Attached files
| file | filename |
|---|---|
| EX-32.1 - EX-32.1 - NCI, Inc. | d328524dex321.htm |
| EX-31.2 - EX-31.2 - NCI, Inc. | d328524dex312.htm |
| EX-31.1 - EX-31.1 - NCI, Inc. | d328524dex311.htm |
| EX-23.1 - EX-23.1 - NCI, Inc. | d328524dex231.htm |
| EX-21.1 - EX-21.1 - NCI, Inc. | d328524dex211.htm |
| EX-10.12 - EX-10.12 - NCI, Inc. | d328524dex1012.htm |
| EX-10.8 - EX-10.8 - NCI, Inc. | d328524dex108.htm |
| EX-10.7 - EX-10.7 - NCI, Inc. | d328524dex107.htm |
| EX-10.6 - EX-10.6 - NCI, Inc. | d328524dex106.htm |
Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 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 December 31, 2016
OR
| ☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission File No. 000-51579
NCI, INC.
(Exact name of registrant as specified in its charter)
| Delaware | 20-3211574 | |
| (State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
| 11730 Plaza America Drive Reston, Virginia |
20190-4764 | |
| (Address of principal executive offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (703) 707-6900
Securities registered pursuant to Section 12(b) of the Act:
| Title of Each Class |
Name of Each Exchange On Which Registered | |
| Class A Common Stock, par value $0.019 per share | The NASDAQ Global Select Market |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No ☒
Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒
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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). ☒ Yes ☐ No
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 or any amendment to this Form 10-K. ☒
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer | ☐ | Accelerated filer | ☒ | |||
| Non-accelerated filer | ☐ (Do not check if a smaller reporting company) | Smaller reporting company | ☐ | |||
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
The aggregate market value of NCI, Inc. Class A common stock held by non-affiliates of the registrant as of June 30, 2016, was approximately $119,572,230.
As of March 27, 2017, there were 9,043,897 shares outstanding of the registrant’s Class A common stock. In addition, there are 4,500,000 shares outstanding of the registrant’s Class B common stock, which are convertible on a one-for-one basis into Class A common stock.
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the definitive Proxy Statement to be filed with the Securities Exchange Commission pursuant to Regulation 14A in connection with the registrant’s 2017 Annual Meeting of Stockholders, to be filed subsequent to the date hereof, are incorporated by reference into Part III (Items 10, 11, 12, 13, and 14) of this Annual Report on Form 10-K. Such definitive Proxy Statement will be filed with the Commission not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
Table of Contents
FORM 10-K
Table of Contents
Forward-Looking Statements
This Annual Report on Form 10-K contains statements that are not statements of historical fact and are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”), each as amended. The forward-looking statements are principally, but not exclusively, contained in “Item 1: Business” and “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations.” These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Forward-looking statements include, but are not limited to, statements about management’s confidence or expectations, our business strategy, our ability to raise capital or borrow funds to consummate acquisitions and the availability of attractive acquisition candidates, our expectations regarding future costs of revenues, our ability to be awarded government contracts, our ability to compete effectively with other firms that provide similar services, the outcome of legal proceedings, investigations and other contingencies, the future impact of the restatement of our historical financial results, our ability to recover funds embezzled by our former controller, our anticipated compliance with the covenants contained in our credit facility, the adequacy of our financial resources and our plans, objectives, expectations and intentions that are not historical facts. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “seek,” “expects,” “plans,” “aim,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “intends,” “think,” “strategy,” “potential,” “objectives,” “optimistic,” “new,” “goal” and similar expressions intended to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions and subject to risks and uncertainties. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We discuss many of these risks in detail under the heading “Item 1A. Risk Factors” beginning on page 5 of this Annual Report on Form 10-K. You should carefully review all of these factors, as well as other risks described in our public filings, and you should be aware that there may be other factors, including factors of which we are not currently aware, that could cause there to be material differences between forward-looking statements contained herein and our actual results. These forward-looking statements represent our estimates and assumptions only as of the date such statements are made and we do not undertake any obligation to update these forward-looking statements, whether as a result of new information, future events, or otherwise. NCI, Inc., a Delaware corporation, and, where appropriate, its subsidiaries, is referred to herein as “we,” “our,” “us,” “NCI,” and “the Company.”
EMBEZZLEMENT AND RESTATEMENT
In January 2017, the Company identified a misappropriation of company funds by the former controller. The Company notified investors in a Form 8-K, filed with the SEC on January 23, 2017, that the quarterly information for the quarters ended March 31, 2016; June 30, 2016; and September 30, 2016 could no longer be relied upon. The Audit Committee engaged independent legal counsel and forensic consultants to investigate the fraud. The investigation was completed in March 2017, and revealed that the former controller had embezzled $19.4 million through a circumvention of controls, which included transfers from the company’s payroll account to his personal account, creating fictitious invoices, and altering bank account statements to conceal the misappropriations. The Company believes that the former controller acted alone and found no evidence that any other NCI employee was aware of, or colluded in, the embezzlement of Company funds or that there was any unlawful activity apart from that associated with the former controller’s embezzlement of Company funds. The amounts embezzled were primarily classified as expenses and were included as fringe benefits costs in costs of revenue and general and administrative expenses and were originally allocated to contracts as allowable costs. After discovery of the embezzlement these costs were restated as misappropriation loss, which is an unallowable cost. The Company had sufficient allowable, but previously unbilled costs allocated to its contracts in fiscal years 2010 through 2015 to offset the unallowable costs related to the embezzlement, such that there was no material change in revenue recognized on its cost reimbursable contracts. The Company has restated the Consolidated Statements of Income for the years ended December 31, 2015 and 2014 to classify the embezzled amounts as “Misappropriation Loss.” The restatements of our Consolidated Statements of Income for the years ended December 31, 2014 and 2015 did not impact our net revenue or earnings for such years. The Company is in the process of amending its quarterly reports on Form 10-Q for the quarters ended March 31, June 30 and September 30, 2016, which will be filed as soon as practicable following the filing of this Form 10-K.
As a result of the fraud, management concluded that material weaknesses in its internal control over financial reporting existed as of December 31, 2016. Management’s Report on Internal Control Over Financial Reporting is included in Item 9A herein.
COMPANY OVERVIEW
NCI is a leading provider of enterprise solutions and services to U.S. defense, intelligence, health and civilian government agencies. We have the expertise and proven track record to solve our customers’ most important and complex mission challenges through technology and innovation. Our team of highly skilled professionals focuses on delivering cost-effective solutions and services in the areas of agile development and lean software O&M; big data and data analytics; cybersecurity and information assurance; engineering and logistics; IT infrastructure optimization and service management; and health and program integrity. We are focused on reshaping the way services and solutions are delivered to our customers in order to proactively understand and meet their mission needs and enable them to rapidly adapt to dynamic environments. Headquartered in Reston, Virginia, we have approximately 2,000 employees
Table of Contents
operating at more than 100 locations worldwide. Substantially all of our revenue was derived from contracts with the U.S. Federal Government, directly as a prime contractor or as a subcontractor. NCI primarily conducts business throughout the U.S. We report operating results and financial data as one reportable segment.
For additional discussion and analysis related to recent business developments, see “Industry Trends” in Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of this Annual Report on Form 10-K.
IT AND PROFESSIONAL SERVICES AND SOLUTIONS
NCI provides IT and professional services and solutions by leveraging our six core service offerings: agile development and lean software O&M; big data and data analytics; cybersecurity and information assurance; engineering and logistics; IT infrastructure optimization and service management; and health and program integrity.
Agile Development and Lean Software O&M
We develop applications and modernize systems using proprietary Agile methodology. We provision and scale data for high performance, processing and analytics, data strategy and analysis, and at-scale data / software engineering automation. And, we bring efficiency and visibility to application O&M using our CK method and teams. Our approach has proven to increase break-fix throughput, reduce lead time and cut support costs. NCI enhanced these capabilities as a result of its acquisition of Computech, Inc. (Computech), a leader in agile and lean application software development and IT operations and maintenance, in January 2015.
Big Data and Data Analytics
As a leader in mission-oriented intelligence-to-operations initiatives that reduce time and turn data into actionable information, NCI focuses on delivering innovative technologies to solve our customers’ complex challenges. We have significantly enriched the intelligence-to-operations lifecycle by applying scalable technologies and advanced algorithms to help interpret data.
Cybersecurity and Information Assurance
Our comprehensive approach aligns information assurance and cybersecurity initiatives that support business objectives, compliance requirements and risk management. We provide our federal government customers the full lifecycle of cybersecurity services and are actively engaged in ensuring their networks are properly secured.
Engineering and Logistics
NCI delivers innovative engineering and logistics solutions enabling affordability, effectiveness and mission readiness anywhere in the world. NCI’s solutions ensure the customer the lowest cost for the best performance anywhere, anytime.
IT Infrastructure Optimization and Service Management
NCI delivers enterprise-class, bare-metal virtualization solutions focused on procuring capacity services and EaaS requirements in a fiscally-strained environment. Our unique, tailored methodology for delivering IT service management is based on defining your needs rather than simply implementing industry “best practices.”
Health and Program Integrity
NCI leverages a deep and diverse skill base. Our health and program integrity solutions enable efficient information sharing, reduce paperwork collection and control efforts, and improve healthcare quality for our government customers. And, we help U.S. federal agencies reduce improper payments by fighting fraud, waste and abuse in entitlement programs.
KEY CUSTOMERS
Our customers include a diverse base of Federal Government defense, intelligence, and civilian agencies. For the year ended December 31, 2016, approximately 57% of our revenue was generated from DoD and Intelligence agency customers, and approximately 43% of our revenue was generated from Federal civilian agency customers. NCI’s PEO Soldier contract is the Company’s largest revenue-generating contract and accounted for 16.2% revenue in 2016 and 9.8% of revenue in 2015.
2
Table of Contents
NCI’s PEO Soldier contract is a cost-plus fee contract consisting of a transition period, a base period and four option periods for a total term of five years. The contract is valued at $211 million and commenced on October 1, 2015. NCI’s Cyber Network Operations and Security Support (CNOSS) program, a cost-plus-fixed-fee, single-award indefinite delivery, indefinite quantity (IDIQ) contract consisting of a 12-month base period with two one-year option periods and one six-month option period. The contract is valued at $125 million and commenced in October 2014. NCI’s CNOSS program accounted for 11.5% of revenue, in 2016 and 7.3% of revenue in 2015.
CONTRACT PROCUREMENT
Our business is heavily regulated, and we must work within laws and regulations relating to the formation, administration and performance of U.S. Government contracts. The U.S. Government procurement environment has evolved due to statutory and regulatory procurement reform initiatives. Today, U.S. Government customers employ several procurement contracting methods to purchase services and solutions. Budgetary pressures and reforms in the procurement process have caused many U.S. Government customers to increasingly purchase services and products using contracting processes that give them the ability to select multiple winners or pre-qualify certain contractors to provide various services or products on established general terms and conditions rather than through single-award contracts. The predominant contracting methods through which U.S. Government agencies procure services and products include the following:
Single-Award Contracts. U.S. Government agencies may procure services and products through single-award contracts, which specify the scope of services and products that will be delivered and identify the contractor that will provide the specified services. When an agency has a requirement, interested contractors are solicited, qualified and then provided with a request for a proposal. The process of qualification, request for proposals and evaluation of contractor bids requires the agency to maintain a large, professional procurement staff; the bidding and selection process can take a year or more to complete. For the contractor, this method of contracting may provide greater certainty of the timing and amounts to be received at the time of contract award because it generally results in the customer contracting for a specific scope of services or products from the single successful awardee.
Indefinite Delivery/Indefinite Quantity (IDIQ) Contracts. The U.S. Government uses IDIQ contracts to obtain commitments from contractors to provide certain services or products on pre-established terms and conditions. The U.S. Government then issues task orders under the IDIQ contracts to purchase the specific services or products it needs. IDIQ contracts are awarded to one or more contractors following a competitive procurement process. Under a single-award IDIQ contract, all task orders under that contract are awarded to one pre-selected contractor. Under a multi-award IDIQ contract, task orders can be awarded to any of the pre-selected contractors, which can result in further limited competition for the award of task orders. Multi-award IDIQ contracts that are open for any government agency to use for the procurement of services are commonly referred to as government-wide acquisition contracts (GWACs). IDIQ contracts often have multi-year terms and unfunded ceiling amounts, therefore enabling –but not committing—the U.S. Government to purchase substantial amounts of services or products from one or more contractors. At the time an IDIQ contract is awarded (prior to the award of any task orders), a contractor may have limited or no visibility as to the ultimate amount of services or products that the U.S. Government will purchase under the contract, and in the case of a multi-award IDIQ, the contractor from which such purchases may be made.
U.S. General Services Administration (GSA) Schedule Contracts. The GSA maintains listings of approved suppliers of services and products with agreed-upon prices for use throughout the U.S. Government. In order for a company to provide services under a GSA Schedule contract, a company must be pre-qualified and awarded a contract by the GSA. When an agency uses a GSA Schedule contract to meet its requirements, the agency, or the GSA on behalf of the agency, conducts the procurement. The user agency, or the GSA on its behalf, evaluates the user agency’s requirements and initiates a competition limited to GSA Schedule-qualified contractors. GSA Schedule contracts are designed to provide the user agency with reduced procurement time and lower procurement costs. Similar to IDIQ contracts, at the time a GSA Schedule contract is awarded, a contractor may have limited or no visibility as to the ultimate amount of services or products that the U.S. Government will purchase under the contract.
We often team with other parties, including our competitors, to submit bids for large U.S Government procurements or other opportunities where we believe that the combination of services and products that we can provide as a team will help us win and best perform the contract. Our relationships with our teammates, including whether we serve as the prime contractor or as a subcontractor, vary with each contract opportunity and typically depend on the program, contract or customer requirements, as well as the relative size, qualifications, capabilities, customer relationships and experience of our Company and our teammates.
Contracting with the U.S. Government also subjects us to substantial regulation and unique risks, including the U.S. Government’s ability to cancel any contract at any time without reason. 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. These regulations and risks are described in more detail below under Item 1A, Risk Factors in Part I of this Annual Report on Form 10-K.
3
Table of Contents
CONTRACT TYPES
Generally, the type of contract for our services and products is determined by or negotiated with the U.S. Government and may depend on certain factors, including the type and complexity of the work to be performed, degree and timing of the responsibility to be assumed by the contractor for the costs of performance, the extent of price competition and the amount and nature of the profit incentive offered to the contractor for achieving or exceeding specified standards or goals. We generate revenues under several types of contracts, including the following:
| • | Cost-reimbursement contracts provide for reimbursement of our direct contract costs and allocable indirect costs, plus a fee. This type of contract is generally used when uncertainties involved in contract performance do not permit costs to be estimated with sufficient accuracy to use a fixed-price contract. Cost-reimbursement contracts generally subject us to lower risk, but generally require us to use our best efforts to accomplish the scope of the work within a specified time and amount of costs. |
| • | Time-and-materials (T&M) contracts typically provide for negotiated fixed hourly rates for specified categories of direct labor plus reimbursement of other direct costs. This type of contract is generally used when there is uncertainty of the extent or duration of the work to be performed by the contractor at the time of contract award or it is not possible to anticipate costs with any reasonable degree of confidence. On T&M contracts, we assume the risk of providing appropriately qualified staff to perform these contracts at the hourly rates set forth in the contracts over the period of performance of the contracts. |
| • | Firm-fixed-price (FFP) contracts provide for a fixed price for specified products, systems and/or services. This type of contract is generally used when the government acquires products and services on the basis of reasonably definitive specifications and which have a determinable fair and reasonable price. These contracts offer us potential increased profits if we can complete the work at lower costs than planned. While FFP contracts allow us to benefit from cost savings, these contracts also increase our exposure to the risk of cost overruns. |
Our earnings and profitability may vary materially depending on changes in the proportionate amount of revenues derived from each type of contract, the nature of services or products provided, as well as the achievement of performance objectives and the stage of performance at which the right to receive fees, particularly under incentive and award fee contracts, is finally determined. Cost reimbursement and T&M contracts generally have lower profitability than FFP contracts. For the proportionate amount of revenues derived from each type of contract for fiscal 2016, 2015 and 2014, see “Contract Type Revenue” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of this Annual Report on Form 10-K.
CONTRACT BACKLOG
Backlog represents the estimated amount of future revenues to be recognized under awarded contracts as work is performed. Our backlog consists of funded backlog and negotiated unfunded backlog, each of which are described in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of this Annual Report on Form 10-K.
GOVERNMENT REGULATION
We are subject to various laws and regulations that may affect our business. U.S. Federal Government contracts are subject to a number of Federal laws and regulations, including the Federal Acquisition Regulation (FAR), which limits our ability to compete for, or perform on, certain other contracts due to conflicts of interest, the Cost Accounting Standards and Cost Principles, which impose accounting requirements that govern our right to reimbursement under certain cost-based U.S. Federal Government contracts, and the Truth in Negotiations Act, which requires certification and disclosure of all cost and pricing data in connection with contract negotiations. We and our subcontractors must also comply with the Foreign Corrupt Practices Act or U.S. export control regulations and laws, regulations, and executive orders restricting the use and dissemination of information classified for national security purposes and the export of certain products and technical data. We may also become subject to other U.S. Federal Governmental regulations, including those pertaining to environmental laws and potential climate change legislation that could impose additional restrictions or costs in order to comply with such regulations.
COMPETITION
We believe that major competitive factors in our market include strong customer relationships, a record of successful contract performance, a reputation for quality, an experienced management team, and employees with a wide range of technical expertise and security clearances. Although procurements based on cost or using a purely lowest price/technically acceptable (LPTA) standard are not as predominant as in past years, we believe that certain of our customers will continue to make contract awards based on lower cost as well as overall technical solutions. This is especially true for labor-intensive, services-based contracts. We often compete against or team with divisions of large Defense and IT services contractors, including General Dynamics Corporation, CSRA,
4
Table of Contents
Raytheon, Harris, BAE Systems, Booz Allen Hamilton, Leidos, and Science Applications International Corporation (SAIC). We also compete against or team with mid-tier Federal contractors, such as CACI International and ManTech International that have specialized capabilities, as well as numerous non-public companies within the sector. Some of our competitors have significantly longer operating histories and more substantial resources than we do. We expect competition in the U.S. Federal Government IT and professional services sector to increase in the future.
EMPLOYEES
As of December 31, 2016, we had approximately 2,000 employees, more than 55% of whom held at least one U.S. Federal Government security clearance. Our employees are located at more than 160 sites worldwide. More than 49% of our staff is located on-site with our customers, allowing us to build and cultivate long-term relationships.
CORPORATE INFORMATION
We were incorporated as NCI, Inc. in Delaware in July 2005. In September 2005, we completed a merger and share exchange as a result of which NCI Information Systems, Inc., a Virginia corporation, which was incorporated in 1989, became a wholly-owned subsidiary. We primarily contract with the U.S. Federal Government through NCI Information Systems, Inc. and its subsidiaries.
COMPANY WEBSITE AND INFORMATION
Our Internet address is www.nciinc.com. Information contained on our website is not part of this report. We make available free of charge on our Internet site our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13 or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Alternatively, you may access these reports at the SEC’s Internet website: www.sec.gov.
You may request a copy of the materials identified in the preceding paragraph, at no cost, by writing or telephoning us at our corporate headquarters:
NCI, Inc.
11730 Plaza America Drive, Suite 700
Reston, Virginia 20190-4764
Attention: Investor Relations
Telephone: (703) 707-6900
You should carefully consider the risks and uncertainties described below, together with information included elsewhere in this Report and other documents we file with the SEC, in your evaluation of our business. The risks and uncertainties described below are those that we have identified as material, but are not the only risks and uncertainties facing us. If any of these risks or uncertainties actually occurs, our business, financial condition, or operating results could be materially harmed and the price of our stock could decline. Our business is also subject to general risks and uncertainties that affect many other companies, such as overall U.S. and non-U.S. economic and industry conditions, including a global economic slowdown, geopolitical events, changes in laws or accounting rules, fluctuations in interest and exchange rates, terrorism, international conflicts, major health concerns, natural disasters, or other disruptions of expected economic and business conditions. Additional risks and uncertainties not currently known to us or that we currently believe are immaterial also may impair our business operations and liquidity.
Risks Related to Our Business
We depend on contracts with the U.S. Federal Government for substantially all of our revenue. If our relationships with U.S. Federal Government Agencies are harmed, our future revenue and operating profits would decline.
For the years ended December 31, 2016 and 2015, we derived substantially all our revenue from U.S. Federal Government contracts, either as a prime contractor or a subcontractor. For the year ended 2016, this included approximately 57% of our revenue from contracts with the DoD and Intelligence Agencies, and 43% of our revenue from contracts with Civilian Agencies. For the year ended 2015, this included approximately 60% of our revenue from contracts with the DoD and Intelligence Agencies, and 40% of our revenue from contracts with Civilian Agencies. We believe that U.S. Federal Government contracts will continue to be the source of substantially all of our revenue for the foreseeable future. For this reason, any issue that compromises our relationship with U.S.
5
Table of Contents
Federal Government Agencies in general, or with the DoD and Intelligence Agencies in particular, would cause our revenue to decline. Among the key factors in maintaining our relationships with U.S. Federal Government Agencies are our performance on individual contracts and task orders, the strength of our professional reputation, and the relationships of our key executives with customer personnel. In addition, if we or one of our business units were charged with or found guilty of any wrongdoing as a result of any U.S. Government investigation, the U.S. Government could suspend us from bidding on or receiving awards of new U.S. Government contracts. If our volume of U.S. Federal Government contracts were to decline for any of these reasons, our revenue and operating results could decline materially.
We face intense competition from many competitors that have greater resources than we do, which could result in price reductions, reduced profitability, or loss of market share.
We operate in highly competitive markets and generally encounter intense competition to win contracts from many other firms, including mid-tier Federal contractors with specialized capabilities and large Defense and IT services providers. Competition in our markets may increase as a result of a number of factors, such as the entrance of new or larger competitors, including those formed through alliances or consolidation. These competitors may have greater financial, technical, marketing and public relations resources; larger customer bases; and greater brand or name recognition than we do. These competitors could, among other things:
| • | divert sales from us by winning very large-scale U.S. Government contracts; |
| • | force us to charge lower prices in order to win competitively awarded contracts; or |
| • | adversely affect our relationships with current customers, including our ability to continue to win competitively awarded engagements where we are the incumbent. |
If we lose business to our competitors or are forced to lower our prices, our revenue and our operating profits could decline. In addition, we may face competition from our subcontractors who, from time to time, seek to obtain prime contractor status on contracts for which they currently serve as a subcontractor to us. If one or more of our current subcontractors are awarded prime contractor status on such contracts in the future, it could divert sales from us or could force us to charge lower prices, which could cause our margins to suffer.
We cannot guarantee that our estimated contract backlog will result in actual revenue.
As of December 31, 2016, our estimated contract backlog totaled approximately $625 million, of which approximately $139 million was funded. There can be no assurance that our backlog will result in actual revenue in any particular period, or at all, or that any contract included in backlog will be profitable. There is a higher degree of risk in this regard with respect to unfunded backlog. The actual receipt and timing of any revenue is subject to various contingencies, many of which are beyond our control. The actual receipt of revenue on contracts included in backlog may never occur or may change because a program schedule could change; the program could be canceled; a contract could be reduced, modified, or terminated early; or an option that we had assumed could not be exercised. Further, while many of our U.S. Federal Government contracts require performance over a period of years, Congress often appropriates funds for these contracts for only one year at a time. Consequently, our contracts typically are only partially funded at any point during their term, and all or some of the work intended to be performed under the contracts will remain unfunded pending subsequent Congressional appropriations and the obligation of additional funds to the contract by the procuring agency. Our estimates are based on our experience under such contracts and similar contracts. However, there can be no assurances that all, or any, of such estimated contract backlog will be recognized as revenue.
