion of a contract.

 

Because of the complexity and scheduling of contracting with government agencies, we occasionally incur costs before receiving contractual funding by the government agency.  In some circumstances, we may not be able to recover these costs.

 

If we are unable to consistently retain existing contracts or win new contract awards, our business, prospects, financial condition and results of operations will be adversely affected.

 

Government audits of our contracts could result in a material charge to our earnings and have a negative effect on our cash position following an audit adjustment.

 

Many of our government contracts are subject to cost audits which may occur several years after the period to which the audit relates.  If an audit identifies significant unallowable costs, we could incur a material charge to our earnings or reduction in our cash position.

 

Our international business exposes us to additional risks, including exchange rate fluctuations, foreign tax and legal regulations and political or economic instability that could harm our operating results.

 

Our international operations, including our contract for the London Transport fare collection system, subject us to risks associated with operating in and selling products or services in foreign countries, including:

 

•                  devaluations and fluctuations in currency exchange rates;

 

•                  changes in foreign laws that adversely affect our ability to sell our products or services or our ability to repatriate profits to the United States;

 

•                  increases or impositions of withholding and other taxes on remittances and other payments by foreign subsidiaries or joint ventures to us;

 

•                  increases in investment and other restrictions or requirements by foreign governments in order to operate in the territory or own the subsidiary;

 

•                  costs of compliance with local laws, including labor laws;

 

•                  export control regulations and policies which govern our ability to supply foreign customers;

 

•                  unfamiliar business practices and customs;

 

•                  domestic and foreign government policies, including requirements to expend a portion of program funds locally and governmental industrial cooperation requirements;

 

•                  the complexity and necessity of using foreign representatives and consultants;

 

•                  the uncertainty of the ability of foreign customers to finance purchases;

 

•                  imposition of tariffs or embargoes, export controls and other trade restrictions;

 

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•                  the difficulty of management and operation of an enterprise in various countries; and

 

•                  economic and geopolitical developments and conditions, including international hostilities, acts of terrorism and governmental reactions, inflation, trade relationships and military and political alliances.

 

Our foreign subsidiaries and joint ventures generally conduct business in foreign currencies and enter into contracts and make purchase commitments that are denominated in foreign currencies.   We are exposed to fluctuations in exchange rates, which could cause a significant impact on our results of operations.  We have no control over the factors that generally affect this risk, such as economic, financial and political events and the supply of and demand for applicable currencies.  While we use foreign exchange forward and option contracts to hedge significant contract sales and purchase commitments that are denominated in foreign currencies, our hedging strategy may not prevent us from incurring losses due to exchange fluctuations.

 

Our operating margins may decline under our fixed-price contracts if we fail to estimate accurately the time and resources necessary to satisfy our obligations.

 

Approximately 85% of our contracts in 2003 were fixed-price contracts under which we bear the risk of cost overruns.  Our profits are adversely affected if our costs under these contracts exceed the assumptions we used in bidding for the contract.  Often, we are required to fix the price for a contract before the project specifications are finalized, which increases the risk that we will incorrectly price these contracts.

 

We may be liable for civil or criminal penalties under a variety of complex procurement laws and regulations, and changes in governmental regulations could adversely affect our business and financial position.

 

Our businesses must comply with and are affected by various government regulations that impact our operating costs, profit margins and our internal organization and operation of our businesses. These regulations affect how we do business and, in some instances, impose added costs.  Any changes in applicable laws could adversely affect our financial performance.  Any material failure to comply with applicable laws could result in contract termination, price or fee reductions or suspension or debarment from contracting.  The more significant regulations include:

 

•                  the Federal Acquisition Regulations and all department and agency supplements, which comprehensively regulate the formation, administration and performance of U.S. government contracts;

 

•                  the Truth in Negotiations Act, and implementing regulations, which require certification and disclosure of all cost and pricing data in connection with contract negotiations;

 

•                  laws, regulations and executive orders restricting the use and dissemination of information classified for national security purposes and the exportation of certain products and technical data; and

 

•                  most state and regional agencies and foreign governments have regulations similar to those described above.

 

Our failure to identify, attract and retain qualified technical and management personnel could adversely affect our existing businesses.

 

We may not be able to attract and retain the highly qualified technical personnel, including engineers, computer programmers, and personnel with security clearances required for classified work, or management personnel to supervise such activities that are necessary for maintaining and growing our existing businesses.