If we fail to maintain an effective system of internal controls over financial reporting, including remediating known material weaknesses in our internal controls as of December 31, 2016, we may not be able to report our financial results timely and accurately or prevent fraud, which could adversely affect investor confidence in our company, and in turn, our results of operations and our stock price.
Effective internal controls are necessary for us to provide reliable financial reports, prevent fraud and operate successfully as a public company. Section 404 of the Sarbanes-Oxley Act of 2002 requires that companies evaluate and report on their systems of internal control over financial reporting. In addition, our independent registered public accounting firm must report on its evaluation of those controls.
As disclosed in more detail in Item 9A, Controls and Procedures in Part II of this Report, we have identified material weaknesses as of December 31, 2016, in our internal controls over financial reporting resulting from our failure to maintain an effective control environment, risk assessment processes and monitoring activities. Due to these material weaknesses in our internal control over financial reporting, we have also concluded our disclosure controls and procedures were not effective as of December 31, 2016.
6
Table of Contents
Notwithstanding the material weaknesses that existed as of December 31, 2016, management has concluded that the consolidated financial statements included in this Report present fairly, in all material respects, the financial position, results of operations and cash flows of the Company in accordance with U.S. generally accepted accounting principles (GAAP). Our management has taken immediate action to begin remediating these material weaknesses, as discussed in more detail under Item 9A, Controls and Procedures in Part II of this Report, and is committed to remediating them as expeditiously as possible. However, certain remedial actions have not started or have only recently been undertaken, and while we expect to continue to implement our remediation plan through 2017, we cannot be certain as to when such remediation will be fully completed. Implementing and monitoring effective internal controls requires us to incur significant incremental expenses and diverts management’s attention and resources from other activities of the business.
If our remedial measures are insufficient to address the material weaknesses, or if we, or our independent registered public accounting firm, identify additional internal control deficiencies that could rise to the level of a material weakness or uncover errors in financial reporting, the disclosure of that fact, even if quickly remedied, could reduce the market’s confidence in our financial statements and harm our stock price. In addition, a failure to maintain effective internal controls could cause a delay in compliance with our reporting obligations, SEC rules and regulations or Section 404 of the Sarbanes-Oxley Act of 2002, which could subject us to a variety of administrative sanctions, including SEC enforcement action, ineligibility for short form resale registration, the suspension or delisting of our common stock from the stock exchange on which it is listed and the inability of registered broker-dealers to make a market in our common stock, which could adversely affect our business and the trading price of our common stock.
Our revenue and operating profits could be adversely affected by significant changes in the contracting or fiscal policies of the U.S. Federal Government.
We depend on continued U.S. Federal Government expenditures on Defense, Intelligence, and other programs that we support.
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 services. Among the factors that could materially adversely affect us are the following:
| • | budgetary constraints affecting U.S. Federal Government spending generally or specific departments or agencies in particular, and changes in fiscal policies or available funding; |
| • | our dependence on our contracts with U.S. Federal Government agencies, particularly within the DoD, for the majority of our revenue; |
| • | a change in funding of our contracts due to bid protests; |
| • | changes in U.S. Federal Government spending priorities; |
| • | changes in contract type, particularly changes from cost-plus fee or time-and-material type contracts to FFP type contracts; |
| • | changes in U.S. Federal Government programs or requirements, including the increased use of small business providers; |
| • | U.S. Federal Government agencies more frequently awarding contracts on an LPTA cost basis in order to reduce expenditures; |
| • | delays in the U.S. Federal Government appropriations process, or budgetary cuts resulting from Congressional committee recommendations or automatic sequestration under the Budget Control Act of 2011; |
| • | U.S. Federal Government shutdowns (such as the shutdown that occurred during the U.S. Federal Government’s 1996 and 2013 fiscal years); |
| • | the use of a Continuing Resolution to fund agencies instead of a budget appropriation, which may cause our customers within those agencies to defer or reduce work under our current contracts; |
| • | a failure of Congress to pass adequate supplemental appropriations to pay for an international conflict or related reconstruction efforts; |
| • | organizational and consultant conflicts of interest (OCI) clauses contained in the FAR and certain of our U.S. Federal Government contracts that may limit our ability to compete for, or perform on certain other contracts (OCIs arise when we engage in activities that may make us unable to render impartial assistance or advice to the U.S. Federal Government, impair our objectivity in performing contract work, or provide us with an unfair competitive advantage); |
| • | curtailment of the U.S. Federal Government’s use of professional services providers, realignment of funds with changed Government priorities including “insourcing” of previously contracted support services, and the realignment of funds to other non-defense related programs, which may reduce the amount of funds available to defense-related and other programs in our core service areas; |
7
Table of Contents
| • | adoption of new laws or regulations; |
| • | our ability to achieve the objectives of near-term or long-range business plans, particularly revenue growth, and the ability to realize future deferred tax assets benefits; |
| • | competition and consolidation in the IT industry; and |
| • | economic conditions in the United States, including conditions that result from terrorist activities or war. |
These or other factors could cause U.S. Federal Government Agencies, or prime contractors for which we are acting as a subcontractor, to reduce their purchases under contracts, to exercise their right to terminate contracts, or elect not to exercise options to renew contracts, any of which could cause our revenue and operating profits to decline.
If we fail to attract and retain skilled employees or employees with the necessary security clearances, we might not be able to perform under our contracts or win new business.
The growth of our business and revenue depends in large part upon our ability to attract and retain sufficient numbers of highly qualified individuals who have advanced information technology and technical services skills. These employees are in great demand and are likely to remain a limited resource in the foreseeable future. Further, obtaining and maintaining security clearances for employees involves a lengthy process, and it is difficult to identify, recruit, and retain employees who already hold security clearances. If we are unable to recruit and retain a sufficient number of these employees, our ability to maintain and grow our business could be limited. In a tight labor market, our direct labor costs could increase or we may be required to engage large numbers of subcontractor personnel, which could cause our profit margins to suffer. In addition, some of our contracts contain provisions requiring us to staff an engagement with personnel that the customer considers key to our successful performance under the contract. In the event we are unable to provide these key personnel or acceptable substitutions, the customer may terminate the contract and we may lose revenue.
In addition, certain U.S. Federal Government contracts require us, and some of our employees, to maintain security clearances. If our employees lose or are unable to obtain security clearances, or if we are unable to hire employees with the appropriate security clearances, the customer may terminate the contract or decide not to renew it upon its expiration. As a result, we may not derive the revenue anticipated from the contract, which if not replaced with revenue from other contracts, could seriously harm our operating results.
If our subcontractors fail to perform their contractual obligations, our performance and reputation as a prime contractor and our ability to obtain future business could suffer.
As a prime contractor, we often rely significantly upon other companies as subcontractors to perform work we are obligated to perform for our customers. As we secure more work under our GWAC and agency-specific IDIQ vehicles, we expect to require an increasing level of support from subcontractors that provide complementary and supplementary services to our offerings. In circumstances in which we are unable to identify, hire, and retain sufficient numbers of qualified employees to perform the task orders we expect to win, we will need to rely on subcontracts with unrelated companies. We are responsible for the work performed by our subcontractors, even though in some cases we have limited involvement in that work. If one or more of our subcontractors fail to satisfactorily perform the agreed-upon services on a timely basis, or violate U.S. Federal Government contracting policies, laws, or regulations, our ability to perform our obligations as a prime contractor or meet our customers’ expectations may be compromised.
We may have disputes with our subcontractors arising from, among other things, the quality and timeliness of work performed by the subcontractor, customer concerns about the subcontractor, our decision not to extend existing task orders or issue new task orders under a subcontract, our hiring of a subcontractor’s personnel or the subcontractor’s failure to comply with applicable law. If any of our subcontractors fail to timely meet their contractual obligations or have regulatory compliance or other problems, our ability to fulfill our obligations as a prime contractor may be jeopardized. Significant losses could arise in future periods and subcontractor performance deficiencies could result in a customer terminating a contract for default. A termination for default could expose us to liability, including liability for the agency’s costs of recompetition, damage our reputation, and hurt our ability to compete for future contracts and could have a material adverse impact on our earnings, cash flow, and financial position.
8
Table of Contents
We are a subcontractor to other businesses on a portion of our business. If these businesses were to encounter financial difficulty, they may fail to perform their contractual obligations. Consequently, our contractual performance and reputation, as well as our financial results could be affected.
We are a subcontractor to other businesses on some of our contracts or task orders (approximately 7% of our revenue in 2016 was derived from contracts where we were a subcontractor). We are not in a position to control overall contract performance, and our payments are subject to the financial capabilities of the prime contractor, not the U.S. Federal Government. If our prime contractor experiences difficulties, it may not have the financial resources to perform its contractual obligations. This failure to perform could harm our reputation and affect our earnings and financial position.
Failure to maintain strong relationships with other contractors could result in a decline in our revenue.
In our role as a subcontractor, we often lack control over fulfillment of a contract, and poor performance on the contract could impact our customer relationship, even when we perform as required. We expect to continue to depend on relationships with other contractors for a portion of our revenue in the foreseeable future. Moreover, our revenue and operating results could differ materially and adversely from those anticipated if any prime contractor or subcontractor chose to offer, directly to the client, services of the type that we provide or if they team with other companies to provide those services.
If we experience systems or service failure, our reputation could be harmed and our customers could assert claims against us for damages or refunds.
We create, implement, and maintain IT solutions that are often critical to our customers’ operations. We may experience some systems and service failures, schedule or delivery delays, and other problems in connection with our work. If we experience these problems, we may:
| • | lose revenue due to adverse customer reaction; |
| • | be required to provide additional services to a customer at no charge; |
| • | receive negative publicity, which could damage our reputation and adversely affect our ability to attract or retain customers; and |
| • | suffer claims for substantial damages. |
In addition to any costs resulting from product or service warranties, contract performance, or required corrective action, these failures may result in increased costs or loss of revenue if customers postpone subsequently scheduled work, or cancel or fail to renew contracts.
While many of our contracts limit our liability for consequential damages that may arise from negligence in rendering services to our customers, we cannot assure that these contractual provisions will be legally sufficient to protect us if we are sued. In addition, our errors and omissions and product liability insurance coverage may not continue to be available on reasonable terms or in sufficient amounts to cover one or more large claims, or the insurer may disclaim coverage as to some types of future claims. As we continue to grow and expand our business into new areas, our insurance coverage may not be adequate. The successful assertion of any large claim against us could seriously harm our business. Even if not successful, these claims could result in significant legal and other costs, may be a distraction to our management, and may harm our reputation.
Internal system or service failures could disrupt our business and impair our ability to effectively provide our products and services to our customers, which could damage our reputation and adversely affect our revenues and profitability.
We are also subject to systems failures, including network, software or hardware failures, whether caused by us, third-party service providers, intruders or hackers, computer viruses, natural disasters, power shortages, or terrorist attacks. Any such failures could cause loss of data and interruptions or delays in our business, cause us to incur remediation costs, subject us to claims, and damage our reputation. In addition, the failure or disruption of our communications or utilities could cause us to interrupt or suspend our operations or otherwise adversely affect our business. Our property and business interruption insurance may be inadequate to compensate us for all losses that may occur as a result of any system or operational failure or disruption and, as a result, our future results could be adversely affected.
Security breaches in sensitive U.S. Federal Government systems could result in the loss of customers and negative publicity.
Many of the systems we develop, install, and maintain involve managing and protecting information involved in Intelligence, national security, and other sensitive or classified U.S. Federal Government functions. A security breach in one of these systems could cause serious harm to our business, damage our reputation, and prevent us from being eligible for further work on sensitive or classified systems for U.S. Federal Government customers. We could incur losses from such a security breach that could exceed the policy limits under our errors and omissions and product liability insurance. Damage to our reputation or limitations on our eligibility for additional work resulting from a security breach in one of the systems we develop, install, and maintain could materially impact our earnings, cash flows, and financial position.
9
Table of Contents
Our business could be negatively impacted by security threats and other disruptions.
As experienced by numerous organizations across the globe, companies in the IT industry are challenged with responding to and mitigating advanced persistent threats (APTs) to their customers’ systems and networking infrastructures. Though unpatched and “zero-day” exploits are common issues, the most effective APTs begin with sophisticated socially-engineered communications (so called “phishing” emails) to trick users into visiting websites that can inject malicious software (malware) onto the users’ local computing devices. Once a company is infected with malware, the APTs work to embed themselves further into the organization, gather information, and then slowly and stealthily extract company data to parties outside of the compromised environment (potentially for long periods of time). We combat APTs by leveraging a combination of management, operational and technical controls. These controls include our risk management, continuous monitoring methodology (and associated solution), ISO 20000 based IT processes, and our corporate Computer, Network, and Internet Security Management policies. Failures to implement and operate these controls may result in contract terminations, adverse legal actions (including potentially the payment of damages to affected parties), additional investments in security management and network/system monitoring tools, and damage to our reputation among our customers and the market at large (leading to potential loss of competitive momentum). In aggregate, failure to focus on APTs may result in a material increase in our costs, reduction in our revenues, and lessened competitive positioning (or some combination thereof).
Our employees, agents, business partners or subcontractors may engage in misconduct or other improper activities, which could cause us to lose contracts, expose us to damages, harm our reputation and diminish investor confidence in our company.
We are exposed to the risk that an employee or subcontractor could commit fraud or other misconduct, including noncompliance with laws (including anti-bribery laws) or insider trading, which could subject us to civil or criminal investigations in the U.S. and in other jurisdictions, lead to civil and criminal penalties and related stockholder lawsuits, cause us to incur significant legal fees, and damage our reputation. As discussed elsewhere in this Report, we recently discovered that our former controller had embezzled approximately $19.4 million over the period of 2010 through January 2017. This discovery has required us to incur investigative expenses, required us to restate certain past quarterly financial statements, subjected us to certain government investigations, and diverted management attention away from other activities of the business. Were we to discover additional instances of employee fraud or misconduct, we anticipate such discovery would have similar adverse effects on our business and operations.
An employee or subcontractor could also commit fraud or misconduct in the performance of one of our U.S. Federal Government contracts, such as by intentionally failing to comply with U.S. Federal Government procurement regulations, engaging in unauthorized activities, or falsifying time records, among other things. Employee or subcontractor misconduct could also involve the improper use of our customers’ sensitive or classified information, which could result in regulatory sanctions against us, liability to third parties, and serious harm to our reputation and could result in a loss of contracts and a reduction in revenue or profitability.
We maintain a system of internal controls to prevent such occurrences, but it is not always possible to deter employee or subcontractor misconduct, and the precautions we take to prevent and detect this activity may not be effective in controlling unknown or unmanaged risks or losses. Any instances of employee or subcontractor fraud or misconduct could cause us to lose contracts, cause a reduction in our revenue, expose us to damages, harm our reputation and diminish investor confidence in our company.
Litigation may adversely affect our business, results of operations and financial condition.
Our business is subject to the risk of litigation by employees, consumers, suppliers, competitors, stockholders, government agencies and others through private actions, class actions, administrative proceedings, regulatory actions or other litigation. The outcome of litigation, particularly class action lawsuits and regulatory actions, is difficult to assess or quantify. Plaintiffs in these types of lawsuits may seek recovery of very large or indeterminate amounts, and the magnitude of the potential loss relating to these lawsuits may remain unknown for substantial periods of time. In addition, certain of these lawsuits, if decided adversely to us or settled by us, may result in liability material to our financial statements as a whole or may negatively affect our operating results if changes to our business operations are required. The cost to defend future litigation may be significant. There also may be adverse publicity associated with litigation that could negatively affect customer perception of our business, regardless of whether the allegations are valid or whether we are ultimately found liable. As a result, litigation may adversely affect our business, results of operations and financial condition. See Item 3, Legal Proceedings in this Report for further details regarding certain of these pending matters.
10
Table of Contents
Our estimates, forward-looking statements, and projections may prove to be inaccurate.
Our earnings and profitability may vary based on the type of contracts we perform and may be adversely affected if we do not accurately estimate and manage the costs, time, and resources necessary to satisfy our contractual obligations. Revenue from some of our FFP contracts is recognized using the percentage-of-completion method with progress toward completion of a particular contract based on actual costs incurred relative to total estimated costs to be incurred over the life of the contract. Estimating costs at completion and award fees on our contracts is complex and involves significant judgment. Adjustments to original estimates are often required as work progresses, experience is gained and additional information becomes known, even though the scope of the work required under the contract may not change. Any adjustment as a result of a change in estimate is recognized as events become known. Adjustments in the underlying assumptions, circumstances or estimates could result in changes that could have a material adverse effect on our future results of operations.
If we fail to manage acquisitions, divestitures, and other transactions, our financial results, business, and future prospects could be harmed.
One of our strategies is to pursue growth through acquisitions. We may not be able to identify suitable acquisition candidates at prices that we consider appropriate. If we do identify an appropriate acquisition candidate, we may not be able to successfully negotiate the terms of the acquisition or finance the acquisition on terms that are satisfactory to us. Negotiations with potential acquisitions and the integration of acquired business operations could disrupt our business by diverting management’s attention from day-to-day operations. Acquisitions of businesses or other material operations may require additional debt or equity financing, resulting in additional leverage or dilution of ownership. We may encounter increased competition for acquisitions, which may increase the price of our acquisitions.
If we are unable to successfully integrate companies we may acquire, our revenue and operating results could suffer. Integrating such businesses into our operations may result in unforeseen operating difficulties (including incompatible accounting and information management systems), may absorb significant management attention, and may require significant financial resources that would otherwise be available for the ongoing development or expansion of our business. These difficulties of integration may require us to coordinate geographically dispersed organizations, integrate personnel with disparate business backgrounds, and reconcile different corporate cultures. In certain acquisitions, the FAR may require us to enter into Government novation agreements, a potentially time-consuming process. In addition, we may not be successful in achieving the anticipated synergies from these acquisitions, including our strategy of offering our services to customers of acquired companies to increase our revenue. We may experience increased attrition, including, but not limited to, key employees of the acquired companies during and following the integration of acquired companies that could reduce our future revenue. In addition, we may need to record write-downs from future impairments of identified intangible assets and goodwill, which could reduce our future reported earnings. Acquired companies may have liabilities or adverse operating issues that we fail to discover through due diligence before the acquisition. In particular, to the extent that prior owners of any acquired businesses or properties failed to comply with or otherwise violated applicable laws or regulations, or failed to fulfill their contractual obligations to the U.S. Federal Government or other customers, we, as the successor owner, may be financially responsible for these violations and failures and may suffer reputational harm or otherwise be adversely affected. The discovery of any material liabilities associated with our acquisitions could cause us to incur additional expenses and cause a reduction in our operating profits.
Our acquisitions could cause unforeseen OCIs, which could preclude us from bidding on related projects, thereby making the acquisition not as profitable as originally forecast. Additionally, the Small Business Administration requires small businesses to re-certify their size standard within 30 days of any sale or merger. It is likely that any small business we acquire will have some component of small business contracts. These regulations may affect our ability to retain some or all the contracts after the acquisition, which, in turn, may affect the value of the acquisition.
To the extent that we do not generate sufficient cash from existing business to provide the capital we require to fund our growth strategy and future operations, we will require additional debt or equity financing. A substantial acquisition could cause us to expand or renegotiate our Amended and Restated Loan and Security Agreement, dated December 13, 2010, as amended, by and among the Company and its subsidiaries, SunTrust Bank, which acted as administrative agent for the lenders, the lenders named therein and the other parties thereto (Credit Agreement). We cannot be certain that additional funds will be available if needed and, if available, that such funds will be available on acceptable terms. Any such funding could require us to incur a significantly higher interest expense. If we cannot raise additional funds on acceptable terms, we may not be able to make future acquisitions.
11
Table of Contents
Terms of our Credit Agreement may adversely affect our ability to run our business and/or reduce stockholder returns.
The terms of our Credit Agreement could impair our ability to operate our business effectively and may limit our ability to take advantage of business opportunities. For example, our Credit Agreement may, among other things: (i) restrict our ability to repurchase or redeem our capital stock, or merge or consolidate with another entity; (ii) limit our ability to borrow additional funds or to obtain other financing in the future for working capital, capital expenditures, acquisitions, investments and general corporate purposes; (iii) limit our ability to dispose of our assets, to create liens on our assets, to extend credit or to issue dividends to our stockholders; and (iv) require us to maintain or satisfy specified financial ratios, which could make us more vulnerable to economic downturns and reduce our flexibility in responding to changing business and economic conditions. Violations of one or more of these covenants, depending on the severity, could require us to renegotiate our Credit Agreement, possibly incurring significant bank fees and additional interest expense. Each of these could have a material adverse impact to our earnings, cash flow, and financial position.
Our business commitments require our employees to travel to potentially dangerous places, which may result in injury to our employees.
Our business involves providing services that require some of our employees to operate in countries that may be experiencing political unrest, war, or terrorism, including Afghanistan and Iraq. Certain senior-level employees or executives may, on occasion, be part of the teams deployed to provide services in these countries. As a result, it is possible that certain of our employees or executives will suffer injury, bodily harm, or death in the course of these deployments. It is also possible that we will encounter unexpected costs in connection with additional risks inherent in sending our employees to dangerous locations, such as increased insurance costs and the repatriation of our employees or executives for reasons beyond our control. We maintain insurance policies that mitigate risk and potential liabilities related to our operations. Our insurance coverage may not be adequate to cover those claims or liabilities, and we may be forced to bear substantial costs from an accident or incident. These problems could cause our actual results to differ materially and adversely from those anticipated.
If we are unable to maintain our current financial position and improve our growth prospects, our business could be adversely affected.
For us to continue to sustain our current financial position and position ourselves for growth, we must continue to improve our operational, financial, and management information systems, as well as to expand, motivate, and manage our workforce. If we are unable to maintain our current financial position and position ourselves for growth while maintaining our quality of service and profit margins, or if new systems that we implement to assist us in maintaining our current financial position and positioning ourselves for growth, do not produce the expected benefits, our business, prospects, financial condition, or operating results could be adversely affected.
We could have substantial investments in recorded goodwill as a result of a future acquisitions, and changes in future business conditions could cause those investments to become impaired, requiring substantial write-downs that could reduce our operating income.
As of December 31, 2016, goodwill accounted for approximately $33.9 million, or approximately 22%, of our recorded total assets. Under GAAP, we review our goodwill for impairment at least annually, or when events or changes in circumstances indicate the carrying value may not be recoverable. If goodwill becomes impaired, we will record a charge to earnings in our financial statements during the period in which any impairment of our goodwill is determined, which may significantly reduce or eliminate our profits.
Our future taxable income may not be sufficient to realize our future tax benefits which could cause our deferred tax asset to become impaired, requiring substantial write-downs that could reduce our net income.
As of December 31, 2016, we had approximately $41.9 million in net deferred tax assets. Deferred tax assets represent temporary differences in the tax basis of an asset or liability and its reported amount in the financial statements that will result in future tax deductions. Deferred tax assets are evaluated to determine if the future tax deductions will be realizable. Future realization of tax benefits ultimately depends on the existence of sufficient taxable income within the appropriate period that is available under the tax law. All available evidence is considered to determine if a valuation allowance for deferred tax assets is needed. As of December 31, 2016, we had a valuation allowance of approximately $0.2 million. If our future taxable income is insufficient to realize the future tax benefits and our deferred tax asset were to become impaired, we would record a charge to earnings in our financial statements during the period in which any impairment of our deferred tax asset is determined, which may significantly reduce or eliminate our profits.
12
Table of Contents
Risks Related to Our Industry
Our U.S. Federal Government contracts may be terminated by the U.S. Federal Government at any time, and if we do not replace them, our revenue and operating profits may be adversely affected.
We derive substantially all of our revenue from U.S. Federal Government contracts that typically span one or more base years and one or more option years. U.S. Federal Government Agencies have the right to decline to exercise these option periods. In addition, our contracts also contain provisions permitting a U.S. Federal Government customer to terminate the contract on short notice and for its convenience, as well as for default. A decision by a U.S. Federal Government Agency not to exercise option periods or to terminate contracts could result in a reduction of our profitability on these contracts and significant revenue shortfalls. If the U.S. Federal Government terminates a contract for convenience, we may recover only our incurred or committed allowable costs, settlement expenses, and profit on work completed before the termination. We cannot recover anticipated profit on terminated work. If the U.S. Federal Government terminates a contract for default, we may not recover even incurred amounts, and instead may be liable for excess costs incurred by the U.S. Federal Government in procuring undelivered items and services from another source.
U.S. Federal Government contracts contain other provisions that may be unfavorable to us.
U.S. Federal Government contracts contain provisions and are subject to laws and regulations that give the U.S. Federal Government rights and remedies not typically found in commercial contracts. These provisions allow the U.S. Federal Government to terminate a contract for convenience or decline to exercise an option to renew. They also permit the U.S. Federal Government to do the following:
| • | reduce or modify contracts or subcontracts; |
| • | cancel multi-year contracts and related orders if funds for contract performance for any subsequent year become unavailable; |
| • | limit our ability to compete for or perform certain other contracts as a result of OCI clauses; |
| • | claim rights in products and systems produced by us; and |
| • | suspend or debar us from doing business with the U.S. Federal Government. |
If the U.S. Federal Government exercises its rights under any of these provisions, our revenue and operating profits could decline.
Many of our U.S. Federal Government customers spend their procurement budgets through Multiple Award Contracts under which we are required to compete for post-award orders or for which we may not be eligible to compete and could limit our ability to win new contracts and grow revenue.
Budgetary pressures and reforms in the procurement process have caused many U.S. Federal Government customers to increasingly purchase goods and services through agency-specific IDIQ contracts, the GSA Schedule 70 task orders, and other multiple-award and/or GWAC vehicles. These contract vehicles have resulted in increased competition and pricing pressure, requiring us to make sustained post-award efforts to realize revenue under the relevant contract vehicle. The U.S. Federal Government’s ability to select multiple winners under multiple-award schedule contracts, GWACs, blanket purchase agreements, and other agency-specific IDIQ contracts, as well as its right to award subsequent task orders among such multiple winners, means that there is no assurance that these multiple-award contracts will result in the actual orders equal to the ceiling value, or result in any actual orders. We are only eligible to compete for work (task orders and delivery orders) as a prime contractor pursuant to GWACs already awarded to us. Our failure to compete effectively in this procurement environment could reduce our revenue. If the U.S. Federal Government elects to use a contract vehicle that we do not hold a position on, we will not be able to compete as a prime contractor.
Our business could be adversely affected by delays caused by our competitors protesting major contract awards received by us, resulting in the delay of the initiation of work.
In addition, most U.S. Federal Government contract awards are subject to protest by competitors. If specified legal requirements are satisfied, these protests require the U.S. Federal Government Agency to suspend the contractor’s performance of the newly awarded contract pending the outcome of the protest. These protests could also result in a requirement to resubmit bids for the contract or in the termination, reduction, or modification of the awarded contract. If we are subject to delays in the startup of work on awarded contracts due to protests, our actual results could differ materially and adversely from those anticipated.
13
Table of Contents
Each of our contract types involves the risk that we could underestimate our costs and incur losses.
We enter into three types of U.S. Federal Government contracts for our services: T&M, cost-plus fee, and FFP. For the year ended December 31, 2016, we derived approximately 17%, 60%, and 23% of our revenue from T&M, cost-plus fee, and FFP contracts, respectively. If we acquire other businesses, our contract mix could change significantly, depending on the size and contract mix of the acquired businesses.
Each of these types of contracts, to differing degrees, involves the risk that we could underestimate our cost of performance, which may result in a reduced profit or a loss on the contract for us. Under T&M contracts, we are reimbursed for labor at negotiated hourly billing rates and for certain expenses. We assume minimal financial risk on delivery of time-and-materials contracts because we only assume the risk of performing those contracts at negotiated hourly rates. However, to perform profitably under T&M contracts, we must be able to staff the contract with appropriately priced individuals. If we cannot find individuals whose fully-burdened cost is less than the contract value, we will incur a loss on the contract. Under cost-plus fee contracts, we are reimbursed for allowable costs and paid a fee, which may be fixed or performance based. To the extent that actual costs incurred in performing a cost-plus fee contract are within the contract ceiling and allowable under the terms of the contract and applicable regulations, we are entitled to reimbursement of our costs, plus a profit. However, if our costs exceed the ceiling or are not allowable under the terms of the contract or applicable regulations, we may not be able to recover those costs. Under FFP contracts, we perform specific tasks for a fixed-price. Compared to T&M and cost-plus fee contracts, FFP contracts generally offer higher margin opportunities but involve greater financial risk because we bear the impact of cost overruns. Because we assume the most risk for cost overruns and contingent losses on FFP contracts, an increase in the percentage of FFP contracts in our contract mix would increase our risk of suffering losses. Failure to properly estimate our costs for FFP contracts could have a material adverse impact on our financial results.
Our failure to comply with complex procurement laws and regulations could cause us to lose business and subject us to a variety of penalties.
We must comply with and are affected by laws and regulations relating to the formation, administration, and performance of U.S. Federal Government contracts, which affect how we do business with our customers and may impose added costs on us. Among the most significant laws and regulations are:
| • | the FAR and agency regulations supplemental to the FAR, which comprehensively regulate the formation, administration, and performance of U.S. Federal Government contracts; |
| • | the Truth in Negotiations Act, which requires certification and disclosure of all cost and pricing data in connection with contract negotiations; |
| • | compliance with the U.S. Foreign Corrupt Practices Act or U.S. export control regulations by us or our subcontractors; |
| • | the Cost Accounting Standards and Cost Principles, which impose accounting requirements that govern our right to reimbursement under certain cost-based U.S. Federal Government contracts; and |
| • | laws, regulations, and executive orders restricting the use and dissemination of information classified for national security purposes and the export of certain products and technical data. |
Moreover, we are subject to security regulations of the DoD and other Federal Agencies that are designed to safeguard against foreigners’ access to classified information. If we were to come under foreign ownership, control, or influence, our U.S. Federal Government customers could terminate or decide not to renew our contracts, and our ability to obtain new contracts could be impaired.
The U.S. Federal Government may revise its procurement or other practices in a manner adverse to us.
The U.S. Federal Government may revise its procurement practices or adopt new contracting rules and regulations, such as cost accounting standards. It could also adopt new contracting methods relating to GSA contracts, GWACs or other multi-award contracts, or adopt new standards for contract awards intended to achieve certain social or other policy objectives. In addition, the U.S. Federal Government may face restrictions from new legislation or regulations, as well as pressure from U.S. Federal Government employees and their unions, on the nature and amount of services the U.S. Federal Government may obtain from private contractors. These changes could impair our ability to obtain new contracts or contracts under which we currently perform when those contracts are up for recompete. Any new contracting methods could be costly or administratively difficult for us to implement, and as a result, could harm our operating results. A realignment of funds with changed U.S. Federal Government priorities, including “insourcing” of previously contracted support services, and the realignment of funds to other non-Defense-related programs may reduce the amount of funds available to defense-related and other programs in our core service areas.
14
Table of Contents
As a result of the Small Business Administration set aside program, the U.S. Federal Government may decide to restrict certain procurements only to bidders that qualify under minority-owned, small, small-disadvantaged businesses, or other such programs. As a result, we would not be eligible to perform work as a prime. In such circumstances, we compete as a subcontractor with small businesses.
We derive significant revenue from contracts awarded through a competitive procurement process, which may require significant upfront bid and proposal costs that could negatively affect our operating results.
We derive significant revenue from U.S. Federal Government contracts that are awarded through a competitive procurement process. We expect that most of the U.S. Federal Government business we seek in the foreseeable future will be awarded through competitive processes. Competitive procurements impose substantial costs and present a number of risks, including the substantial cost, managerial time, and effort that we spend to prepare bids and proposals for contracts that may not be awarded to us and could reduce our profitability.
Unfavorable results of any U.S. Federal Government audit or other investigation could subject us to a variety of penalties and sanctions and could harm our reputation and relationships with our customers and impair our ability to win new contracts.
The U.S. Federal Government, including the Defense Contract Audit Agency (DCAA), routinely audits and reviews our performance on contracts, pricing practices, cost structure, and compliance with applicable laws, regulations and standards. The DCAA reviews a contractor’s internal control system and policies, including the contractor’s purchasing, property, estimating, compensation, and management information systems, and the contractor’s compliance with such policies. Any costs found to be improperly allocated to a specific contract will not be reimbursed, while such costs already reimbursed may be required to be refunded. Adverse findings in a DCAA audit could materially affect our competitive position and result in a substantial adjustment to our revenue and profit.
Additionally, we are subject to certain investigations into the Company being conducted by the SEC and the U.S. Attorney’s Office for the Eastern District of Virginia (USAO EDVA) in connection with the recently discovered misappropriation of Company funds by our former controller, as discussed more fully in Item 3, Legal Proceedings of this Report, and may in the future become subject to other U.S. Federal Government investigations into our compliance with U.S. laws and regulations.
If a U.S. Federal Government audit or investigation uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including fines, termination of contracts, forfeiture of profits, suspension of payments, and suspension or debarment from doing business with U.S. Federal Government Agencies. In addition, we could suffer serious harm to our reputation and competitive position if allegations of impropriety were made against us, whether or not true. If our reputation or relationship with U.S. Federal Government Agencies were impaired, or if the U.S. Federal Government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our revenue and operating profit could decline.
Other Risks Related to Our Stock
Our stock price is subject to volatility and could decline.
The stock market in general has been highly volatile. As a result, the market price of our Class A common stock is likely to be similarly volatile, and investors in our Class A common stock may experience a decrease in the value of their stock, including decreases unrelated to our operating performance or prospects. The price of our Class A common stock could be subject to wide fluctuations in response to a number of factors, including those listed in this “Risk Factors” section.
In the past, securities class action litigation has, at times, been instituted against companies following periods of volatility in their stock price. This type of litigation against us could result in substantial costs and divert our management’s attention and resources.
Our quarterly operating results may fluctuate significantly as a result of factors outside of our control, which could cause the market price of our common stock to decline.
We expect our revenue and operating results to vary from quarter to quarter. As a result, our operating results may fall below the expectations of securities analysts and investors, which could cause the price of our common stock to decline. Factors that may affect our operating results include those listed in this “Risk Factors” section and others such as:
| • | changes in contract type and profitability; |
| • | fluctuations in revenue recognized on contracts; |
15
Table of Contents
| • | variability in demand for our services and solutions; |
| • | commencement, completion, or termination of contracts during any particular quarter; |
| • | timing of award or performance incentive-fee notices; |
| • | timing of significant bid and proposal costs; |
| • | timing of acquisition activities and the expensing of acquisition-related costs; |
| • | announcement of the commencement or results of any U.S. Federal Government audit or investigation; |
| • | variable purchasing patterns under the GSA Schedule 70 task orders, GWACs, blanket purchase agreements, and other agency-specific IDIQ contracts; |
| • | strategic decisions by us or our competitors, such as acquisitions, divestitures, spin-offs, and joint ventures; |
| • | strategic investments or changes in business strategy; |
| • | changes in the extent to which we use subcontractors; |
| • | fluctuations in staff utilization rates or penalties associated with not meeting staffing requirements; and |
| • | U.S. Federal Government shutdowns or temporary facility closings. Reductions in revenue in a particular quarter could lead to lower profitability during that quarter because a relatively large amount of our expenses are fixed in the short-term. We may incur significant operating expenses during the startup and early stages of large contracts and may not be able to recognize corresponding revenue during that same quarter. We also may incur additional expenses when contracts expire, are terminated, or are not renewed. |
In addition, payments due to us from U.S. Federal Government Agencies may be delayed due to billing cycles or as a result of failures of Government budgets to gain Congressional and administration approval in a timely manner. The U.S. Federal Government’s fiscal year ends September 30. If a Federal budget for the next Federal fiscal year has not been approved by that date in each year, our customers may have to suspend engagements that we are working on until a budget has been approved. Any such suspensions may reduce our revenue during the fourth quarter of that calendar year or the first quarter of the subsequent year. The U.S. Federal Government’s fiscal year-end can also trigger increased purchase requests from customers for equipment and materials. Any increased purchase requests we receive as a result of the U.S. Federal Government’s fiscal year-end would serve to increase our third- or fourth-quarter revenue but will generally decrease profit margins for that quarter, as these activities generally are not as profitable as our typical offerings.
Mr. Narang, our founder and Chairman, controls the Company, and his interests may not be aligned with yours.
As of December 31, 2016, Mr. Narang, our founder and Chairman, through his beneficial ownership of 4,500,000 shares of our Class B common stock and 117,659 shares of our Class A common stock, owned or controlled approximately 84% of the combined voting power and approximately 34% of the outstanding shares of the common stock. Accordingly, Mr. Narang controls the vote on all matters submitted to a vote of our stockholders. As long as Mr. Narang beneficially owns the majority of the voting power of our common stock, he will have the ability – without the consent of our public stockholders – to elect all members of our board of directors and to control our management and affairs. Mr. Narang’s voting control may have the effect of preventing or discouraging transactions involving a change in control, including proxy contests, tender offers, mergers, or other purchases of the capital stock of the Company, regardless of whether a premium is offered over then-current market prices.
A substantial number of shares of our common stock are eligible for sale by Mr. Narang, which could cause our common stock price to decline significantly.
As of December 31, 2016, Mr. Narang beneficially owned 4,500,000 outstanding shares of Class B common stock and 117,659 shares of Class A common stock of the Company. Mr. Narang may, at his discretion, sell these shares in the public market, subject to applicable volume restriction and manner of sale requirements imposed on affiliates under Rule 144 of the Securities Act. The market price of our common stock could drop significantly if Mr. Narang sells his interests in the Company or is perceived by the market as intending to sell them.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
16
Table of Contents
We lease office facilities used in our business. Our executive offices and principal operations are located at 11730 Plaza America Drive, Reston, Virginia, where we occupy space under a lease that expires in 2018. We also lease space located in Arizona, California, Illinois, Maryland, Massachusetts, Nebraska, North Carolina, Ohio, Tennessee, Texas, Utah, Virginia, and Washington. The majority of our employees are located in facilities provided by the U.S. Federal Government. We do not currently own any real estate used in the performance of ongoing contracts and maintain flexibility in facility occupancy through termination and subleasing options concurrent with contract terms in many of our leases. We believe our facilities meet our current needs and that additional facilities will be available as needed.
Civil Suit Against Former Controller
As previously disclosed on January 23, 2017, the Company commenced an internal investigation upon discovering that its former controller, Jon Frank, had been embezzling money from the Company. Upon completion of the internal investigation, the Company determined that the actual amount of the embezzlement by Mr. Frank during the period from January 2010 through January 2017 was approximately $19.4 million. The Company believes that Mr. Frank acted alone and found no evidence that any other NCI employee was aware of or colluded in the embezzlement of Company funds and found no evidence of any unlawful activity apart from that associated with Mr. Frank’s embezzlement of Company funds.
On January 23, 2017, we filed a lawsuit against Mr. Frank in the Circuit Court of Fairfax County in the State of Virginia to recover the embezzled funds.
On February 2, 2017, the Honorable Chief Judge White entered an Order for Preliminary Injunction and Asset Freeze (the “Preliminary Injunction”) against Mr. Frank. Among other things, the Preliminary Injunction placed an immediate freeze on all monies and assets of Mr. Frank and ordered Mr. Frank to prepare and deliver to the Company an accounting of his personal assets. In addition, pursuant to the Preliminary Injunction, Mr. Frank agreed to cooperate with the Company to identify, recover and return to the Company all assets that he obtained wrongfully or acquired with wrongfully-obtained funds.
Government Agency Investigations
In connection with the discovery of Mr. Frank’s embezzlement of money from the Company, we self-reported such matter to the U.S. Securities and Exchange Commission (“SEC”) and the civil and criminal divisions of the U.S. Department of Justice (“DOJ”).
By letter to the Company dated February 1, 2017, the DOJ has identified the Company as a possible victim of Mr. Frank’s conduct. On February 8, 2017, the SEC commenced a formal investigation and has served the Company with a subpoena requesting certain documents and information relevant to the embezzlement of Company funds by Mr. Frank. The Company is cooperating fully with the DOJ and the SEC in connection with their respective investigations, which are ongoing.
On February 16, 2017, the United States Attorney’s Office for the Eastern District of Virginia (“USAO EDVA”) notified the Company that it had opened a civil fraud investigation into the impact of Mr. Frank’s conduct on the Company’s government contracts. The Company is cooperating fully with the USAO EDVA and the Inspectors General of relevant government agencies in connection with this investigation, which is ongoing. At this time, we do not have an estimate of the financial impact on the Company, if any, of the investigations being conducted by the USAO EDVA or the SEC.
Other Legal Proceedings
From time to time, we are involved in legal proceedings arising in the ordinary course of business. At this time, the probability is remote that the outcome of any such ordinary course litigation matters currently pending will have a material adverse effect on our financial condition and results of operations.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
17
Table of Contents
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Since October 24, 2005, our Class A common stock has been listed on The NASDAQ Global Select Market under the symbol “NCIT.” The following table sets forth, for the periods indicated, the high and low closing prices of our shares of common stock, as reported on the NASDAQ Global Select Market.
| 2016 | 2015 | |||||||||||||||
| Quarters |
High | Low | High | Low | ||||||||||||
| First |
$ | 15.00 | $ | 11.52 | $ | 12.27 | $ | 9.53 | ||||||||
| Second |
15.10 | 12.35 | 11.61 | 9.86 | ||||||||||||
| Third |
14.11 | 11.13 | 16.16 | 10.03 | ||||||||||||
| Fourth |
14.10 | 11.25 | 16.79 | 12.84 | ||||||||||||
There is no established public market for our Class B common stock.
As of March 28, 2017, there were 115 holders of record of our Class A common stock and one holder of record of our Class B common stock. The number of holders of record of our Class A common stock is not representative of the number of beneficial holders because many of the shares are held by depositories, brokers, or nominees. As of March 28, 2017, the closing price of our Class A common stock was $15.00.
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
Our Board of Directors authorized management to repurchase up to $25.0 million of our Class A common stock pursuant to a stock repurchase program. The amounts do not give effect to any fees, commissions or other costs associated with repurchases of shares. If shares are repurchased, the shares will be repurchased pursuant to open market purchases, privately negotiated transactions, or block transactions. We have no obligation to repurchase shares under the authorization, and the timing, actual number and value of the shares which are repurchased (and the manner of any such repurchase) will be at the discretion of management and will depend on a number of factors, including the price of our common stock, our cash needs, the borrowing capacity under our Credit Agreement, interest rates, and our financial performance and position. We may suspend or discontinue repurchases at any time. During 2016 no shares were repurchased. At December 31, 2016, $16.7 million was remaining under the Board of Directors’ authorization for share repurchases.
Dividend Policy
Prior to 2015 we had not paid any cash dividends. On February 10, 2015, the Company’s Board of Directors declared a special cash dividend in the amount of $0.12 per share, payable on March 13, 2015 to all persons who were holders of record of the Company’s common stock at the close of business on February 25, 2015. On February 8, 2016, the Company’s Board of Directors declared a cash dividend in the amount of $0.15 per share, payable on March 18, 2016 to all persons who were holders of record of the Company’s common stock at the close of business on February 26, 2016. Any future determination as to the declaration and payment of cash dividends will be at the discretion of our Board of Directors and will depend on then-existing conditions, business prospects, and any other factors our Board of Directors deems relevant. Our existing Credit Agreement allows us, with approval of our lenders, to pay a dividend of up to $4 million in any calendar year or trailing 12-month period if, after it is paid, we meet certain financial criteria. Otherwise we will be in default under our Credit Agreement. In addition, the terms of any future credit agreement may prevent us from paying any dividends or making any distributions or payments with respect to our capital stock.
18
Table of Contents
Recent Sales of Unregistered Securities
There were no sales of unregistered securities in 2016.
Performance Graph
The following graph compares the cumulative total stockholder return on our common stock from December 31, 2011 through December 31, 2016, with the cumulative total return on (i) the NASDAQ Composite — Total Returns, (ii) the Russell 2000 stock index, and (iii) a peer group composed of NCI and the following other U.S. Federal Government service providers with whom we compete: CACI International Inc., ICF International, Inc., and ManTech International Corporation. The comparison also assumes that all dividends are reinvested and all returns are market-cap weighted. The historical information set forth below is not necessarily indicative of future performance.
COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURNS
AMONG NCI, THE NASDAQ COMPOSITE — TOTAL RETURNS, THE RUSSELL 2000 INDEX, AND U.S. FEDERAL GOVERNMENT SERVICES PEER GROUP
Comparison of 5 Year Total Cumulative Return Assumes Initial Investment of $100 on December 31, 2011
| December 31, 2016 | ||||
| NCI, Inc. |
$ | 122.32 | ||
| NASDAQ Composite—Total Returns |
219.89 | |||
| Russell 2000 Index |
196.45 | |||
| U.S. Federal Government services peer group |
197.37 | |||
19
Table of Contents
ITEM 6. SELECTED FINANCIAL DATA
The following tables set forth the selected consolidated financial data for each of the years in the five-year period ended December 31, 2016. We derived the selected consolidated financial data from our audited consolidated financial statements, which should be read in conjunction with Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of this Annual Report on Form 10-K and our consolidated financial statements and the related notes included elsewhere in this report.
| Year ended December 31, | ||||||||||||||||||||
| 2016(a) | 2015(b) | 2014 | 2013(c) | 2012(d) | ||||||||||||||||
| (in thousands except per share data) | ||||||||||||||||||||
| Statements of Operations Data: |
||||||||||||||||||||
| Revenue |
$ | 322,410 | $ | 333,095 | $ | 317,028 | $ | 332,325 | $ | 368,387 | ||||||||||
| Operating costs and expenses: |
||||||||||||||||||||
| Cost of revenue – restated (a) |
266,238 | 275,329 | 267,836 | 287,297 | 320,188 | |||||||||||||||
| General and administrative expenses – restated (a) |
27,437 | 25,765 | 25,585 | 23,211 | 25,984 | |||||||||||||||
| Depreciation and amortization |
7,020 | 7,659 | 5,692 | 6,298 | 6,926 | |||||||||||||||
| Stock option tender offer |
— | — | — | — | 2,311 | |||||||||||||||
| Acquisition and integration related expenses |
— | 428 | 150 | — | — | |||||||||||||||
| Purchase contingency gain |
— | — | — | (864 | ) | — | ||||||||||||||
| Impairment of goodwill and intangible assets |
— | — | — | — | 150,752 | |||||||||||||||
| Misappropriation loss – restated (a) |
4,907 | 3,238 | 3,284 | 2,273 | 2,257 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Total operating expenses |
305,602 | 312,419 | 302,547 | 318,215 | 508,418 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Operating income (loss) |
16,808 | 20,676 | 14,481 | 14,110 | (140,031 | ) | ||||||||||||||
| Interest expense, net |
1,241 | 865 | 406 | 784 | 1,325 | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Income (loss) before income taxes |
15,567 | 19,811 | 14,075 | 13,326 | (141,356 | ) | ||||||||||||||
| Provision (benefit) for income taxes |
6,086 | 7,639 | 5,607 | 5,588 | (54,532 | ) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Net income (loss) |
$ | 9,481 | $ | 12,172 | $ | 8,468 | $ | 7,738 | $ | (86,824 | ) | |||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Earnings (loss) per share: |
||||||||||||||||||||
| Basic |
$ | 0.72 | $ | 0.94 | $ | 0.66 | $ | 0.60 | $ | (6.51 | ) | |||||||||
| Diluted |
$ | 0.69 | $ | 0.89 | $ | 0.63 | $ | 0.60 | $ | (6.51 | ) | |||||||||
| Weighted average shares: |
||||||||||||||||||||
| Basic |
13,195 | 13,012 | 12,899 | 12,829 | 13,335 | |||||||||||||||
| Diluted |
13,834 | 13,705 | 13,516 | 12,829 | 13,335 | |||||||||||||||
| Cash dividend per common share |
$ | 0.15 | $ | 0.12 | — | — | — | |||||||||||||
| As of December 31, | ||||||||||||||||||||
| 2016 | 2015 | 2014 | 2013 | 2012 | ||||||||||||||||
| (in thousands) | ||||||||||||||||||||
| Balance Sheet Data: |
||||||||||||||||||||
| Cash and cash equivalents |
$ | 1,014 | $ | 233 | $ | 25,819 | $ | 50 | $ | 763 | ||||||||||
| Net working capital |
17,651 | 23,028 | 46,001 | 29,011 | 28,420 | |||||||||||||||
| Total assets |
155,422 | 163,868 | 136,684 | 127,394 | 141,776 | |||||||||||||||
| Total long-term debt |
— | 10,000 | — | 1,000 | 17,500 | |||||||||||||||
| Total stockholders’ equity |
114,340 | 106,560 | 93,777 | 81,807 | 72,890 | |||||||||||||||
Notes to Five-Year Summary
| (a) | In January 2017, the Company discovered that its former controller had embezzled approximately $19.4 million over the period of January 2010 to January 2017. Prior to the discovery, the embezzled funds had primarily been included in cost of revenue and general and administrative expenses. The Consolidated Statements of Operations for the fiscal years ended December 31, 2015, 2014, 2013 and 2012 were restated to reclassify the embezzled amounts to misappropriation loss as follows: |
| Year Ended December 31, | ||||||||||||||||
| 2015 | 2014 | 2013 | 2012 | |||||||||||||
| Cost of revenue |
$ | (2,987 | ) | $ | (3,019 | ) | $ | (2,091 | ) | $ | (2,093 | ) | ||||
| General and administrative expenses |
(251 | ) | (265 | ) | (182 | ) | (164 | ) | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Misappropriation loss |
$ | 3,238 | $ | 3,284 | $ | 2,273 | $ | 2,257 | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
20
Table of Contents
| (b) | Effective January 1, 2015, we acquired Computech and incurred $0.4 million in acquisition and integration related costs. On March 13, 2015, NCI paid a special dividend of $0.12 per share. No dividends were paid in 2014, 2013, 2012 or 2011. |
| (c) | During the third quarter 2013, we recognized a gain on a purchase contingency that consisted of fees the Company received for the collection of past due receivables as part of the AdvanceMed Corporation (AdvanceMed) acquisition in April 2011. |
| (d) | During 2012, we recognized a goodwill impairment of $150.3 million and an impairment of intangible assets of $0.4 million. During the third quarter 2012, we completed a cash tender offer for certain vested and unvested out-of-the-money stock options held by current and former employees, officers, and directors of NCI that were granted prior to January 1, 2012, incurring a charge of approximately $2.3 million. |
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our financial statements and the related notes included elsewhere in this Form 10-K. This discussion and analysis contains forward-looking statements that involve risks, uncertainties, and assumptions, such as statements of our plans, objectives, expectations, and intentions. Our actual results could differ materially from those anticipated in the forward-looking statements. Factors that could cause or contribute to our actual results differing materially from those anticipated include, but are not limited to, those discussed in Item 1A Risk Factors in Part I of this Annual Report on Form 10-K and elsewhere in this Form 10-K.
EMBEZZLEMENT AND RESTATEMENT
In January 2017, the Company identified a misappropriation of company funds by its former controller. The Audit Committee engaged independent legal counsel and forensic consultants to investigate the fraud. The investigation was completed in March 2017, and revealed that the former controller had embezzled $19.4 million through a circumvention of controls, which included transfers from the Company’s payroll account to his personal account, creating fictitious invoices, and altering bank account statements to conceal the misappropriations. The Company believes that the former controller acted alone and found no evidence that any other NCI employee was aware of, or colluded in, the embezzlement of Company funds or that there was any unlawful activity apart from that associated with the former controller’s embezzlement of Company funds. The amounts embezzled were primarily classified as expenses and were included as fringe benefits costs in costs of revenue and general and administrative expenses and were originally allocated to contracts as allowable costs. After discovery of the embezzlement these costs were restated as misappropriation loss, which is an unallowable cost. The Company had sufficient allowable, but previously unbilled costs allocated to its contracts in fiscal years 2010 through 2015 to offset the unallowable costs related to the embezzlement, such that there was no material change in revenue recognized on its cost reimbursable contracts. The Company has restated the Consolidated Statements of Income for the years ended December 31, 2015 and 2014 to classify the embezzled amounts as “misappropriation loss”.
OVERVIEW
We are a provider of information technology (IT) and professional engineering services and solutions to U.S. Federal Government Agencies. Our technology and industry expertise enables us to provide a wide spectrum of services and solutions that assist our customers in achieving their program goals. We deliver these complex services and solutions by leveraging our skills across six core competencies:
| • | Agile Development and Lean Software O&M |
| • | Big Data and Data Analytics |
| • | Cybersecurity and Information Assurance |
| • | Engineering and Logistics |
| • | IT Infrastructure Optimization and Service Management |
| • | Health and Program Integrity |
Our significant long-term strategic initiatives include:
| • | achieving annual organic revenue growth by deploying internal resources and forming tactical and strategic relationships while better leveraging key differentiators across NCI; |
21
Table of Contents
| • | achieving annual revenue and EBITDA growth both organically and through targeted mergers and acquisitions by means of: |
| • | showing exceptional commitment to our employees by continuously demonstrating that we value our employees as key assets of the Company. We will also invest in our people, including employee training and development programs, with a focus on retention and recruiting; |
| • | applying a differentiated focus on our customers’ missions by being distinctively different through our customer relationships; and |
| • | demonstrating technical excellence and business acumen by delivering better-than-expected results in a highly cost-competitive environment; |
| • | achieving disciplined and targeted growth in the federal market by enhancing our business development capabilities and past performance metrics; |
| • | achieving long-term improvement in our operating income margin through solid contract execution, growth in higher-margin business areas, and ongoing improvement in our infrastructure and related business processes; and |
| • | disciplined deployment of our cash resources and use of our capital structure to enhance growth and shareholder value through acquisitions, internal growth initiatives, stock repurchases, dividends and other uses as conditions warrant. |
Industry Trends
In fiscal 2016, essentially all of our revenues were derived 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, of which approximately 63% is attributable to revenues under contracts with the DoD, including subcontracts under which the DoD is the ultimate purchaser, and approximately 37% is attributable to revenues under contracts with Civilian Agencies, including subcontracts under which the Civilian Agencies are the ultimate purchaser. Accordingly, our business performance is subject to changes in the overall level of U.S. Government spending, especially national security, including defense, 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.
Faced with significant budget pressures, in recent years the U.S. government has implemented reductions in government spending, including reductions in appropriations for the DoD and other federal agencies. In 2011, the United States Congress enacted the Budget Control Act of 2011 (the BCA), which established specific limits on annual appropriations for government fiscal years (GFYs) 2012 through 2021. The BCA was amended by the American Taxpayer Relief Act of 2012, the Bipartisan Budget Act of 2013 and the Bipartisan Budget Act of 2015 (the BBA) and, as a result, DoD funding levels have fluctuated over this period and have been difficult to predict. For example, the DoD budget was reduced by 8 % in GFY 2013 compared with GFY 2012, but remained essentially flat for GFYs 2014 and 2015. The BBA raised DoD funding for GFY 2016 by approximately 5% relative to GFY 2015, but the ultimate DoD funding for GFY 2017 remains uncertain because the DoD is operating under a continuing resolution. This continuing resolution limits certain key funding levels, such as operations and maintenance, to GFY 2016 levels and does not authorize new program starts. Future spending levels are subject to a wide range of outcomes, depending on Congressional action.
In a follow-up to the White House’s top line February 2017 budget release, the Office of Management and Budget released its “skinny” GFY 2018 budget request, so called due to its lack of granularity owing to the administration’s short time in office. As expected, national security-focused agencies like the DoD benefited under this budget request, which raised GFY 2018 defense spending 10% above sequestration levels set by the 2011 BCA to $603 billion. To accomplish this, the White House cut 10% from non-defense agencies.
In addition, in recent years the U.S. government has been unable to complete its budget process before the end of its fiscal year, resulting in a governmental shut-down. Additionally, the national debt has recently threatened to reach the statutory debt ceiling, and such an event in future years could result in the U.S. government defaulting on its debts. As a result, U.S. defense spending levels are difficult to predict beyond the near-term.
We believe that the following trends and developments with respect to the U.S. government spending and reduction in appropriations may influence our future results of operations:
| • | uncertainty around the timing, extent, nature and effect of Congressional and other U.S. government actions to address caps on the discretionary budget for defense and non-defense departments and agencies, including the ability of Congress to determine how to allocate the available budget authority and pass appropriations bills to fund both U.S. government departments and agencies that are, and those that are not, subject to the caps for the remainder of the U.S. government’s fiscal year 2017; |
| • | budget deficits and the growing U.S. national debt, which increases pressure on the U.S. government to reduce federal spending across all federal agencies together with associated uncertainty about the size and timing of those reductions; |
22
Table of Contents
| • | uncertainty regarding budgetary constraints cause clients to (i) not issue task orders in sufficient volume to reach current contract ceilings; (ii) alter historical patterns of contract awards, including the typical increase in the award of task orders or completion of other contract actions by the U.S. government in the period before the end of the U.S. government’s fiscal year on September 30; (iii) delay requests for new proposals and contract awards; (iv) rely on short-term extensions and funding of current contracts; or (v) reduce staffing levels and hours of operation; and |
| • | potential delays in the completion of future U.S. government’s budget processes, particularly government fiscal year 2018, which begins on October 1, 2017, which have in the past and could in the future delay procurement of the services and solutions we provide. |
In addition, we believe that the following trends and developments in the U.S. government IT services industry and our markets may influence our future results of operations:
| • | changes in the relative mix of overall U.S. government spending and areas of spending growth, with projected lower spending on federal civilian agencies and programs, including, among others, homeland security; the Environmental Protection Agency; the Internal Revenue Service; the Federal Communications Commission; and Medicare and Medicaid; |
| • | the implementation of interim rules adopted by federal agencies pursuant to the Bipartisan Budget Act of 2013 published on June 24, 2014, which substantially limit the amount of allowable executive compensation under flexibly priced contracts and extend such limitations to a larger segment of our executives and our entire contract base; |
| • | increased audit, review, investigation and general scrutiny by U.S. government agencies of government contractors’ performance under U.S. government contracts and compliance with the terms of those contracts and applicable laws; |
| • | the federal focus on refining the definition of “inherently governmental” work, including proposals to limit contractor access to sensitive or classified information and work assignments, which will continue to drive pockets of insourcing in various agencies, particularly in the intelligence market; |
| • | U.S. government agencies awarding contracts on an LPTA basis, which could have a negative impact on our ability to win certain contracts; |
| • | increased competition from other government contractors and market entrants seeking to take advantage of certain of the trends identified above, and industry trend towards consolidation, which may result in the emergence of companies that are better able to compete against us; |
| • | agencies’ increased use of performance measurement, “program integrity” efforts to reduce waste, fraud and abuse in entitlement programs and renewed focus on improving procurement practices for and interagency use of IT services, including through the use of cloud based options and data center consolidation; |
| • | increasingly complex requirements of the DoD and the U.S. Intelligence Community, including with respect to cyber-security standards, managing federal health care cost growth and focus on reforming existing government regulation of various sectors of the economy, such as financial regulation and healthcare; |
| • | increasing small business regulations across the DoD and civilian agency clients continue to be apparent. For example, agencies are required to meet high small business set-aside targets, and large business prime contractors are required to subcontract in accordance with considerable small business participation goals necessary for contract award; and |
| • | changes in agency and mission priorities anticipated in the DoD and civilian agency landscape with the presidential and administration transaction and changes in defense priorities anticipated to be driven by the National Defense Authorization Act for the government’s fiscal year 2017, which authorizes the necessary funding for the U.S. military. |
For more information on these risks and uncertainties, see Item 1A, Risk Factors in Part I of this Report.
23
Table of Contents
Key Financial Metrics
Prime Contractor Revenue
The following table shows our revenue derived from contracts on which we serve as a prime contractor.
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Revenue derived from prime contracts |
93 | % | 92 | % | 92 | % | ||||||
Customer Group Revenue
We generate substantially all of our revenue from U.S. Federal Government contracts. We report operating results and financial data as one operating segment. Revenue from our contracts and task orders is generally linked to trends in U.S. Federal Government spending by Defense, Intelligence, and Federal Civilian Agencies. The following table shows our revenue from the customer groups listed as a percentage of total revenue for the period shown.
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Defense and Intelligence Agencies |
63 | % | 60 | % | 75 | % | ||||||
| Federal Civilian Agencies |
37 | % | 40 | % | 25 | % | ||||||
Contract Type Revenue
Our services and solutions are provided under three basic types of contracts: time-and-materials; cost-plus fee; and firm fixed-price. Our contract mix varies from year to year due to numerous factors including our business strategies and U.S. Federal Government procurement objectives.
For a discussion of the types of contracts under which we generate revenue, see “Contract Types” in Item 1 Business in Part I of this Annual Report on Form 10-K. The following table summarizes revenues by contract type as a percentage of total revenues for the last three fiscal years:
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2013 | ||||||||||
|
Time-and-materials |
17 | % | 23 | % | 16 | % | ||||||
| Cost-plus fee |
60 | % | 49 | % | 51 | % | ||||||
| Firm fixed-price |
23 | % | 28 | % | 33 | % | ||||||
Contract Backlog
| Year ended December 31, | ||||||||
| 2016 | 2015 | |||||||
| (in millions) | ||||||||
| Funded backlog |
$ | 139 | $ | 147 | ||||
| Total backlog |
$ | 625 | $ | 552 | ||||
We define backlog as our estimate of the remaining future revenue from existing signed contracts over the remaining base contract performance period and from the option periods of those contracts that we believe have a more likely than not probability of being exercised. Our backlog does not include any estimate of future potential delivery orders that might be awarded under our GWAC, agency-specific IDIQ, or other multiple-award contract vehicles. We define funded backlog as the portion of backlog for which funding currently is appropriated and obligated to us under a contract or other authorization for payment signed by an authorized purchasing agency, less the amount of revenue we have previously recognized. Our funded backlog does not represent the full
24
Table of Contents
potential value of our contracts, as Congress often appropriates funds for a particular program or agency on a quarterly or yearly basis, even though the contract may provide for the provision of services over a number of years. We define unfunded backlog as the total backlog less the funded backlog. Unfunded backlog includes values for contract options that have been priced but not yet funded.
Operating Expenses
Cost of Revenue
Cost of revenue primarily includes direct costs incurred to provide our services and solutions to customers. The most significant portion of these costs is salaries and wages, plus associated fringe benefits, including stock compensation, of our employees directly serving customers, in addition to the related management, facilities, and infrastructure costs. Cost of revenue also includes the costs of subcontractors and outside consultants, third-party materials, such as hardware or software that we purchase and provide to the customer as part of an integrated solution, and any other related direct costs, such as travel expenses. Because we earn higher profits on our own labor services, we expect the ratio of cost of revenue as a percentage of revenue to decline when our labor services mix increases relative to subcontracted labor or third-party material. Conversely, as subcontracted labor or third-party material purchases for customers increase relative to our own labor services, we expect the ratio of cost of revenue as a percentage of revenue to increase. Changes in the mix of services and equipment provided under our contracts can result in variability in our contract margins. In addition, as we continue to bid and win larger contracts, our own labor services component could decrease. This is because the larger contracts typically are broader in scope and require more diverse capabilities, resulting in more subcontracted labor and the potential for more third-party hardware and software purchases. While these factors could lead to a higher ratio of cost of revenue as a percentage of revenue, the economics of these larger jobs are nonetheless generally favorable because they increase revenue, broaden our customer base, and have a favorable return on invested capital.
General and Administrative Expenses
General and administrative expenses include costs related to corporate business development, bid and proposal, contracts administration, finance and accounting, legal, corporate governance, and executive and senior management. The primary items of general and administrative expenses are the salaries and wages, plus associated fringe benefits, including stock compensation, of our employees performing these functions, as well as the related facilities and information technology support costs.
Depreciation and Amortization
Depreciation includes the depreciation of computers, furniture and other equipment, the amortization of third-party software we use internally, and leasehold improvements. Amortization of acquired intangible assets includes the amortization of identifiable, acquired intangible assets over their estimated useful lives. Non-compete agreements are generally amortized straight line over the term of the agreement, while contracts and related customer relationships are amortized proportionately against the acquired backlog.
Acquisition and Integration Related Expenses
Acquisition and integration related expenses include costs related to our acquisition or potential acquisitions. These expenses include external professional fees such as accounting, legal, investment banking, as well as other fees.
Misappropriation Loss
As disclosed elsewhere in this report, in January 2017, the Company announced that it had discovered that its former controller had embezzled Company funds. An internal investigation revealed that the Company’s former controller had embezzled approximately $19.4 million over the period from January 2010 through January 2017. Prior to discovery, the embezzled funds were primarily disguised as health insurance payments and included in cost of revenues and general and administrative expenses. As such, these costs had been treated as allowable costs allocated to contracts in the years that the costs were incurred, but upon reclassification to misappropriation loss, are now treated as unallowable costs for contract revenue recognition. The Company had sufficient allowable, but previously unbilled costs allocated to its cost reimbursable contracts in the fiscal years 2010 through 2015 to offset the unallowable costs related to the embezzlement, such that there was no material change in revenue recognized on such contracts.
Interest Expense, net
Interest income is primarily related to earnings on short-term, highly liquid investments of our excess cash. Interest expense is primarily related to interest expense incurred or accrued under our outstanding borrowings and amortization of deferred financing fees.
25
Table of Contents
Results of Operations
Year Ended December 31, 2016 Compared to Year Ended December 31, 2015
The following table sets forth certain items from our consolidated statements of operations for the years ended December 31:
| 2016 | 2015 | 2016 | 2015 | |||||||||||||
| (in thousands) | (as a Percentage of Revenue) | |||||||||||||||
| Revenue |
$ | 322,410 | $ | 333,095 | 100.0 | % | 100.0 | % | ||||||||
| Operating expenses: |
||||||||||||||||
| Cost of revenue - restated |
266,238 | 275,329 | 82.6 | 82.7 | ||||||||||||
| General and administrative expenses - restated |
27,437 | 25,765 | 8.5 | 7.7 | ||||||||||||
| Depreciation and amortization |
7,020 | 7,659 | 2.2 | 2.3 | ||||||||||||
| Acquisition and integration related expenses |
— | 428 | 0.0 | 0.1 | ||||||||||||
| Misappropriation loss - restated |
4,907 | 3,238 | 1.5 | 1.0 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Total operating expenses |
305,602 | 312,419 | 94.8 | 93.8 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Operating income |
16,808 | 20,676 | 5.2 | 6.2 | ||||||||||||
| Interest expense, net |
1,241 | 865 | 0.4 | 0.3 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Income before income taxes |
15,567 | 19,811 | 4.8 | 5.9 | ||||||||||||
| Provision for income taxes |
6,086 | 7,639 | 1.9 | 2.2 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Net income |
$ | 9,481 | $ | 12,172 | 2.9 | % | 3.7 | % | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
Revenue
Revenue for the year ended December 31, 2016 was $322.4 million, compared to $333.1 million for the year ended December 31, 2015, representing a decrease of $10.7 million, or 3.2%. This decrease was principally due to contracts that ended during the year; lower revenue on several recently won recompetes; reductions in staffing and scope of work on other contracts; and delayed revenue on new contracts awarded in 2016. The decrease was partially offset by higher revenues derived under the PEO Soldier program, the CNOSS program and new contract awards in the past year.
Our PEO Soldier contract accounted for $52.2 million and $32.7 million of our revenue in 2016 and 2015, respectively. This represented 16.2% and 9.8% of our revenue in 2016 and 2015, respectively. The CNOSS contract accounted for $37.0 million and $24.4 million of our revenue in 2016 and 2015, respectively. This represented 11.5% and 7.3% of our revenue in 2016 and 2015, respectively.
Cost of revenue
Cost of revenue for the year ended December 31, 2016 was $266.2 million, or 82.6% of revenue, compared to $275.3 million, or 82.7% of revenue, for the year ended December 31, 2015. The decrease in cost of revenue was primarily the result of the decreased contract base due to the reductions in scope of work and staffing on certain contracts.
General and administrative expenses
General and administrative expenses for the year ended December 31, 2016 were $27.4 million, or 8.5% of revenue, compared to $25.8 million, or 7.7% of revenue, for the year ended December 31, 2015. The increase in general and administrative expenses was primarily due to approximately $1.8 million of costs associated with the transition of named executive officers in the fourth quarter of 2016, partially offset by lower stock compensation expense.
Depreciation and amortization
Depreciation and amortization for the years ended December 31, 2016 and 2015 was $7.0 million and $7.7 million, respectively. The decrease was primarily due to the reduction of amortization of purchased intangible assets associated with prior acquisitions.
Acquisition and integration related expenses
We incurred approximately $0.4 million of acquisition and integration related expenses for the year ended December 31, 2015 related to our acquisition of Computech on January 1, 2015. These expenses include external professional fees such as accounting, legal, investment bank and other fees. We incurred no acquisition and integration expenses during the year ended December 31, 2016.
26
Table of Contents
Misappropriation loss
We incurred approximately $4.9 million and $3.2 million of loss due to the embezzlement of funds by our former controller for the years ended December 31, 2016 and 2015, respectively.
Interest expense, net
For the year ended December 31, 2016, net interest expense was $1.2 million compared to $0.9 million for the year ended December 31, 2015. The increase was primary attributable to an increase in interest expense for uncertain tax positions related to the embezzlement of funds by our former controller of $0.6 million, partially offset by decreased net interest expense relating to our Credit Agreement due to a lower average loan balance for the year ended December 31, 2016. During 2016, we had a weighted average outstanding loan balance of $11.6 million and a weighted average borrowing rate of approximately 2.6%, whereas, during 2015, we had a weighted average outstanding loan balance of $22.4 million and a weighted average borrowing rate of approximately 2.3%.
Provision for Income taxes
For the year ended December 31, 2016, our provision for income taxes was 39.1% of our income before tax. This represents an increase from 38.6% for the year ended December 31, 2015.
Year Ended December 31, 2015 Compared to Year Ended December 31, 2014
The following table sets forth certain items from our consolidated statements of operations for the years ended December 31:
| 2015 | 2014 | 2015 | 2014 | |||||||||||||
| (in thousands) | (as a Percentage of Revenue) | |||||||||||||||
| Revenue |
$ | 333,095 | $ | 317,028 | 100.0 | % | 100.0 | % | ||||||||
| Operating expenses: |
||||||||||||||||
| Cost of revenue - restated |
275,329 | 267,836 | 82.7 | 84.5 | ||||||||||||
| General and administrative expenses - restated |
25,765 | 25,585 | 7.7 | 8.1 | ||||||||||||
| Depreciation and amortization |
7,659 | 5,692 | 2.3 | 1.8 | ||||||||||||
| Acquisition and integration related expenses |
428 | 150 | 0.1 | 0.0 | ||||||||||||
| Misappropriation loss - restated |
3,238 | 3,285 | 1.0 | 1.0 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Total operating expenses |
312,419 | 302,547 | 93.8 | 95.4 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Operating income |
20,676 | 14,481 | 6.2 | 4.6 | ||||||||||||
| Interest expense, net |
865 | 406 | 0.2 | 0.1 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Income before income taxes |
19,811 | 14,075 | 6.0 | 4.5 | ||||||||||||
| Provision for income taxes |
7,639 | 5,607 | 2.3 | 1.8 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Net income |
$ | 12,172 | $ | 8,468 | 3.7 | % | 2.7 | % | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
Revenue
Revenue for the year ended December 31, 2015 was $333.1 million, compared to $317.0 million for the year ended December 31, 2014, representing an increase of $16.1 million, or 5.1%. The year-over-year increase in revenue was principally due to revenue driven from Computech contracts as well as new awards during 2015, partially offset by lower year-over-year revenue from our PEO Soldier program and contracts completed during the year.