 

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We may incur significant costs in protecting our intellectual property which could adversely affect our profit margins. Our inability to protect our patents and proprietary rights could adversely affect our businesses’ prospects and competitive positions.

 

We seek to protect proprietary technology and inventions through patents and other proprietary-right protection.  The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States.  If we are unable to obtain or maintain these protections, we may not be able to prevent third parties from using our proprietary rights. In addition, we may incur significant expense both in protecting our intellectual property and in defending or assessing claims with respect to intellectual property owned by others.

 

We also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive.  We have taken measures to protect our trade secrets and know-how, including the use of confidentiality agreements with our employees, consultants and advisors.  These agreements may be breached and remedies for a breach may not be sufficient to compensate us for damages incurred.  We generally control and limit access to our product documentation and other proprietary information.  Other parties may independently develop our know-how or obtain access to our technology.

 

We compete primarily for government contracts against many companies that are larger, better financed and better known than us.  If we are unable to compete effectively, our business and prospects will be adversely affected.

 

Our businesses operate in highly competitive markets.  Many of our competitors are larger, better financed and better known companies who may compete more effectively than we can.  In order to remain competitive, we must keep our capabilities technically advanced and compete on price and on value added to our customers.  Our ability to compete may be adversely affected by limits on our capital resources and our ability to invest in maintaining and expanding our market share.

 

The terms of our financing arrangements may restrict our financial and operational flexibility, including our ability to invest in new business opportunities.

 

We currently have unsecured notes payable to several insurance companies.  The terms of these notes include provisions that require and/or limit our levels of working capital, debt and tangible net worth and coverage of fixed charges.    We also have provided performance guarantees to various customers that include financial covenants including limits on working capital, debt, tangible net worth and cash flow coverage.

 

We may incur future obligations that would subject us to additional covenants that affect our financial and operational flexibility or subject us to different events of default.

 

Our revenues could be less than expected if we are not able to deliver services or products as scheduled due to disruptions in supply.

 

Because our internal manufacturing capacity is limited, we use contract manufacturers. While we use care in selecting our manufacturers, we have less control over the reliability of supply, quality and price of products or components than if we manufactured them.  In some cases, we obtain products from a sole supplier or a limited group of suppliers.  Consequently, we risk disruptions in our supply of key products and components if our suppliers fail or are unable to perform because of strikes, natural disasters, financial condition or other factors.  Any material supply disruptions could adversely affect our ability to perform our obligations under our contracts and could result in cancellation of contracts or purchase orders, penalties, delays in realizing revenues, payment delays, as well as adversely affect our ongoing product cost structure.

 

Failure to perform by one of our subcontractors could materially and adversely affect our prime contract performance and our ability to obtain future business.

 

Our performance of contracts may involve subcontracts, upon which we rely to deliver the products to our customers.  We may have disputes with subcontractors.  A failure by a subcontractor to satisfactorily deliver products or services may adversely affect our ability to perform our obligations as a prime contractor.  Any subcontractor performance deficiencies could result in the customer terminating our

 

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contract for default, which could expose us to liability for excess costs of reprocurement by the customer and have a material adverse effect on our ability to compete for other contracts.

 

For example, one of the subcontractors we engaged to perform a portion of the work on the PRESTIGE contract with TranSys failed to perform.  Consequently, we were forced to terminate this subcontractor and are completing the subcontractor’s work on our own.  We have incurred and will continue to incur additional costs to complete this work and have asserted a claim against the subcontractor to recover appropriate damages.  The subcontractor has claimed that we wrongfully terminated the subcontract and seeks damages from us.  This situation has resulted in our realizing lower profit margins than we had anticipated, and could limit increases in future profit margins and cash flows from the contract until the situation is resolved.  There can be no assurance that we will be able to complete the subcontractor’s work in a cost effective manner, that the failure will not adversely affect our contract with TranSys, that we will not be liable to the subcontractor’s claim or that we will be able to recover any of our damages from the subcontractor.

 

We may acquire other companies, which could increase our costs or liabilities or be disruptive.

 

Part of our strategy involves the acquisition of other companies.  We recently completed the acquisition of ECC International Corp., a defense company that sells simulated and related training programs for armed forces, for a cost of approximately $43.9 million.  We may not be able to integrate this business, or any other acquisitions successfully without substantial expense, delay or operational or financial problems.  The acquisition and integration of new businesses involves risk.  The integration of acquired businesses may be costly and may adversely impact our results of operations or financial condition:

 

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