Our PEO Soldier program accounted for $32.7 million and $36.5 million of our revenue in 2015 and 2014, respectively. This represented 9.8% and 11.5% of our revenue in 2015 and 2014, respectively.
Cost of revenue
Cost of revenue for the year ended December 31, 2015 was $275.3 million, or 82.7% of revenue, compared to $267.8 million, or 84.5% of revenue, for the year ended December 31, 2014. The increase in cost of revenue was primarily the result of the increased contract base due to the acquisition of Computech in January 2015. Cost of revenue as a percentage of revenue decreased primarily as a result of higher-margin revenue from Computech contracts, and improving operating performance.
27
Table of Contents
General and administrative expenses
General and administrative expenses for the year ended December 31, 2015 were $25.8 million, or 7.7% of revenue, compared to $25.6 million, or 8.1% of revenue, for the year ended December 31, 2014. The increase in general and administrative expenses was primarily due to higher business development costs to support our increased bid and proposal efforts, partially offset by lower stock compensation expense. The decrease in general and administrative expenses as a percent of revenue is primarily due to the higher revenue base with a smaller increase in expenses.
Depreciation and amortization
Depreciation and amortization for the years ended December 31, 2015 and 2014 was $7.7 million and $5.7 million, respectively. The year-over-year increase was primarily due to the amortization of intangible assets associated with the acquisition of Computech.
Acquisition and integration related expenses
Acquisition and integration related expenses include costs of $0.4 million related to our acquisition of Computech on January 1, 2015. These expenses include external professional fees such as accounting, legal, investment bank and other fees.
Misappropriation loss
We incurred approximately $3.2 million and $3.3 million of loss due to the embezzlement of funds by our former controller for the years ended December 31, 2015 and 2014, respectively.
Interest expense, net
For the year ended December 31, 2015, net interest expense was $0.9 million compared to $0.4 million for the year ended December 31, 2014. Net interest expense increased primarily due to a higher average loan balance for the year ended December 31, 2015 resulting from the acquisition of Computech in January 2015. During 2015, we had a weighted average outstanding loan balance of $22.4 million and a weighted average borrowing rate of approximately 2.3%. During 2014, we had a weighted average outstanding loan balance of $1.3 million and a weighted average borrowing rate of approximately 2.3%.
Provision for Income taxes
For the year ended December 31, 2015, our provision for income taxes was 38.6% of our income before tax. This represents a decrease from 39.8% for the year ended December 31, 2014. The decrease was primarily attributable to a change in our state apportionment factors, a change in the consolidated state tax rate, and the federal tax rate on future tax benefits.
Effects of Inflation
We generally have been able to price our contracts in a manner to accommodate the rates of inflation experienced in recent years. During 2016, approximately 17% of our revenue was generated under time-and-materials contracts, where labor rates are usually adjusted annually by predetermined escalation factors. Also during 2016, approximately 60% of our revenue was generated under cost-plus fee contracts, which automatically adjust for changes in cost. The remaining 23% of our revenue was generated under firm fixed-price contracts, in which we include a predetermined escalation factor and for which we generally have not been adversely affected by inflation.
Trends in Revenue
We continue to experience fluctuations in scope of services and contract modifications as a result of shifting budget priorities of the U.S. Federal Government as described more fully under “Industry Trends” in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations in Part II of this Annual Report on Form 10-K above. We expect these fluctuations will result in a reduction in revenue from our existing contracts in 2017, and we expect that revenue derived from successful contract recompetes and new business awards in 2016 and 2017 will partially offset these reductions in revenue from our existing contracts.
28
Table of Contents
Misappropriation loss—Costs and Recovery
As discussed in Item 3, Legal Proceedings, the Company initiated civil legal proceedings against our former controller seeking to recover assets acquired by him with funds wrongfully obtained by him through his embezzlement of Company funds and that litigation is ongoing. The court has frozen all of our former controller’s assets. The Company carries insurance that could cover up to $5 million of the misappropriation loss. The timing and amount of final recoveries, net of expenses of recovery, is uncertain. The Company has not yet recognized an estimated value of the potential recovery due to the limited amount of information available to it at this time. The Company estimates that it incurred approximately $5 million in costs during the first quarter of 2017 related to the embezzlement, including legal, auditing and forensic accounting fees.
Liquidity and Capital Resources
Our primary liquidity needs are for financing working capital, capital expenditures, stock repurchases, and making selective strategic acquisitions. Historically, we have relied primarily on our cash flow from operations and borrowings under our Credit Agreement to provide the capital for our liquidity needs. As part of our growth strategy, we may pursue acquisitions that could require us to incur additional debt or issue new equity. We expect the combination of our current cash, cash flow from operations, and the available borrowing capacity under our Credit Agreement to continue to meet our normal working capital, capital expenditures and other cash requirements.
During 2016, the balance of accounts receivable decreased by $8.9 million to $51.1 million at December 31, 2016. Days sales outstanding of accounts receivable (DSO) decreased 5 days to 61 days at December 31, 2016 as compared to 66 days at December 31, 2015.
On January 31, 2017, NCI, entered into the Fourth Amendment (the “Amendment”) to the Credit Agreement.
The Amendment modifies certain provisions of the Credit Agreement to, among other things:
| • | decrease the Company’s borrowing capacity under the revolving line of credit from $80.0 million to $50.0 million; |
| • | extend the commitment termination date from January 31, 2017 to May 31, 2017; |
| • | amend the definition of “Required Lenders” to include all lenders which means, among other things, that amendments to and waivers of the terms of the Credit Agreement, as amended, will require the consent and approval of all lenders; and |
| • | include additional restrictions with respect to certain acquisitions and restricted payments, including certain acquisitions, dividends, and repurchase or redemption of our capital stock. |
As of December 31, 2016, we had no funded debt under the Credit Agreement, as compared to $10 million of outstanding borrowings as of December 31, 2015, reflecting $10.0 million of net payments during 2016. Our Board of Directors authorized management to repurchase up to $25.0 million of our Class A common stock pursuant to a stock repurchase program. If shares are repurchased, the shares will be repurchased pursuant to open market purchases, privately negotiated transactions, or block transactions. We have no obligation to repurchase shares under the authorization, and the timing, actual number and value of the shares which are repurchased (and the manner of any such repurchase) will be at the discretion of management and will depend on a number of factors, including the price of our common stock, our Company’s cash needs, borrowing capacity under the Credit Agreement, interest rates, and our financial performance and position. We may suspend or discontinue repurchases at any time. During 2014, 2015, and 2016 we did not repurchase any shares. At December 31, 2016, we had $16.7 million remaining under the Board of Directors’ authorization for share repurchases. The Amendment to the Credit Agreement dated January 31, 2017, restricts our ability to repurchase or redeem our capital stock, pending the consent and approval of all lenders.
The Company expects to enter into a new credit agreement prior to the expiration of the Credit Agreement on May 31, 2017. Our goal is to reestablish a credit agreement that will support our stated goals for financing working capital, capital expenditures, stock repurchases, and making selective strategic acquisitions.
As of December 31, 2016, we were in compliance with all our loan covenants.
29
Table of Contents
Off-Balance Sheet Arrangements
We do not have any material off-balance sheet arrangements.
30
Table of Contents
Contractual Obligations
The following table summarizes our contractual obligations as of December 31, 2016, that requires us to make future cash payments.
| Payments due by period | ||||||||||||||||||||
| Contractual obligations: |
Total | Less than 1 year |
1–3 years |
3–5 years |
More than 5 years |
|||||||||||||||
| (in thousands) | ||||||||||||||||||||
| Credit facility |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Uncertain tax position |
5,472 | 5,472 | — | — | — | |||||||||||||||
| Operating lease obligations |
13,091 | 6,323 | 5,709 | 1,059 | — | |||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Total |
$ | 18,563 | $ | 11,795 | $ | 5,709 | $ | 1,059 | $ | — | ||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
Critical Accounting Policies
Revenue Recognition
Our revenue recognition policy addresses our three different types of contractual arrangements: time-and-materials contracts; cost-plus fee contracts; and firm fixed-price contracts.
Time-and-Materials Contracts: Revenue for time-and-materials contracts is recognized as services are performed, generally on the basis of contract allowable labor hours worked multiplied by the contract defined billing rates, plus the direct costs and indirect cost burdens associated with materials and other direct expenses used in performance on the contract. Profits on time-and-material contracts result from the difference between the cost of services performed and the contract-defined billing rates for these services.
Cost-Plus Fee Contracts: Generally, revenue on cost-plus fee contracts is recognized as services are performed based on the allowable costs incurred during the period, plus any recognizable earned fee. The Company does not recognize award-fee income until the fees are fixed or determinable. Due to such timing, and to fluctuations in the level of revenue, profit as a percentage of revenue on award-fee contracts will fluctuate period to period.
Firm Fixed-Price Contracts: Revenue recognition methods on firm fixed-price contracts will vary depending on the nature of the work and the contract terms. Revenue on firm fixed-price service contracts is recognized as services are performed. Generally, revenue is deferred until all of the following have occurred: (1) there is a contract in place, (2) delivery has occurred, (3) the price is fixed or determinable, and (4) collectability is reasonably assured. Revenue on firm fixed-price contracts that require delivery of specific items is recognized based on a price per unit as units are delivered. Revenue for firm fixed-price contracts in which we are paid a specific amount to provide services for a stated period of time or where we are designing, engineering, or manufacturing to the customer’s specifications is recognized on the percentage-of-completion method of accounting, generally using costs incurred in relation to total estimated costs to measure progress toward completion.
Profits on firm fixed-price contracts result from the difference between the incurred costs and the revenue earned. Contract accounting requires significant judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Due to the size and nature of many of our contracts, the estimation of total revenue and cost at completion requires the use of estimates. Contract costs include material, labor, and subcontracting costs, as well as an allocation of allowable indirect costs. Assumptions have to be made regarding the length of time to complete the contract because costs also include expected increases in wages and prices for materials. For contract change orders, claims or similar items, we apply judgment in estimating the amounts and assessing the potential for realization. These amounts are only included in contract value when they can be reliably estimated and realization is considered probable. Estimates of total contract revenue and costs are continuously monitored during the term of the contract and are subject to revision as the contract progresses. Anticipated losses on contracts accounted for under the percentage-of-completion method of accounting are recognized in the period they are deemed probable and can be reasonably estimated.
Our contracts may include the delivery of a combination of one or more of our service offerings (e.g., a combination of hardware components, related integration or other services). Each deliverable within a multiple-deliverable revenue arrangement is accounted for as a separate unit of accounting if both of the following criteria are met: (1) the delivered item or items have value to the customer on a standalone basis and (2) for an arrangement that includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. We consider a deliverable to have standalone value if we sell this item separately or if the item is sold by another vendor or could be resold by the customer. Further, our revenue arrangements generally do not include a general right of return relative to delivered products. Deliverables not meeting the criteria for being a separate unit of accounting are combined with a deliverable that does meet that criterion. The appropriate allocation of arrangement consideration and recognition of revenue is then determined for the combined unit of accounting.
31
Table of Contents
Goodwill and Intangible Assets
The purchase price of an acquired business is allocated to tangible assets and separately identifiable intangible assets based upon their respective fair values, with the excess recorded as goodwill.
Net tangible and identifiable intangible assets acquired and liabilities assumed are recognized at their estimated fair values at the date of acquisition. At the time of the acquisition, all intangibles, including contracts and related customer relationships and non-compete agreements, are reviewed to determine the term of amortization for each intangible asset.
FASB ASC 350 — Intangibles — Goodwill and Other, requires that entities with goodwill periodically test goodwill for impairment. ASC 350 requires the test for impairment of goodwill to be done at the reporting unit level, even if an entity only has one reportable segment. The requirement for goodwill impairment testing to be done at the reporting unit level makes the determination of an entity’s operating segment or segments and reporting unit or units the first step in the goodwill impairment process. Operating segments, not reportable segments, are the basis for the determination of reporting units, which represent the level at which an entity must assess goodwill for impairment. NCI has one reporting unit and one operating segment and therefore we test for impairment of goodwill at our one operating segment which is also our one reporting unit, as we manage our business and allocate resources at the consolidated level to serve our customers.
Goodwill is reviewed for impairment no less than annually or when circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. Annually on October 1, and when circumstances dictate, we perform a fair value analysis of our reporting unit. If goodwill becomes impaired, we will record a charge to earnings in our financial statements in the period in which any impairment of our goodwill is determined. We had $33.9 million of goodwill as of the measurement date in 2016.
Intangible assets are reviewed for impairment whenever events or circumstances indicate that the carrying amount of the intangible asset many not be fully recoverable. An impairment loss is recognized if the sum of the long-term undiscounted cash flows is less than the carrying amount of the long-lived asset being evaluated. An impairment loss is measured as the amount by which the carrying amount exceeds its fair value. Any write-downs are treated as permanent reductions in the carrying amount of the assets and will result in a reduction of earnings in the period incurred. During 2016, the Company did not record any intangible impairment charge.
Contract and customer relationships are amortized proportionately against the acquired backlog. Non-compete agreements are amortized over their estimated useful lives.
Deferred Tax Assets
Deferred tax assets represent temporary differences in the tax basis of an asset or liability and its reported amount in the financial statements that will result in future tax deductions. Deferred tax assets are evaluated to determine if the future tax deductions will be realizable. Future realization of tax benefits ultimately depends on the existence of sufficient taxable income within the appropriate period that is available under the tax law. All available evidence is considered to determine if a valuation allowance for deferred tax assets is needed.
Our acquisitions to date have been treated as asset purchases under the Internal Revenue Code. As such, the goodwill generated from those acquisitions is deductible for tax purposes. For the year ended December 31, 2016, the tax deduction was approximately $12.1 million. At our tax rate of 38.1%, this deduction reduced our current tax expenditure by approximately $4.5 million in current income tax expenditures. As of December 31, 2016, we had approximately $93.3 million in future goodwill tax deductions. As of December 31, 2016, we had approximately $41.9 million in net deferred tax assets and a valuation allowance of $0.2 million. Based primarily on recent earnings history and actual taxable income, as well as projections of future taxable income, we believe there is sufficient positive evidence to conclude that it is more likely than not that substantially all of the deferred tax assets are fully realizable.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk relates to changes in interest rates for borrowings under our credit facility. For the year ended December 31, 2016, a 1% change in interest rates would have changed our interest expense and cash flows by approximately $0.1 million. This estimate is based on our average loan balances for the year. Additionally, we are subject to credit risks associated with our cash and accounts receivable. We believe that the concentration of credit risk with respect to cash equivalents is limited due to the high credit quality of these investments. Our investment policy requires that we invest excess cash in high-quality investments, which preserve principal, provide liquidity, and minimize investment risk. We also believe that our credit risk associated with accounts receivable is limited as they are primarily with the U.S. Federal Government.
32
Table of Contents
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of NCI, Inc. are included in this report beginning on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
The Company has had no disagreements with its independent accountants on accounting principles, practices, or financial statement disclosure during and through the date of the financial statements included in this Report.
ITEM 9A. CONTROLS AND PROCEDURES
Background to Embezzlement and Misappropriation Loss
On January 23, 2017, the Company announced that it had discovered, based on preliminary findings of an internal investigation, that its controller had been embezzling Company funds.
On the same date, the Company announced the Board of Directors’ conclusion that, as a result of the preliminary information obtained to date in connection with such internal investigation, (i) the unaudited interim financial statements included in the Company’s Quarterly Report on Form 10-Q for the three-months ending March 31, 2016, filed on April 29, 2016; (ii) the unaudited interim financial statements included in the Company’s Quarterly Report on Form 10-Q for the three- and six-months ending June 30, 2016, filed on August 1, 2016; and (iii) the unaudited interim financial statements included in the Company’s Quarterly Report on Form 10-Q for the three- and nine-months ending September 30, 2016, filed on November 7, 2016, should no longer be relied upon. In addition, the Board of Directors also determined that investors, analysts and other persons should not rely upon management’s report on internal control over financial reporting or the Company’s independent registered public accounting firm’s report on the effectiveness of the Company’s internal control over financial reporting filed with the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2015.
The internal investigation revealed that the Company’s former controller had embezzled approximately $19.4 million from the Company from January 1, 2010 through January 10, 2017. The embezzlement was accomplished by the former controller’s unauthorized transfers of Company funds to the controller’s personal bank accounts using his authority as controller to approve automated clearing house (ACH) payments from the Company’s payroll account. The former controller was able to conceal the unauthorized transfers by falsifying certain corporate records and Company bank statements and lying to other NCI employees and to the Company’s independent registered public accountants when questioned about the suspicious payments. The Company was unable to confirm any unauthorized transfers of Company funds by the former controller prior to 2010, as the Company’s bank no longer maintains the records necessary to identify the specific beneficiaries of any such remittances. The Company believes that the former controller acted alone and found no evidence that any other NCI employee was aware of or colluded in the embezzlement of Company funds or that there was any unlawful activity apart from that associated with the former controller’s embezzlement of Company funds.
The embezzled funds were primarily disguised as payments to the administrator of the Company’s self-insured employee medical benefits plan that led to an overstatement of fringe benefit costs. Such costs were included in the Company’s cost of revenues and general and administrative expenses in its financial statements for the fiscal years ended December 31, 2010 through 2015 and were originally allocated to contracts as allowable costs. The Company has reclassified such costs to misappropriation loss for the years 2010 through 2016, with appropriate reductions in cost of revenues and general and administrative expenses, and such costs are now treated as unallowable costs. The Company had sufficient allowable but previously unbilled costs allocated to its contracts during the period from 2010 through 2015 to offset the unallowable costs related to the embezzlement, such that there was no material change in revenue recognized on its cost reimbursable contracts for the fiscal years ended December 31, 2010 through 2015. Accordingly, the Company does not believe that there was a material impact on its results of operations for such periods.
As previously announced, the Company’s unaudited interim financial statements for the nine-month period ended September 30, 2016 contain material errors related to the embezzlement. Therefore, as soon as reasonably practicable following the filing of this Form 10-K, the Company will file amendments to its previously issued Quarterly Reports on Form 10-Q for the quarterly
33
Table of Contents
periods ended March 31, 2016, June 30, 2016 and September 30, 2016 to reflect the restatements of the unaudited financial statements for those periods for the correction of accounting errors relating to the embezzlement.
Disclosure Controls and Procedures
We maintain disclosure controls and procedures as defined in Rules 13a-15(e) and 15d- 15(e) under the Exchange Act that are intended to ensure that information that would be required to be disclosed in Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to our management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our system contains control-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Audit Committee of the Board of Directors (Audit Committee) and management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to the Exchange Act Rules 13a-15(e) and 15d-15(e). Based on this evaluation, and due to the material weaknesses described below in Management’s Report on Internal Control over Financial Reporting, the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2016, the disclosure controls and procedures of the Company were not effective.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Internal control over financial reporting is a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer, and effected by the Company’s management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of management and the Company’s Board of Directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material adverse effect on the Company’s financial statements.
The effectiveness of any system of internal control over financial reporting is subject to inherent limitations, including the exercise of judgment in designing, implementing, operating, and evaluating the controls and procedures, and the inability to eliminate misconduct completely. Accordingly, any system of internal control over financial reporting can only provide reasonable, not absolute, assurances. In addition, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. We intend to continue to monitor and upgrade our internal controls as necessary or appropriate for our business, but cannot assure that such improvements will be sufficient to provide us with effective control over financial reporting.
In accordance with the internal control reporting requirements of the SEC, our management completed an assessment of the effectiveness of our internal control over financial reporting as of December 31, 2016. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control—Integrated Framework (2013). The COSO framework summarizes each of the components of a company’s internal control system, including the: (i) control environment; (ii) control activities (process-level controls), (iii) risk assessment; (iii) information and communication; and (iv) monitoring activities. The COSO framework defines a “material weakness” as a deficiency, or combination of deficiencies, that results in a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. Management’s evaluation of our internal control over financial reporting identified material weaknesses resulting from several control deficiencies in the internal control system that allowed the misappropriation of funds and the failure to detect them for an extended period of time.
As a result of this assessment, our management has concluded that as of December 31, 2016, our internal control over financial reporting was not effective due to the material weaknesses described below. Our independent registered public accounting firm has issued an attestation report on the effectiveness of our internal control over financial reporting, which is included elsewhere in this Report.
Management identified the following material weaknesses:
| 1. | Control Environment. We did not maintain an effective control environment that fully emphasized the establishment of adherence to effective internal controls over financial reporting throughout the Company’s management. We did not give sufficient consideration to the risk of management override of internal controls. The Company had not ensured that certain of the accounting personnel were adequately trained to properly execute critical internal controls. |
| 2. | Control Activities. We did not have control activities that were designed and operating effectively. The Company did not establish adequate controls over its banking relationship and the use of the electronic payment system provided by our bank. The Company did not maintain sufficient segregation of duties with respect to certain activities of its former controller, the Human Resources Department, and the Payroll Department. The Company did not maintain adequate monitoring and oversight of the work performed by the former controller, specifically in performing balance sheet reconciliations and reviews in order to prevent or detect management override of controls and the resulting misappropriation of assets by the former controller. The Company’s Financial Planning and Analysis and Human Resources Departments failed to coordinate their activities with respect to monitoring the expense of the self-insured employee medical benefits plan until the fraudulent payments were identified in January 2017. |
34
Table of Contents
| 3. | Risk Assessment. We did not have an effective risk assessment process. Our former controller managed the activity of documenting our processes and the related internal controls, the fraud risk assessments and scoping of management’s testing of the internal control over financial reporting. The resulting documentation of our processes and internal control was incomplete and contributed to failures in evaluating and testing the effectiveness of the Company’s internal controls over financial reporting. |
| 4. | Information and Communication. We did not adequately communicate to all employees of the organization information regarding the importance of internal controls over financial reporting and employees’ duties and responsibilities, including segregation of duties. |
| 5. | Monitoring Activities. We did not maintain effective monitoring controls related to the evaluation and testing of our internal controls over financial reporting. The external accounting consultants engaged by the Audit Committee of the Company’s Board of Directors failed to identify the material weaknesses in the Company’s internal controls over financial reporting. |
The management team, through the results of the internal investigation and from substantive validation procedures and review processes, was able to obtain a reasonable level of assurance that financial statement balances for the fiscal year ended December 31, 2016 were accurate and complete. As a result of these procedures, we believe the consolidated financial statements included in this Report for the year ended December 31, 2016 fairly present, in all material respects, our financial position, results of operations and cash flows for the periods presented in conformity with GAAP.
Remediation Plan
Immediately upon learning of the embezzlement, the Audit Committee engaged a team of investigators and forensic accountants to fully investigate such matter to confirm the extent of the fraudulent actions. As stated elsewhere in this Report, based on its internal investigation, the Company believes that the former controller acted alone and found no evidence that any other NCI employee was aware of or colluded in the embezzlement of Company funds and the Company found no evidence of any unlawful activity apart from that associated with the former controller’s embezzlement of Company funds.
Management is committed to remediating each of the material weaknesses identified above by implementing changes to the Company’s internal control over financial reporting. Management has implemented, or is in the process of implementing, the following changes to the Company’s internal control systems and procedures:
| • | We have initiated a project led by a senior executive independent of the Finance and Accounting organization, and aided by outside consultants, to fully document our processes to serve as the basis for activities during 2017 to assess our fraud risks and evaluate and test our internal controls over financial reporting. |
| • | We have updated our delegation of authority over our banking activities, and are establishing a treasury function that will improve the segregation of duties surrounding the controller to better safeguard cash. |
| • | The Audit Committee of the Board of Directors will re-assess its past practice of engaging an outside accounting consultant to assist in the evaluation and testing of the Company’s internal controls over financial reporting and we intend to conduct a more expansive risk assessment, with additional oversight by the Audit Committee. |
| • | We will require that the Financial Planning and Analysis and Human Resources Departments perform regular joint reviews of expenses associated with our employee benefit plans to ensure the actual expenses are consistent with the terms of the plans. |
We immediately terminated the former controller upon discovering the fraudulent payments by him. We have initiated a search for a new controller and are considering other personnel actions to improve the overall level of competence in the accounting department.
Management intends to finalize its efforts around implementing effective internal controls and closely test and monitor the operating effectiveness of these controls throughout 2017 to ensure they meet their designed control objectives and, where necessary, take additional corrective measures to ensure that deficiencies are remediated.
We believe the remediation measures described above will strengthen our internal control over financial reporting and remediate the material weaknesses we have identified.
35
Table of Contents
Changes in Internal Control Over Financial Reporting
Except as described above, there have been no changes to the Company’s internal control over financial reporting that occurred during the quarter ended December 31, 2016, that have materially affected, or are reasonably likely to affect, the Company’s internal control over financial reporting. The remediation plan noted above was initiated in the first quarter of 2017 and we expect that our remediation efforts, including design, implementation and testing, will continue throughout 2017.
Completion of Internal Investigation
On January 23, 2017, the Company announced that it had discovered, based on preliminary findings of an internal investigation, that its controller had been embezzling Company funds. The Company’s then-preliminary findings indicated that these funds were reflected as expenses in the Company’s financial statements and that those expenses were treated as allowable indirect costs on the Company’s government contracts, but should have been classified as unallowable costs.
On March 31, 2017, the Company announced that it had completed its internal investigation into the facts and circumstances surrounding the embezzlement by its former controller. The internal investigation revealed that the Company’s former controller had embezzled approximately $19.4 million during the period from January 1, 2010 through January 10, 2017. The embezzlement was accomplished by the former controller’s unauthorized transfers of Company funds to the controller’s personal bank accounts using his authority as controller to approve “ACH” payments from the Company’s payroll account. The former controller was able to conceal the unauthorized transfers by falsifying certain corporate records and Company bank statements and lying to other NCI employees and to the Company’s independent registered public accountants when questioned about the suspicious payments. The Company was unable to confirm any unauthorized transfers of Company funds by the former controller prior to 2010, as the Company’s bank no longer maintains the records necessary to identify the specific beneficiaries of any such remittances. The Company believes that the former controller acted alone and found no evidence that any other NCI employee was aware of or colluded in the embezzlement of Company funds or that there was any unlawful activity apart from that associated with the former controller’s embezzlement of Company funds.
The embezzled funds were primarily disguised as payments to the administrator of the Company’s self-insured employee medical benefits plan that led to an overstatement of fringe benefit costs. Such costs were included in the Company’s cost of revenues and general and administrative expenses in its financial statements for the fiscal years ended December 31, 2010 through 2015 and were originally allocated to contracts as allowable costs. The Company has reclassified such costs to misappropriation loss for the years 2010 through 2016, with appropriate reductions in cost of revenues and general and administrative expenses, and such costs are now treated as unallowable costs. The Company had sufficient allowable but previously unbilled costs allocated to its contracts during the period from 2010 through 2015 to offset the unallowable costs related to the embezzlement, such that there was no material change in revenue recognized on its cost reimbursable contracts for the fiscal years ended December 31, 2010 through 2015. Accordingly, the Company does not believe that there was a material impact on its results of operations for such periods.
The Company previously announced on January 23, 2017, that the unaudited interim financial statements for the nine-month period ended September 30, 2016 contain material errors related to the embezzlement and the Company will provide amended financial results for such nine-month period as part of the completion of its financial reporting process for the fiscal year 2016. As soon as reasonably practicable following the filing of this Report, we will file amendments to our previously issued Quarterly Reports on Form 10-Q for the periods ended March 31, 2016, June 30, 2016 and September 30, 2016 to reflect the restatements of the unaudited financial statements for those periods for the effect of the embezzlement described herein.
36
Table of Contents
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of NCI, Inc.
Reston, Virginia
We have audited NCI, Inc. and subsidiaries’ (the “Company’s”) internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Controls Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on that risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses have been identified and included in management’s assessment: (i) The Company did not maintain effective control activities, as it had not established adequate controls over its banking relationship and the use of the electronic payment system provided by its bank; did not maintain sufficient segregation of duties with respect to certain activities of its former controller, the Human Resources Department, and the Payroll Department; did not maintain adequate monitoring and oversight of the work performed by the former controller, specifically in performing balance sheet reconciliations and reviews in order to prevent or detect management override of controls and the resulting misappropriation of assets; and failed to coordinate the activities of certain of the Company’s functional departments with respect to monitoring the expense of the self-insured employee medical benefits plan until the fraudulent payments were identified in January of 2017; (ii) The Company did not have an effective risk assessment process, as the Company’s controller managed the risk assessment process and scoping of management’s testing of the internal controls over financial reporting, which contributed to failures in evaluating and testing the effectiveness of the Company’s internal controls over financial reporting; (iii) The Company did not maintain an effective control environment, as the control environment did not fully emphasize the establishment of adherence to effective internal controls over financial reporting and did not give sufficient consideration to the risk of management override of internal controls; and had not ensured that certain of the accounting personnel were adequately trained to properly execute critical internal controls; (iv) The Company did not maintain effective information and communication, as the Company did not adequately communicate to all employees of the organization information regarding the importance of internal controls over financial reporting and employees’ duties and responsibilities, including segregation of duties; (v) The Company did not maintain effective monitoring controls related to the evaluation and testing of its internal controls over financial reporting, as these functions did not timely identify the material weaknesses set forth above. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements as of and for the year ended December 31, 2016, of the Company and this report does not affect our report on such financial statements.
37
Table of Contents
In our opinion, because of the effect of the material weaknesses identified above on the achievement of the objectives of the control criteria, the Company has not maintained effective internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We do not express an opinion or any other form of assurance on management’s statements regarding the Remediation Plan described in Management’s Report on Internal Controls Over Financial Reporting.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2016, of the Company and our report dated March 31, 2017 expressed an unqualified opinion on those financial statements, and included an explanatory paragraph regarding a restatement to correct the classification of misappropriation losses as discussed in Note 22 to the financial statements.
/s/ DELOITTE & TOUCHE LLP
McLean, Virginia
March 31, 2017
38
Table of Contents
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS OF THE REGISTRANT AND CORPORATE GOVERNANCE
The information concerning our directors and executive officers required by Item 401 of Regulation S-K is included under the captions “Election of Directors” and “Executive Compensation,” respectively, in our definitive Proxy Statement to be filed with the SEC in connection with our 2017 Annual Meeting of Stockholders (2017 Proxy Statement), and that information is incorporated by reference in this Form 10-K.
The information required by Item 405 of Regulation S-K concerning compliance with Section 16(a) of the Exchange Act is included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
The information required by Item 406 of Regulation S-K concerning the Company’s Code of Ethics is included under the caption “Election of Directors” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
The information required by Item 407(c)(3) of Regulation S-K concerning the procedures by which Company stockholders may recommend nominees to the Company’s Board of Directors is included under the caption “Election of Directors” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
The information required by Item 407(d)(4) of Regulation S-K concerning the Audit Committee is included under the caption “Report of the Audit Committee of the Board of Directors” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
The information required by Item 407(d)(5) of Regulation S-K concerning the designation of an audit committee financial expert is included under the caption “Report of the Audit Committee of the Board of Directors” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is included in the text and tables under the caption “Executive Compensation” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this Item 12 is included under the captions “Beneficial Ownership” and “Equity Compensation Plan Information” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by this Item 13 is included under the captions “Election of Directors” and “Certain Relationships and Related Transactions” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item 14 is included under the caption “Ratification of Appointment of Independent Registered Public Accounting Firm” in our 2017 Proxy Statement, and that information is incorporated by reference in this Form 10-K.
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as a part of this Report:
(1)
Report of Independent Registered Public Accounting Firm on Internal Controls Over Financial Reporting
Report of Independent Registered Public Accounting Firm On The Consolidated Financial Statements
39
Table of Contents
Consolidated Statements of Income for the years ended December 31, 2016, 2015, and 2014
Consolidated Balance Sheets as of December 31, 2016, and 2015
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2016, 2015, and 2014
Consolidated Statements of Cash Flows for the years ended December 31, 2016, 2015, and 2014
Notes to Consolidated Financial Statements
(b) Exhibits required by Item 601 of Regulation S-K:
| Number |
Description | |
| 2.1 | Securities Purchase Agreement by and among NCI Information Systems, Inc., a wholly owned subsidiary of registrant (“NCIIS”), Computer Services Corporation, Dyncorp and, AdvanceMed Corporation dated as of February 24, 2011 (incorporated herein by reference from Exhibit 2.1 to registrant’s Current Report on Form 8-K, as filed with the Commission on April 4, 2011). | |
| 2.2 | Stock Purchase Agreement among NCIIS, the Sellers named therein, the Phantom Stock Holders named therein and Computech, Inc., dated as of December 24, 2014, (incorporated herein by reference from Exhibit 2.1 to registrant’s Current Report on Form 8-K, as filed with the Commission on December 29, 2014). | |
| 3.1 | Amended and Restated Certificate of Incorporation of the Registrant (incorporated herein by reference from Exhibit 3.1 to registrant’s Registration Statement on Form S-1 (File No. 333-127006), as filed with the Commission on October 4, 2005, as amended). | |
| 3.2 | Bylaws of the Registrant (incorporated herein by reference from Exhibit 3.2 to registrant’s registration Statement on Form S-1 (File No. 333-127006), as filed with the Commission on July 29, 2005). | |
| 4.1 | Specimen Class A Common Stock Certificate (incorporated herein by reference from Exhibit 4.1 to registrant’s Registration Statement on Form S-1 (File No. 333-127006), as filed with the Commission on October 20, 2005, as amended). | |
| 4.2* | NCI, Inc. Amended and Restated 2005 Performance Incentive Plan (incorporated herein by reference from Appendix A to registrant’s Proxy Statement on Form DEF 14A, as filed with the Commission on April 30, 2009). | |
| 4.3* | Form of Amended and Restated 2005 Performance Incentive Plan Notice of Stock Option Grant and Stock Option Agreement (incorporated herein by reference from Exhibit 4.2 to registrant’s Current Report on Form 8-K, as filed with the Commission on June 12, 2009). | |
40
Table of Contents
| Number |
Description | |
| 10.1 | Amended and Restated Loan and Security Agreement, dated as of December 13, 2010, by and among NCI and its Subsidiaries, as Borrowers, the several banks and financial institutions from time to time parties thereto, as Lenders, SunTrust Bank as the Administrative Agent to the Lenders and SunTrust Robinson Humphrey, Inc., as Lead Arranger and Book Manager (incorporated by reference from Exhibit 10.1 to registrant’s Current Report on Form 8-K as filed with the Commission on December 15, 2010). | |
| 10.2* | Executive Change in Control and Severance Agreement, dated March 9, 2013, by and among, NCI, Inc. and Brian J. Clark. (incorporated herein by reference from Exhibit 10.2 to registrant’s Annual Report on Form 10-K (File No. 000-51579), as filed with the Commission on March 12, 2013). | |
| 10.3* | Executive Change in Control and Severance Agreement, dated March 9, 2012, by and among, NCI, Inc. and Marco de Vito (incorporated herein by reference from Exhibit 10.3 to registrant’s Annual Report on Form 10-K (File No. 000-51579), as filed with the Commission on March 12, 2012). | |
| 10.4* | Executive Change in Control and Severance Agreement, dated March 9, 2012, by and among, NCI, Inc. and Michele R. Cappello (incorporated herein by reference from Exhibit 10.4 to registrant’s Annual Report on Form 10-K (File No. 000-51579), as filed with the Commission on March 12, 2012). | |
| 10.5* | Executive Change in Control and Severance Agreement, dated March 9, 2012, by and among, NCI, Inc. and Lucas J. Narel (incorporated herein by reference from Exhibit 10.5 to registrant’s Annual Report on Form 10-K (File No. 000-51579), as filed with the Commission on March 12, 2012). | |
| 10.6*‡ | Executive Change in Control and Severance Agreement, dated November 1, 2016, by and among, NCI, Inc. and Paul A. Dillahay. | |
| 10.7*‡ | Separation and Transition Agreement, dated as of October 30, 2016, by and between NCI, Inc., on behalf of itself and its subsidiaries and affiliates, and Brian J. Clark. | |
| 10.8*‡ | Separation and Transition Agreement, dated as of November 29, 2016, by and between NCI, Inc., on behalf of itself and its subsidiaries and affiliates, and Marco de Vito. | |
| 10.9 | Waiver and Amendment to Amended and Restated Loan and Security Agreement, dated as of December 31, 2012, by and among NCI, Inc., and NCI Information Systems Incorporated, as Borrowers, the several banks and financial institutions from time to time parties thereto, as Lenders, SunTrust Bank as the Administrative Agent to the Lenders and SunTrust Robinson Humphrey, Inc., as Lead Arranger and Book Manager (incorporated by reference from Exhibit 10.1 to registrant’s Current Report on Form 8-K as filed with the Commission on January 8, 2013). | |
| 10.10 | Second Amendment to Amended and Restated Loan and Security Agreement, dated as of December 19, 2013, by and among NCI and its Subsidiaries, as Borrowers, the several banks and financial institutions from time to time parties thereto, as Lenders, SunTrust Bank as the Administrative Agent to the Lenders and SunTrust Robinson Humphrey, Inc., as Lead Arranger and Book Manager (incorporated by reference from Exhibit 10.1 to registrant’s Current Report on Form 8-K as filed with the Commission on December 23, 2013). | |
| 10.11 | Third Amendment to Amended and Restated Loan and Security Agreement, dated as of December 22, 2014, by and among NCI, Inc., and NCI Information Systems Incorporated, as Borrowers, the several banks and financial institutions from time to time parties thereto, as Lenders, SunTrust Bank as the Administrative Agent to the Lenders as Issuing Bank and Swingline Lender (incorporated by reference from Exhibit 10.1 to registrant’s Current Report on Form 8-K as filed with the Commission on December 29, 2014). | |
| 10.12‡ | Fourth Amendment to Amended and Restated Loan and Security Agreement, dated as of January 31, 2017, by and among NCI, Inc., and its Subsidiaries, as Borrowers, the several banks and financial institutions from time to time parties thereto, as Lenders, SunTrust Bank as the Administrative Agent to the Lenders as Issuing Bank and Swingline Lender | |
| 21.1‡ | Subsidiaries of Registrant | |
| 23.1‡ | Consent of Deloitte & Touche LLP, independent registered public accounting firm | |
| 31.1‡ | Certification of the Chief Executive Officer pursuant to rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. | |
| 31.2‡ | Certification of the Chief Financial Officer pursuant to rule 13a-14(a) of the Securities Exchange Act of 1934, as amended. | |
| 32.1‡ | Certification of the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. | |
41
Table of Contents
| Number |
Description | |
| 101.INS | XBRL Instance Document | |
| 101.SCH | XBRL Extension Schema | |
| 101.CAL | XBRL Extension Calculation Linkbase | |
| 101.DEF | XBRL Extension Definition Linkbase | |
| 101.LAB | XBRL Extension Label Linkbase | |
| 101.PRE | XBRL Extension Presentation Linkbase | |
| ‡ | Included with this filing. |
| * | Management Contract or Compensatory Plan or Arrangement. |
None.
42
Table of Contents
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| NCI, Inc. Registrant | ||||||
| Date: March 31, 2017 | By: | /s/ PAUL A. DILLAHAY | ||||
| Paul A. Dillahay Chief Executive Officer and President | ||||||
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Each person whose signature appears below hereby constitutes and appoints each of Paul A. Dillahay and Lucas J. Narel as his attorney-in-fact and agent, with full power of substitution and resubstitution for him in any and all capacities, to sign, any or all amendments to this report and to file same, with exhibits thereto and other documents in connection therewith, granting unto such attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary in connection with such matters and hereby ratifying and confirming all that such attorney-in-fact and agent or his substitutes may do or cause to be done by virtue hereof.
| Signature |
Title |
Date | ||
| /s/ PAUL A. DILLAHAY Paul A. Dillahay |
Chief Executive Officer, President and Director | March 31, 2017 | ||
| /s/ LUCAS J. NAREL Lucas J. Narel |
Executive Vice President, Chief Financial Officer and Treasurer, Principal Accounting Officer | March 31, 2017 | ||
| /s/ JAMES P. ALLEN James P. Allen |
Director | March 31, 2017 | ||
| /s/ PAUL V. LOMBARDI Paul V. Lombardi |
Director | March 31, 2017 | ||
| /s/ CINDY E. MORAN Cindy E. Moran |
Director | March 31, 2017 | ||
| /s/ CHARLES K. NARANG Charles K. Narang |
Director | March 31, 2017 | ||
| /s/ AUSTIN J. YERKS Austin J. Yerks |
Director | March 31, 2017 | ||
| /s/ DANIEL R. YOUNG Daniel R. Young |
Director | March 31, 2017 | ||
43
Table of Contents
Notes to Consolidated Financial Statements
December 31, 2015
INDEX TO FINANCIAL STATEMENTS
NCI, INC.
F-1
Table of Contents
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of NCI, Inc.
Reston, Virginia
We have audited the accompanying consolidated balance sheets of NCI, Inc. and subsidiaries (the “Company”) as of December 31, 2016 and 2015, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of NCI, Inc. and subsidiaries at December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 22 to the consolidated financial statements, management identified a fraud involving the former controller and the consolidated statements of income for the years ended December 31, 2015 and 2014 have been restated to correct the classification of such losses.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2016, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 31, 2017 expressed an adverse opinion on the Company’s internal control over financial reporting because of material weaknesses.
/s/ DELOITTE & TOUCHE LLP
McLean, Virginia
March 31, 2017
F-2
Table of Contents
NCI, Inc.
Consolidated Statements of Income
(in thousands, except per share amounts)
| Year ended December 31, | ||||||||||||
| 2016 | 2015 (Restated) |
2014 (Restated) |
||||||||||
| Revenue |
$ | 322,410 | $ | 333,095 | $ | 317,028 | ||||||
| Operating expenses: |
||||||||||||
| Cost of revenue |
266,238 | 275,329 | 267,836 | |||||||||
| General and administrative expenses |
27,437 | 25,765 | 25,585 | |||||||||
| Depreciation and amortization |
7,020 | 7,659 | 5,692 | |||||||||
| Acquisition and integration related expenses |
— | 428 | 150 | |||||||||
| Misappropriation loss |
4,907 | 3,238 | 3,284 | |||||||||
|
|
|
|
|
|
|
|||||||
| Total operating expenses |
305,602 | 312,419 | 302,547 | |||||||||
|
|
|
|
|
|
|
|||||||
| Operating income |
16,808 | 20,676 | 14,481 | |||||||||
| Interest expense, net |
1,241 | 865 | 406 | |||||||||
|
|
|
|
|
|
|
|||||||
| Income before income taxes |
15,567 | 19,811 | 14,075 | |||||||||
| Provision for income taxes |
6,086 | 7,639 | 5,607 | |||||||||
|
|
|
|
|
|
|
|||||||
| Net income |
$ | 9,481 | $ | 12,172 | $ | 8,468 | ||||||
|
|
|
|
|
|
|
|||||||
| Earnings per common and common equivalent share: |
||||||||||||
| Basic: |
||||||||||||
| Weighted average shares outstanding |
13,195 | 13,012 | 12,899 | |||||||||
| Net income per share |
$ | 0.72 | $ | 0.94 | $ | 0.66 | ||||||
| Diluted: |
||||||||||||
| Weighted average shares outstanding |
13,834 | 13,705 | 13,516 | |||||||||
| Net income per share |
$ | 0.69 | $ | 0.89 | $ | 0.63 | ||||||
The accompanying notes are an integral
part of these consolidated financial statements
F-3
Table of Contents
NCI, Inc.
(in thousands, except par value)
| As of December 31, | ||||||||
| 2016 | 2015 | |||||||
| Assets: |
||||||||
| Current assets: |
||||||||
| Cash and cash equivalents |
$ | 1,014 | $ | 233 | ||||
| Accounts receivable, net |
51,112 | 60,044 | ||||||
| Prepaid expenses and other current assets |
4,062 | 3,447 | ||||||
|
|
|
|
|
|||||
| Total current assets |
56,188 | 63,724 | ||||||
| Property and equipment, net |
6,332 | 6,698 | ||||||
| Other assets |
1,526 | 1,548 | ||||||
| Deferred tax assets, net |
41,912 | 38,789 | ||||||
| Intangible assets, net |
15,586 | 19,231 | ||||||
| Goodwill |
33,878 | 33,878 | ||||||
|
|
|
|
|
|||||
| Total assets |
$ | 155,422 | $ | 163,868 | ||||
|
|
|
|
|
|||||
| Liabilities and stockholders’ equity: |
||||||||
| Current liabilities: |
||||||||
| Accounts payable |
$ | 9,995 | $ | 19,693 | ||||
| Accrued salaries and benefits |
17,665 | 18,977 | ||||||
| Deferred revenue |
4,571 | 2,217 | ||||||
| Corporate taxes payable |
2,272 | — | ||||||
| Other accrued expenses |
4,034 | 3,843 | ||||||
|
|
|
|
|
|||||
| Total current liabilities |
38,537 | 44,730 | ||||||
| Long-term debt |
— | 10,000 | ||||||
| Other long-term liabilities |
2,545 | 2,578 | ||||||
|
|
|
|
|
|||||
| Total liabilities |
41,082 | 57,308 | ||||||
|
|
|
|
|
|||||
| Stockholders’ equity: |
||||||||
| Class A common stock, $0.019 par value—37,500 shares authorized; 10,002 shares issued and 9,085 shares outstanding as of December 31, 2016, and 9,843 shares issued and 8,961 shares outstanding as of December 31, 2015 |
189 | 187 | ||||||
| Class B common stock, $0.019 par value—12,500 shares authorized; 4,500 shares issued and outstanding as of December 31, 2016 and December 31, 2015 |
86 | 86 | ||||||
| Additional paid-in capital |
76,886 | 76,569 | ||||||
| Treasury stock at cost—917 shares of Class A common stock as of December 31, 2016 and 2015 |
(8,331 | ) | (8,331 | ) | ||||
| Retained earnings |
45,510 | 38,049 | ||||||
|
|
|
|
|
|||||
| Total stockholders’ equity |
114,340 | 106,560 | ||||||
|
|
|
|
|
|||||
| Total liabilities and stockholders’ equity |
$ | 155,422 | $ | 163,868 | ||||
|
|
|
|
|
|||||
The accompanying notes are an integral
part of these consolidated financial statements
F-4
Table of Contents
NCI, Inc.
Consolidated Statements of Changes in Stockholders’ Equity
(in thousands)
| Class A common stock |
Class B common stock |
Additional Paid-in-Capital |
Retained Earnings |
Class A Treasury Stock |
Class A Treasury Stock |
Total Stockholders’ Equity |
||||||||||||||||||||||||||||||
| Shares | Amount | Shares | Amount | Shares | Amount | |||||||||||||||||||||||||||||||
| Balance at January 1, 2014 |
8,226 | $ | 174 | 4,700 | $ | 89 | $ | 70,905 | $ | 18,970 | 917 | $ | (8,331 | ) | $ | 81,807 | ||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Net income |
— | — | — | — | — | 8,468 | — | — | 8,468 | |||||||||||||||||||||||||||
| Stock compensation expense |
— | — | — | — | 3,044 | — | — | — | 3,044 | |||||||||||||||||||||||||||
| Exercise of stock options |
91 | 1 | — | — | 482 | — | — | — | 483 | |||||||||||||||||||||||||||
| Repurchase and cancellation of stock awards |
(11 | ) | — | — | — | (55 | ) | — | — | — | (55 | ) | ||||||||||||||||||||||||
| Tax benefit from stock transactions |
— | — | — | — | 30 | — | — | — | 30 | |||||||||||||||||||||||||||
| Balance at December 31, 2014 |
8,306 | $ | 175 | 4,700 | $ | 89 | $ | 74,406 | $ | 27,438 | 917 | $ | (8,331 | ) | $ | 93,777 | ||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Net income |
— | — | — | — | — | 12,172 | — | — | 12,172 | |||||||||||||||||||||||||||
| Stock compensation expense |
— | — | — | — | 1,307 | — | — | — | 1,307 | |||||||||||||||||||||||||||
| Exercise of stock options |
145 | 3 | — | — | 830 | — | — | — | 833 | |||||||||||||||||||||||||||
| Restricted stock grants, net of repurchase |
310 | 6 | — | — | (59 | ) | — | — | — | (53 | ) | |||||||||||||||||||||||||
| Tax benefit from stock transactions |
— | — | — | — | 85 | — | — | — | 85 | |||||||||||||||||||||||||||
| Cash dividend of $0.12 per common share |
— | — | — | — | — | (1,561 | ) | — | — | (1,561 | ) | |||||||||||||||||||||||||
| Conversion of Class B shares to Class A |
200 | 3 | (200 | ) | (3 | ) | — | — | — | — | — | |||||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Balance at December 31, 2015 |
8,961 | $ | 187 | 4,500 | $ | 86 | $ | 76,569 | $ | 38,049 | 917 | $ | (8,331 | ) | $ | 106,560 | ||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Net income |
— | — | — | — | — | 9,481 | — | — | 9,481 | |||||||||||||||||||||||||||
| Stock compensation expense |
— | — | — | — | 878 | — | — | — | 878 | |||||||||||||||||||||||||||
| Exercise of stock options |
111 | 2 | — | — | 626 | — | — | — | 628 | |||||||||||||||||||||||||||
| Restricted stock grants, net of cancellations |
13 | — | — | — | — | — | — | — | — | |||||||||||||||||||||||||||
| Tax benefit from stock transactions |
— | — | — | — | 1,465 | — | — | — | 1,465 | |||||||||||||||||||||||||||
| Cash dividend of $0.15 per common share |
— | — | — | — | — | (2,020 | ) | — | — | (2,020 | ) | |||||||||||||||||||||||||
| Repurchase of vested stock options |
— | — | — | — | (2,652 | ) | — | — | — | (2,652 | ) | |||||||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
| Balance at December 31, 2016 |
9,085 | $ | 189 | 4,500 | $ | 86 | $ | 76,886 | $ | 45,510 | 917 | $ | (8,331 | ) | $ | 114,340 | ||||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||||||||
The accompanying notes are an integral
part of these consolidated financial statements
F-5
Table of Contents
NCI, Inc.
Consolidated Statements of Cash Flows
(in thousands)
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Cash flows from operating activities: |
||||||||||||
| Net income |
$ | 9,481 | $ | 12,172 | $ | 8,468 | ||||||
| Adjustments to reconcile net income to net cash provided by operating activities: |
||||||||||||
| Depreciation and amortization |
7,020 | 7,659 | 5,692 | |||||||||
| Stock compensation expense |
878 | 1,307 | 3,044 | |||||||||
| Deferred income taxes |
(3,123 | ) | 3,000 | 1,419 | ||||||||
| Changes in operating assets and liabilities: |
||||||||||||
| Accounts receivable, net |
8,932 | (1,803 | ) | 11,135 | ||||||||
| Prepaid expenses and other assets |
(593 | ) | 3,049 | (72 | ) | |||||||
| Accounts payable |
(9,698 | ) | 3,138 | (1,725 | ) | |||||||
| Accrued expenses and other liabilities |
3,473 | (4,084 | ) | (305 | ) | |||||||
|
|
|
|
|
|
|
|||||||
| Net cash provided by operating activities |
16,370 | 24,438 | 27,656 | |||||||||
|
|
|
|
|
|
|
|||||||
| Cash flows from investing activities: |
||||||||||||
| Purchases of property and equipment |
(3,010 | ) | (2,671 | ) | (1,467 | ) | ||||||
| Cash paid for acquisitions, net of cash acquired |
— | (56,657 | ) | — | ||||||||
|
|
|
|
|
|
|
|||||||
| Net cash used in investing activities |
(3,010 | ) | (59,328 | ) | (1,467 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Cash flows from financing activities: |
||||||||||||
| Borrowings under credit facility |
160,604 | 194,739 | 42,496 | |||||||||
| Repayments on credit facility |
(170,604 | ) | (184,739 | ) | (43,496 | ) | ||||||
| Financing costs paid |
— | — | (5 | ) | ||||||||
| Proceeds from exercise of stock options |
628 | 833 | 482 | |||||||||
| Excess tax benefit from stock transactions |
1,465 | 85 | 158 | |||||||||
| Purchase of equity awards |
(2,652 | ) | (53 | ) | (55 | ) | ||||||
| Cash dividend |
(2,020 | ) | (1,561 | ) | — | |||||||
|
|
|
|
|
|
|
|||||||
| Net cash provided by (used) in financing activities |
(12,579 | ) | 9,304 | (420 | ) | |||||||
|
|
|
|
|
|
|
|||||||
| Net change in cash and cash equivalents |
781 | (25,586 | ) | 25,769 | ||||||||
| Cash and cash equivalents, beginning of year |
233 | 25,819 | 50 | |||||||||
|
|
|
|
|
|
|
|||||||
| Cash and cash equivalents, end of year |
$ | 1,014 | $ | 233 | $ | 25,819 | ||||||
|
|
|
|
|
|
|
|||||||
| Supplemental disclosure of cash flow information: |
||||||||||||
| Cash paid during the year for: |
||||||||||||
| Interest |
$ | 341 | $ | 762 | $ | 246 | ||||||
|
|
|
|
|
|
|
|||||||
| Income taxes |
$ | 5,402 | $ | 4,971 | $ | 2,700 | ||||||
|
|
|
|
|
|
|
|||||||
| Supplemental disclosure of non-cash activities: |
||||||||||||
| Leasehold improvements acquired with tenant improvement funds |
$ | 99 | $ | — | $ | 222 | ||||||
The accompanying notes are an integral
part of these consolidated financial statements
F-6
Table of Contents
NCI, Inc.
Notes to Consolidated Financial Statements
December 31, 2016
1. Business Overview
NCI is a leading provider of enterprise solutions and services to U.S. defense, intelligence, health and civilian government agencies. The company has the expertise and proven track record to solve its customers’ most important and complex mission challenges through technology and innovation. NCI’s team of highly skilled professionals focuses on delivering cost-effective solutions and services in the areas of agile development and lean software O&M; big data and data analytics; cybersecurity and information assurance; engineering and logistics; IT infrastructure optimization and service management; and health and program integrity. Headquartered in Reston, Virginia, NCI has approximately 2,000 employees operating at more than 100 locations worldwide. The Company provides these services to U.S. Defense, Intelligence, and Healthcare, and Civilian Government Agencies. Substantially all of the Company’s revenue was derived from contracts with the U.S. Federal Government, directly as a prime contractor or as a subcontractor. The Company primarily conducts business throughout the United States.
2. Summary of Significant Accounting Policies
Basis of Consolidation
The consolidated financial statements include the accounts of the Company’s wholly-owned subsidiaries. All intercompany transactions and accounts have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Revenue Recognition
Substantially all of the Company’s revenue is derived from services and solutions provided to the U.S. Federal Government, primarily by Company employees and, to a lesser extent, subcontractors. The Company generates its revenue from three different types of contractual arrangements: time-and-materials contracts; cost-plus fee contracts; and firm fixed-price contracts.
Revenue for time-and-materials contracts is recognized as services are performed, generally on the basis of contract allowable labor hours worked multiplied by the contract defined billing rates, plus the direct costs and indirect cost burdens associated with materials and other direct expenses used in performance on the contract. Profits on time-and-materials contracts result from the difference between the cost of services performed and the contract-defined billing rates for these services.
Generally, revenue on cost-plus fee contracts is recognized as services are performed, based on the allowable costs incurred in the period, plus any recognizable earned fee. The Company does not recognize award-fee income until the fees are fixed or determinable. Due to such timing, and to fluctuations in the level of revenue, profit as a percentage of revenue on award-fee contracts will fluctuate period to period.
Revenue recognition methods on firm fixed-price contracts will vary depending on the nature of the work and the contract terms. Revenue on firm fixed-price service contracts is recognized as services are performed. Generally, revenue is deferred until all the following have occurred: (1) there is a contract in place, (2) delivery has occurred, (3) the price is fixed or determinable, and (4) collectability is reasonably assured. Revenue on firm fixed-price contracts that require delivery of specific items is recognized based on a price per unit as units are delivered. Revenue for firm fixed-price contracts in which the Company is paid a specific amount to provide services for a stated period of time is recognized ratably over the service period. Profits related to contracts accounted for under this method may fluctuate from period to period, particularly in the early phases of the contract.
Revenue on certain firm fixed-price contracts where the Company is designing, engineering, or manufacturing to the customer’s specifications is recognized on the percentage-of-completion method of accounting, generally using costs incurred in relation to total estimated costs to measure progress toward completion. Profits on firm fixed-price contracts result from the difference between the incurred costs and the revenue earned. Contract accounting requires significant judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Due to the size and nature of many of the Company’s contracts, the estimation of total revenue and cost at completion requires the use of estimates. Contract costs include
F-7
Table of Contents
material, labor, and subcontracting costs, as well as an allocation of allowable indirect costs. Assumptions have to be made regarding the length of time to complete the contract because costs also include expected increases in wages and prices for materials. For contract change orders, claims or similar items, the Company applies judgment in estimating the amounts and assessing the potential for realization. These amounts are only included in contract value when they can be reliably estimated and realization is considered probable. Estimates of total contract revenue and costs are continuously monitored during the term of the contract and are subject to revision as the contract progresses. Anticipated losses on contracts accounted for under the percentage-of-completion method are recognized in the period they are deemed probable and can be reasonably estimated.
Cash and Cash Equivalents
The Company considers cash on deposit and all highly liquid investments with original maturities of three months or less to be cash and cash equivalents.
Fair Value Measurements
The Company’s financial assets and liabilities are measured at fair value which is defined as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants. Valuation techniques are based on observable or unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions.
These two types of inputs have created the following fair value hierarchy:
| • | Level 1 — Quoted prices for identical instruments in active markets. |
| • | Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which significant value drivers are observable. |
| • | Level 3 — Valuations derived from valuation techniques in which significant value drivers are unobservable. |
The carrying values of cash and cash equivalents, contract receivables and accounts payable approximate fair value because of the short-term nature of these instruments. The Company’s nonfinancial assets measured at fair value on a nonrecurring basis include intangible assets and long-lived tangible assets including property and equipment. The valuation methods used to determine fair value require a significant degree of management judgment to determine the key assumptions. As such, the Company classifies nonfinancial assets subject to nonrecurring fair value adjustments at Level 3 measurements. The carrying value of the long-term debt approximates fair value because the interest rate is variable and therefore deemed to reflect a market rate of interest.
Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are recorded at face amount, less an allowance for doubtful accounts. The Company maintains an allowance for doubtful accounts at an amount that it estimates to be sufficient to cover the risk of collecting less than full payment on receivables. On a quarterly basis, the Company reevaluates its receivables, especially receivables that are past due, and reassesses the allowance for doubtful accounts primarily based on specific customer collection issues.
Property and Equipment
Property, equipment, and leasehold improvements are recorded at cost and are depreciated on a straight-line basis over their estimated useful lives, which range from three to seven years for furniture and equipment, over the shorter of the lease term or the useful lives for leasehold improvements, and 30 years for real property.
Long-Lived Assets (Excluding Goodwill)
A review of long-lived assets for impairment is performed when events or changes in circumstances indicate the carrying value of such assets may not be recoverable. If an indicator of impairment is present, the Company compares the estimated undiscounted future cash flows to be generated by the asset to its carrying amount. If the undiscounted future cash flows are less than the carrying amount of the asset, the Company records an impairment loss equal to the excess of the asset’s carrying amount over its fair value. Any write-downs are treated as permanent reductions in the carrying amount of the assets. Based on the analysis performed, the Company determined that there were no such impairments, nor indicators of impairments, for such assets during 2016, 2015 or 2014.
F-8
Table of Contents
Goodwill and Intangible Assets
Goodwill represents the excess of cost over fair value of net tangible and identifiable intangible assets of acquired companies. Goodwill is reviewed for impairment annually or when events or changes in circumstances indicate the carrying value may not be fully recoverable. NCI performs its annual goodwill impairment analysis on October 1 of each year. The first step is used to identify any potential impairment by comparing the fair value of the Company with its carrying amount of equity. If the first step results in the fair value of the reporting unit being less than the carrying amount of equity, a second step in necessary. The second step is used to measure the amount of impairment loss, if any, by comparing the implied fair value of goodwill with the carrying amount of goodwill. If goodwill becomes impaired, the Company would record a charge to earnings in the financial statements during the period in which any impairment of goodwill is determined.
Intangible assets consist of acquisition-related contracts and customer relationships as well as non-compete agreements. Contract and customer relationships are amortized over the expected backlog life based on projected cash flows, which are proportionate to acquired backlog, or generally between three to 11 years. Non-compete agreements are amortized over their contractual life, which is between three to five years.
There was no impairment of goodwill in 2016 or 2015.
Common Stock
Holders of Class A common stock are entitled to one vote for each share held of record, and holders of Class B common stock are entitled to 10 votes for each share held of record, except with respect to any “going private transaction,” as to which each share of Class A common stock and Class B common stock are both entitled to one vote per share. The Class A common stock and the Class B common stock vote together as a single class on all matters submitted to a vote of stockholders, including the election of directors, except as required by law. Holders of the Company’s common stock do not have cumulative voting rights in the election of directors. Each share of Class B common stock is convertible into one share of Class A common stock at any time at the option of the Class B stockholder, and in certain other circumstances.
Holders of common stock are entitled to receive, when and if declared by the Board of Directors from time to time, such dividends and other distributions in cash, stock or property from the Company’s assets or funds legally available for such purposes. Each share of Class A common stock and Class B common stock is equal with respect to dividends and other distributions in cash, stock or property, except that in the case of stock dividends—when authorized by the Board of Directors and allowable under terms of the company’s credit facility only shares of Class A common stock will be distributed with respect to the Class A common stock and only shares of Class B common stock will be distributed with respect to Class B common stock.
Segment Information
Management has concluded that the Company operates in one segment based upon the information used by the Chief Operating Decision Maker in evaluating the performance of its business and allocating resources and capital.
Income Taxes
We account for income taxes in accordance with ASC 740, Income Taxes. Under this method, deferred income taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of enacted tax laws. Deferred income tax provisions and benefits are based on changes to the assets or liabilities from year-to-year. In providing for deferred taxes, we consider tax regulations of the jurisdictions in which we operate, estimates of future taxable income and available tax planning strategies. If tax regulations, operating results or the ability to implement tax-planning strategies vary, adjustments to the carrying value of deferred tax assets and liabilities may be required. Valuation allowances are recorded related to deferred tax assets based on the “more likely than not” criteria. We periodically assess our tax filing exposures related to periods that are open to examination. Based on the latest available information, we evaluate tax positions to determine whether the position will more likely than not be sustained upon examination by the applicable tax authorities. The Company recognizes liabilities for uncertain tax positions on open tax years 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 at the Company’s best estimate of the taxes ultimately expected to be paid. If we determine that the tax position is more likely than not to be sustained, we record the largest amount of benefit that is more likely than not to be realized when the tax position is settled. If we cannot reach that determination, no benefit is recorded. We record interest and penalties related to income taxes as Interest Expense and General and Administrative Expenses in the Consolidated Statement of Income, respectively.
F-9
Table of Contents
3. Recently Issued Accounting Pronouncements
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which will replace most of the current revenue recognition guidance under U.S. GAAP when it becomes effective for annual periods beginning after December 15, 2017, and interim periods therein. While this new accounting standard will not affect the Company until the Company’s 2018 fiscal year, it does require either a full retrospective approach reflecting the application of the standard in each prior reporting period, or a retrospective approach with the cumulative effect of initially adopting the ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures).
The main principle of ASU 2014-09 is that revenue should be recognized when contracted goods or services are transferred to customers in an amount that reflects the consideration that the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 defines a five-step process to achieve this new principle which will require entities to apply significantly more management judgment and may require the use of more estimates than are required under existing U.S. GAAP. NCI is currently evaluating the impact of the pending adoption of ASU 2014-09 on the Company’s consolidated financial statements and has not yet determined the method by which NCI will adopt the standard in 2018.
In February 2016, the FASB issued ASU 2016-02, which requires the recognition of right-to-use assets and lease liabilities arising from capital leases and operating leases in the statement of comprehensive income and the statement of financial position, respectively. The Company will adopt the standard effective January 1, 2019 and does not anticipate that this new accounting guidance will have a material impact on its consolidated statement of operations. The Company has not yet completed its evaluation of the impact on the consolidated balance sheet. The actual impact will depend on the Company’s lease portfolio at the time of adoption.
In March 2016, the FASB issued ASU 2016-09, which simplifies several aspects of the accounting for share-based payments, including immediate recognition of all excess tax benefits and deficiencies in the income statement, changing the threshold to qualify for equity classification up to the employees’ maximum statutory tax rates, allowing an entity-wide accounting policy election to either estimate the number of awards that are expected to vest or account for forfeitures as they occur, and clarifying the classification on the statement of cash flows for the excess tax benefit and employee taxes paid when an employer withholds shares for tax- withholding purposes. The Company is evaluating the full effect that ASU 2016-09 will have on its consolidated financial statements and will adopt the standard effective January 1, 2017.
In August 2016, the FASB issued ASU 2016-15, which provides updated guidance on eight specific cash flow issues and how they should be presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other Topics. The eight specific cash flow issues addressed are being evaluated by the Company as to the likelihood of those cash flow transactions occurring and potential corresponding effect on the Company’s statement of cash flows. The Company will adopt the standard effective January 1, 2018.
In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350) that simplifies the subsequent measurement of goodwill by eliminating Step 2 from the current goodwill impairment test in the event that there is evidence of an impairment based on qualitative or quantitative assessments. ASU 2017-04 does not change how the goodwill impairment is
F-10
Table of Contents
identified, and the Company will continue to perform a quantitative assessment annually to determine whether the two-step impairment test is required. Under the current accounting standards, the impairment loss to recognize under Step 2 of the impairment test requires the Company to calculate the implied fair value of goodwill by assigning fair value to the reporting unit’s assets and liabilities as if the reporting unit has been acquired in a business combination, and subtracting the implied goodwill from the carrying amount of the goodwill. The new standard would require the Company to determine the fair value of the reporting unit and subtracting it from its carrying amount. ASU 2017-04 is effective for the Company for fiscal years after December 15, 2019, and early adoption is permitted. ASU 2017-04 is required to be adopted prospectively, and the adoption is effective for annual goodwill impairment tests performed in the year of adoption. The Company is currently evaluating the impact of the adoption of ASU 2017-04 on the consolidated financial statements.
F-11
Table of Contents
4. Earnings Per Share
Basic earnings per share exclude dilution and are computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted earnings per share include the incremental effect of stock options calculated using the treasury stock method. Shares that are anti-dilutive are not included in the computation of diluted earnings per share. NCI has both Class A and Class B shares and both share the same rights and preferences and thus the two-class method does not result in a different outcome and is therefore not presented. For the years ended December 31, 2016, 2015 and 2014, approximately 55,000, 17,000 and 44,000 shares, respectively, were not included in the computation of diluted earnings per share, because to do so would have been anti-dilutive. The following details the historical computation of basic and diluted earnings per common share (Class A and Class B) for the years ended December 31, 2016, 2015 and 2014:
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| (in thousands, except per share data) | ||||||||||||
| Net income |
$ | 9,481 | $ | 12,172 | $ | 8,468 | ||||||
|
|
|
|
|
|
|
|||||||
| Weighted average number of basic shares outstanding during the year |
13,195 | 13,012 | 12,899 | |||||||||
| Dilutive effect of stock options after application of treasury stock method |
639 | 693 | 617 | |||||||||
|
|
|
|
|
|
|
|||||||
| Weighted average number of diluted shares outstanding during the year |
13,834 | 13,705 | 13,516 | |||||||||
|
|
|
|
|
|
|
|||||||
| Basic earnings per share |
$ | 0.72 | $ | 0.94 | $ | 0.66 | ||||||
| Diluted earnings per share |
$ | 0.69 | $ | 0.89 | $ | 0.63 | ||||||
5. Major Customers
The Company earned substantially all of its revenue from the U.S. Federal Government for each of the years ended December 31, 2016, 2015 and 2014. During 2016, 2015 and 2014, the Company’s PEO Soldier contract accounted for revenue in the amounts of $52.2 million, $32.4 million and $36.5 million, respectively. The Company’s PEO Soldier contract was a cost-plus fee contract and was originally awarded in 2012 for a three year term, which expired in September 2015. The Company’s current PEO Soldier contract is a cost-plus fee contract that consists of a transition period, a base period and four option periods for a total term of five years, which commenced on October 1, 2015. NCI’s Cyber Network Operations and Security Support (CNOSS) program, a cost-plus-fixed-fee, single-award indefinite delivery, indefinite quantity (IDIQ) contract consisting of a 12-month base period with two one-year option periods and one six-month option period. The contract is valued at $125 million and commenced in October 2014. NCI’s CNOSS program accounted for 11.5% of revenue, in 2016 and 7.3% of revenue in 2015. Revenue by customer for each of the three years ended December 31 was as follows:
| Year ended December 31, | ||||||||||||||||||||||||
| 2016 | 2015 | 2014 | ||||||||||||||||||||||
| (in thousands) | ||||||||||||||||||||||||
| Defense and Intelligence Agencies |
$ | 202,939 | 63 | % | $ | 201,194 | 60 | % | $ | 237,194 | 75 | % | ||||||||||||
| Federal Civilian Agencies |
$ | 119,471 | 37 | % | $ | 131,901 | 40 | % | $ | 79,834 | 25 | % | ||||||||||||
F-12
Table of Contents
6. Accounts Receivable (in thousands)
Accounts receivable consist of billed and unbilled amounts at the end of each year:
| As of December 31, | ||||||||
| 2016 | 2015 | |||||||
| Billed receivables |
$ | 19,367 | $ | 23,621 | ||||
| Unbilled receivables: |
||||||||
| Amounts billable at end of year |
25,484 | 27,185 | ||||||
| Other |
7,003 | 9,980 | ||||||
|
|
|
|
|
|||||
| Total unbilled receivables |
32,487 | 37,165 | ||||||
|
|
|
|
|
|||||
| Total accounts receivable |
51,854 | 60,786 | ||||||
| Less: allowance for doubtful accounts |
742 | 742 | ||||||
|
|
|
|
|
|||||
| Total accounts receivable, net |
$ | 51,112 | $ | 60,044 | ||||
|
|
|
|
|
|||||
Other unbilled receivables primarily consist of amounts that will be billed upon milestone completions and other accrued amounts that cannot be billed as of the end of the period. All unbilled receivables are expected to be billed and collected within the next year.
The following table details the Allowance for Doubtful Accounts at the end of each year:
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Balance at beginning of year |
$ | 742 | $ | 742 | $ | 788 | ||||||
| Charged to expense |
— | — | — | |||||||||
| Deductions |
— | — | (46 | ) | ||||||||
|
|
|
|
|
|
|
|||||||
| Balance at end of year |
$ | 742 | $ | 742 | $ | 742 | ||||||
|
|
|
|
|
|
|
|||||||
7. Property and Equipment (in thousands)
The following table details property and equipment at the end of each year:
| As of December 31, | ||||||||
| 2016 | 2015 | |||||||
| Property and equipment |
||||||||
| Furniture and equipment |
$ | 21,799 | $ | 26,573 | ||||
| Leasehold improvements |
7,450 | 9,323 | ||||||
| Real property |
549 | 549 | ||||||
|
|
|
|
|
|||||
| 29,798 | 36,445 | |||||||
| Less: Accumulated depreciation and amortization |
23,466 | 29,747 | ||||||
|
|
|
|
|
|||||
| Property and equipment, net |
$ | 6,332 | $ | 6,698 | ||||
|
|
|
|
|
|||||
Depreciation expense for the years ended December 31, 2016, 2015 and 2014 was $3.4 million, $3.5 million and $4.1 million, respectively.
F-13
Table of Contents
8. Intangible Assets (in thousands)
The following table details intangible assets at the end of each year:
| As of | ||||||||
| December 31, 2016 |
December 31, 2015 |
|||||||
| Contract and customer relationships |
$ | 33,284 | $ | 39,594 | ||||
| Developed software |
1,113 | 1,113 | ||||||
| Less: Accumulated amortization |
(18,811 | ) | (21,476 | ) | ||||
|
|
|
|
|
|||||
| Intangible assets, net |
$ | 15,586 | $ | 19,231 | ||||
|
|
|
|
|
|||||
Amortization expense of intangible assets for the years ended December 31, 2016, 2015 and 2014 was $3.6 million, $4.2 million and $1.6 million, respectively. The weighted average amortization period of the acquired customer relationships as of December 31, 2016, was approximately eight years. The weighted average amortization period of the acquired developed software as of December 31, 2016, was approximately three years. Contract and customer relationships are amortized over the expected backlog life based on projected cash flows, which are proportionate to acquired backlog, or generally between three to 11 years. Non-compete agreements are amortized over their contractual life, which is generally between three to five years. Future amortization expense related to intangible assets is expected to be as follows:
| For the year ending December 31, |
||||
| 2017 |
$ | 3,632 | ||
| 2018 |
3,150 | |||
| 2019 |
3,049 | |||
| 2020 |
3,027 | |||
| 2021 |
2,728 | |||
| Thereafter |
— | |||
|
|
|
|||
| $ | 15,586 | |||
9. Goodwill
As of December 31, 2016, goodwill accounted for approximately $33.9 million, or approximately 22%, of our recorded total assets.
The activity and balance of our goodwill for the years ended December 31, 2016 and 2015 are as follows:
| Goodwill (in thousands) |
||||
| Balance as of January 1, 2015 |
$ | — | ||
| Goodwill acquired |
33,878 | |||
|
|
|
|||
| Balance as of December 31, 2015 |
33,878 | |||
|
|
|
|||
| Goodwill acquired |
— | |||
|
|
|
|||
| Balance as of December 31, 2016 |
$ | 33,878 | ||
|
|
|
|||
The goodwill amounts acquired are from the acquisition of Computech in January 2015.
10. Other Accrued Expenses (in thousands)
Other accrued expenses consist of the following at the end of each year:
| As of December 31, | ||||||||
| 2016 | 2015 | |||||||
| Accrued health claims |
$ | 1,352 | $ | 1,331 | ||||
| Deferred rent, current |
776 | 729 | ||||||
| Restructuring charge, current |
32 | 135 | ||||||
| Other accrued expenses |
1,874 | 1,648 | ||||||
|
|
|
|
|
|||||
| Total other accrued expenses |
$ | 4,034 | $ | 3,843 | ||||
|
|
|
|
|
|||||
F-14
Table of Contents
11. Leases
The Company leases office space and equipment under operating leases that expire on various dates through January 31, 2021. Several of the leases contain escalation clauses ranging from 2.5% to 5.0% per year, which are reflected in the amounts below.
Minimum lease payments under the Company’s non-cancelable operating leases are as follows:
| Operating leases |
||||
| (in thousands) | ||||
| For the year ending December 31, |
||||
| 2017 |
$ | 6,323 | ||
| 2018 |
3,628 | |||
| 2019 |
2,081 | |||
| 2020 |
977 | |||
| 2021 |
82 | |||
| Thereafter |
— | |||
|
|
|
|||
| Total minimum lease payments |
$ | 13,091 | ||
|
|
|
|||
The Company incurred rent expense including amortization of deferred rent expense, under operating leases of $5.6 million, $5.5 million, and $5.4 million for the years ended December 31, 2016, 2015, and 2014, respectively.
12. Debt
On January 31, 2017, the Company entered into the Fourth Amendment (the “Amendment”) to the Amended and Restated Loan and Security Agreement, dated December 13, 2010, as amended, by and among the Company and its subsidiaries, SunTrust Bank, which acted as administrative agent for the lenders, the lenders named therein and the other parties thereto (the “Credit Agreement”). The Amendment modifies certain provisions of the Credit Agreement to, among other things:
| • | decrease the Company’s borrowing capacity under the revolving line of credit from $80.0 million to $50.0 million; |
| • | extend the commitment termination date from January 31, 2017 to May 31, 2017; |
| • | amend the definition of “Required Lenders” to include all lenders which means, among other things, that amendments to and waivers of the terms of the Credit Agreement, as amended, will require the consent and approval of all lenders; and |
| • | include additional restrictions with respect to certain acquisitions and restricted payments, including certain acquisitions, dividends, and repurchase or redemption of our capital stock. |
The outstanding borrowings are collateralized by a security interest in substantially all the Company’s assets. The lenders also require a direct assignment of all contracts at the lenders’ discretion. The outstanding balance under the Credit Agreement accrues interest based on one-month LIBOR plus an applicable margin, ranging from 210 to 310 basis points, based on the ratio of our outstanding senior funded debt to Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA) as defined in the credit facility agreement.
Our Credit Agreement (i) restricts our ability to repurchase or redeem our capital stock, or merge or consolidate with another entity; (ii) limits our ability to borrow additional funds or to obtain other financing in the future for working capital, capital expenditures, acquisitions, investments and general corporate purposes; and (iii) limits our ability to dispose of our assets, to create liens on our assets, to extend credit or to issue dividends to our stockholders. For a discussion of share repurchases, see Note 14—Stock Repurchase.
For the years ending December 31, 2016, 2015, and 2014, the Company had a weighted average outstanding loan balance of $11.6 million, $22.4 million, and $1.3 million, respectively, and a weighted average borrowing rate of 2.6%, 2.3%, and 2.3%, respectively.
F-15
Table of Contents
As of December 31, 2016, there was no outstanding balance under the Credit Agreement. Interest accrues at a rate of LIBOR plus 210 basis points, or 2.7%, on future borrowings. As of December 31, 2015, the outstanding balance under the Credit Agreement was $10.0 million and interest would have accrued at a rate of LIBOR plus 210 basis points, or 2.3%. As of December 31, 2016, and 2015, the Company was in compliance with all of its financial loan covenants.
13. Computech Acquisition
On January 1, 2015, the Company completed its purchase of 100% of the outstanding stock of Computech, Inc. (“Computech”), a leader in agile and lean application software development and IT operations and maintenance, for approximately $56.7 million, net of cash acquired.
The acquisition has been accounted for under the acquisition method of accounting which requires the total purchase consideration to be allocated to the assets acquired and liabilities assumed based on estimates of fair value. The excess of the purchase consideration over the amounts assigned to tangible or intangible assets acquired and liabilities assumed is recognized as goodwill. Total acquisition and integration related costs expensed through December 31, 2015 were approximately $0.4 million.
The following unaudited pro forma results are prepared for comparative purposes only and do not necessarily reflect the results that would have occurred had the acquisition occurred at the beginning of the year presented or the results which may occur in the future. The following unaudited pro forma results of operations assume the Computech acquisition had occurred on January 1, 2014. Amortization of purchased intangibles and acquisition and integration related costs for the acquisition of Computech are included in all periods presented:
| Pro Forma Financial Information Twelve months ended December 31, |
||||||||
| 2015 | 2014 | |||||||
| Revenue |
$ | 333,095 | $ | 360,673 | ||||
| Net income |
$ | 12,172 | $ | 14,041 | ||||
| Basic earnings per share |
$ | 0.94 | $ | 1.09 | ||||
| Diluted earnings per share |
$ | 0.89 | $ | 1.04 | ||||
Allocation of Purchase Price
NCI has completed the valuation of the assets acquired and liabilities assumed of Computech. The fair values assigned to the intangible assets acquired were based on preliminary estimates, assumptions, and other information compiled by management, including independent valuations that utilized established valuation techniques. Based on the Company’s valuation, the total consideration of approximately $56.7 million, net of $3.3 million of cash acquired, has been allocated to assets acquired (including identifiable intangible assets and goodwill) and liabilities assumed, as follows:
| Accounts receivable and other assets |
8,407 | |||
| Goodwill |
33,878 | |||
| Definite-life intangible assets |
19,720 | |||
| Accrued salary and benefits |
(4,112 | ) | ||
| Other accrued expenses |
(1,236 | ) | ||
|
|
|
|||
| $ | 56,657 | |||
|
|
|
The definite life intangibles recognized in the allocation of the Computech purchase price consists of $18.6 million in contracts and customer relationships and $1.1 million in developed software. The fair value of the definite-lived intangible asset for contracts and customer relationships is based on existing customer contracts and anticipated follow-on contracts with existing customers and will be amortized on a straight-line basis over its expected life of seven years. The fair value of the definite-lived intangible asset for developed software will be amortized on a straight-line basis over its expected useful life of three years.
All goodwill and intangible asset amortization related to the acquisition of Computech is expected to be deductible for income tax purposes.
14. Stock Repurchase
NCI’s Board of Directors authorized management to repurchase up to $25.0 million of our Class A common stock pursuant to a stock repurchase program. Shares may be repurchased pursuant to open market purchases, privately negotiated transactions, or block transactions. Under the terms of the Credit Agreement dated January 31, 2017, any further repurchase of the company’s Class A common stock requires the consent and approval of all lenders.
During 2016, 2015 and 2014, the Company did not repurchase any shares. At December 31, 2016, we had $16.7 million remaining under the Board of Directors’ authorization for share repurchases.
15. Performance Incentive Plan
The Board of Directors of the Company has adopted The Amended and Restated 2005 Performance Incentive Plan (the Plan), which has been approved by the Company’s stockholders. As of December 31, 2016, the Plan has reserved 4,300,000 shares of Class A common stock for issuance, which increases annually by 100,000 shares. The Plan provides for the grant of incentive stock options and non-qualified stock options, and the grant or sale of restricted shares of common stock to the Company’s directors, employees, and consultants. The Compensation Committee of the Company administers the Plan.
F-16
Table of Contents
| As of December 31, 2016 |
||||
| (in thousands) | ||||
| Shares reserved under the plan |
4,300 | |||
| Shares vested and options exercised |
(1,868 | ) | ||
| Restricted shares and options outstanding |
(1,613 | ) | ||
|
|
|
|||
| Shares available for future grants |
819 | |||
|
|
|
|||
16. Share-Based Payments
Compensation expense for all stock-based awards is measured at fair value on the date of grant and recognition of compensation expense is recorded over the requisite service period for awards expected to vest. The Company determines the fair value of our stock options using the Black-Scholes-Merton valuation model or other models that incorporate into the valuation the possibility that market conditions may not be satisfied. The application of the Black-Scholes-Merton model to the valuation of options requires the use of input assumptions, including expected volatility, expected term, expected dividend yield, and expected risk-free interest rate. During 2015, approximately 335,000 of the options granted in June of 2013 vested on an accelerated vesting schedule after the Company’s stock price reached the final acceleration milestone of a continuous 30-day average stock price of $12.00 per share. This accelerated vesting added a nominal amount in additional stock compensation costs to general and administrative expenses and cost of revenue.
Assumptions Used in Fair Value determination
The following weighted-average assumptions were used for option grants made during the years ended December 31, 2016, 2015 and 2014:
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Expected Volatility |
53.0 | % | 56.7 | % | 56.3 | % | ||||||
| Expected Term (in years) |
5.0 | 4.5 | 4.6 | |||||||||
| Risk-free Interest Rate |
1.3 | % | 1.5 | % | 1.7 | % | ||||||
| Dividend Yield |
1.3 | % | 0.0 | % | 0.0 | % | ||||||
| • | Expected Volatility. The expected volatility of the Company’s shares was estimated based upon the historical volatility of the Company’s share price. |
| • | Expected Term. Because the Company does not have significant historical data on employee exercise behavior, it uses the “Simplified Method” as defined under SAB Topic 14 to calculate the expected term. The simplified method is calculated by averaging the vesting period and contractual term of the option. |
| • | Risk-free Interest Rate. The Company bases the risk-free interest rate used in the Black-Scholes-Merton valuation method on the implied yield available on a U.S. Treasury note with a term equal to the expected term of the underlying grants. |
| • | Dividend Yield. The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. |
F-17
Table of Contents
The following table summarizes stock option activity for the period January 1, 2014 through December 31, 2016:
| Options | ||||||||
| Number of Options (in thousands) |
Weighted- Average Exercise Price per Share |
|||||||
| Outstanding at January 1, 2014 |
1,785 | $ | 5.43 | |||||
| Granted |
60 | 9.33 | ||||||
| Forfeited/cancelled |
(87 | ) | 7.83 | |||||
| Exercised |
(91 | ) | 5.04 | |||||
|
|
|
|
|
|||||
| Outstanding at January 1, 2015 |
1,667 | $ | 5.44 | |||||
| Granted |
85 | 10.41 | ||||||
| Forfeited/cancelled |
(60 | ) | 7.65 | |||||
| Exercised |
(145 | ) | 5.75 | |||||
|
|
|
|
|
|||||
| Outstanding at January 1, 2016 |
1,548 | $ | 5.60 | |||||
| Granted |
275 | 11.44 | ||||||
| Forfeited/cancelled |
(428 | ) | 5.59 | |||||
| Exercised |
(111 | ) | 5.67 | |||||
|
|
|
|
|
|||||
| Outstanding at December 31, 2016 |
1,285 | 6.84 | ||||||
|
|
|
|
|
|||||
| Vested or expected to vest at December 31, 2016 |
1,245 | 6.71 | ||||||
|
|
|
|
|
|||||
| Exercisable at December 31, 2016 |
968 | 5.40 | ||||||
|
|
|
|
|
|||||
The following table summarizes stock option vesting, non-vested options and restricted stock for the period January 1, 2014 through December 31, 2016:
| Options | Restricted Stock | |||||||||||||||
| Number of Options (in thousands) |
Weighted- Average Fair Value |
Number of Restricted Shares (in thousands) |
Weighted- Average Fair Value |
|||||||||||||
| Non-vested January 1, 2014 |
1,566 | $ | 2.45 | 84 | $ | 16.58 | ||||||||||
| Granted |
60 | 4.44 | — | — | ||||||||||||
| Vested |
(859 | ) | 2.24 | (29 | ) | 17.46 | ||||||||||
| Forfeited |
(87 | ) | 7.83 | (11 | ) | 16.61 | ||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Non-vested December 31, 2014 |
680 | $ | 2.72 | 44 | $ | 15.97 | ||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Vested December 31, 2014 |
987 | $ | 2.40 | |||||||||||||
|
|
|
|
|
|||||||||||||
| Granted |
85 | 4.66 | 315 | 13.30 | ||||||||||||
| Vested |
(503 | ) | 2.49 | (33 | ) | 17.01 | ||||||||||
| Forfeited |
(49 | ) | 3.23 | (5 | ) | 20.24 | ||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Non-vested December 31, 2015 |
213 | $ | 3.90 | 321 | $ | 13.19 | ||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Vested December 31, 2015 |
1,334 | $ | 2.41 | |||||||||||||
|
|
|
|
|
|||||||||||||
| Granted |
275 | 4.76 | 135 | 11.65 | ||||||||||||
| Vested |
(135 | ) | 3.50 | (6 | ) | 7.28 | ||||||||||
| Forfeited |
(390 | ) | 2.60 | (122 | ) | 13.34 | ||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Non-vested December 31, 2016 |
317 | $ | 4.75 | 329 | $ | 12.61 | ||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Vested December 31, 2016 |
968 | $ | 2.53 | |||||||||||||
|
|
|
|
|
|||||||||||||
F-18
Table of Contents
The following table summarizes stock options outstanding at December 31, 2016:
| Range of exercise prices |
Number of Options |
Weighted- Average Exercise Price |
Intrinsic Value Outstanding Options |
Weighted-Average Remaining Contractual Life |
Options exercisable |
Intrinsic Value Vested Options |
||||||||||||||||||
| (in thousands) | (in thousands) | (in years) | (in thousands) | (in thousands) | ||||||||||||||||||||
| $1.00 – $6.99 | 695 | $ | 4.46 | $ | 6,594 | 3.3 | 695 | $ | 6,594 | |||||||||||||||
| $7.00 – $12.99 | 590 | 9.65 | 2,536 | 4.0 | 273 | 1,680 | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| 1,285 | $ | 6.84 | $ | 9,130 | 4.0 | 968 | $ | 8,274 | ||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
Stock options and restricted stock granted generally vest over a period of three to five years from the date of grant in accordance with the individual stock option agreement. The maximum contractual term of stock options is seven years.
The following table summarizes stock compensation for the three years ended December 31, 2016, 2015 and 2014:
| Year Ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| (in thousands) | ||||||||||||
| Cost of revenue |
$ | 114 | $ | 239 | $ | 667 | ||||||
| General and administrative |
764 | 1,068 | 2,377 | |||||||||
|
|
|
|
|
|
|
|||||||
| $ | 878 | $ | 1,307 | $ | 3,044 | |||||||
|
|
|
|
|
|
|
|||||||
As of December 31, 2016, there was $3.5 million of total unrecognized compensation cost of unvested stock compensation arrangements. This cost is expected to be fully amortized over the next five years, with $1.2 million, $1.0 million, $0.6 million, $0.5 million and $0.2 million amortized during 2017, 2018, 2019, 2020 and 2021, respectively. These future costs include an estimated forfeiture rate. Our stock compensation costs may differ based on actual experience. The cost of stock compensation is included in the Company’s Consolidated Statements of Income before, or in conjunction with, the vesting of options.
The following table summarizes cash proceeds received for stock options exercised, intrinsic value of vested options, and income tax benefits realized for the three years ending December 31, 2016, 2015 and 2014:
| Year Ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| (in thousands) | ||||||||||||
| Cash proceeds received |
$ | 628 | $ | 833 | $ | 482 | ||||||
| Intrinsic value |
8,273 | 11,391 | 4,754 | |||||||||
| Income tax benefits realized |
1,465 | 85 | 32 | |||||||||
On October 30, 2016, in connection with his resignation from the Company, the former CEO, Brian Clark, agreed to forfeit 390,000 vested stock options in exchange for $2.7 million. On November 29, 2016, in connection with his separation from the Company, the former COO, Marco de Vito, agreed to forfeit 272,000 vested stock options in exchange for $2.1 million upon his retirement in January 2017.
17. Provision for Income Taxes
Significant components of the provision for income taxes for the three years ended December 31, 2016, 2015, and 2014 are as follows:
| Year Ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| (in thousands) | ||||||||||||
| Current |
||||||||||||
| Federal |
$ | 8,566 | $ | 3,651 | $ | 3,380 | ||||||
| State and Local |
673 | 878 | 780 | |||||||||
|
|
|
|
|
|
|
|||||||
| Total Current |
9,239 | 4,529 | 4,160 | |||||||||
| Deferred |
||||||||||||
| Federal |
(2,308 | ) | 3,041 | 941 | ||||||||
| State and Local |
(845 | ) | 69 | 506 | ||||||||
|
|
|
|
|
|
|
|||||||
| Total Deferred |
(3,153 | ) | 3,110 | 1,447 | ||||||||
|
|
|
|
|
|
|
|||||||
| Total Income Tax Provision |
$ | 6,086 | $ | 7,639 | $ | 5,607 | ||||||
|
|
|
|
|
|
|
|||||||
F-19
Table of Contents
The differences between the expense (benefit) from income taxes at the statutory U.S. Federal income tax rate of 34% and those reported in the Statements of Income are as follows:
| Year ended December 31, | ||||||||||||
| 2016 | 2015 | 2014 | ||||||||||
| Federal income tax at statutory rates |
34.0 | % | 34.0 | % | 34.0 | % | ||||||
| State income taxes, net of Federal benefit |
4.3 | 4.6 | 5.6 | |||||||||
| Other |
0.8 | 0.0 | 0.2 | |||||||||
|
|
|
|
|
|
|
|||||||
| Total income tax expense |
39.1 | % | 38.6 | % | 39.8 | % | ||||||
|
|
|
|
|
|
|
|||||||
Other differences include, among other things, the nondeductible portion of meals and entertainment.
Deferred income taxes arise from temporary differences in the recognition of income and expense for income tax purposes and were computed using the liability method reflecting the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes.
Components of the Company’s deferred tax assets and liabilities are as follows as of December 31:
| 2016 | 2015 | |||||||
| (in thousands) | ||||||||
| Deferred tax assets |
||||||||
| Accrued vacation and compensation |
$ | 2,531 | $ | 2,651 | ||||
| Intangible assets excluding goodwill |
4,779 | 4,441 | ||||||
| Stock compensation |
1,111 | 1,622 | ||||||
| Restructuring charge and other accrued liabilities |
1,780 | 1,625 | ||||||
| Allowance for doubtful accounts |
289 | 286 | ||||||
| Deferred rent |
572 | 820 | ||||||
| Goodwill |
23,390 | 27,848 | ||||||
| Property and equipment |
100 | — | ||||||
| Misappropriation loss |
7,345 | — | ||||||
| Interest for uncertain tax position |
246 | — | ||||||
|
|
|
|
|
|||||
| Total deferred tax assets |
42,143 | 39,293 | ||||||
|
|
|
|
|
|||||
| Less: valuation allowance |
(231 | ) | (218 | ) | ||||
|
|
|
|
|
|||||
| Total net deferred tax assets |
41,912 | 39,075 | ||||||
|
|
|
|
|
|||||
| Deferred tax liabilities |
||||||||
| Property and equipment |
— | (286 | ) | |||||
|
|
|
|
|
|||||
| Total deferred tax liabilities |
— | (286 | ) | |||||
|
|
|
|
|
|||||
| Net deferred tax asset |
$ | 41,912 | $ | 38,789 | ||||
|
|
|
|
|
|||||
Balances as of December 31, 2016 and 2015, reflect the impact of the adoption of ASU 2015-17, Balance Sheet Classification of Deferred Taxes, in the Company’s first fiscal quarter ended March 31, 2016 related to balance sheet classification of deferred taxes.
Deferred tax assets are evaluated to determine if the future tax deductions will be realizable. Future realization of tax benefits ultimately depends on the existence of sufficient taxable income within the appropriate period that is available under the tax law. All available evidence was considered to determine if a valuation allowance for deferred tax assets was needed. Based primarily on recent earnings history and actual taxable income, as well as projections of future taxable income, management believes there is sufficient positive evidence to conclude that it is more likely than not that substantially all of the deferred tax assets are fully realizable and no valuation allowance is necessary for most deferred tax assets.
As of December 31, 2015, the Company’s analysis of uncertain tax positions determined that the Company had no uncertain tax positions and as such, no liability has been recorded as of December 31, 2015 and 2014. In 2016, the Company recognized a cumulative impact for unrecognized tax benefits in the amount of $5.4 million for the tax years ended December 31, 2010 through 2015. It is reasonably possible that within the next twelve months we will resolve the matters in uncertain tax benefits.
F-20
Table of Contents
As of December 31, 2016, the Company accrued interest expense related to uncertain tax positions totaling $0.6 million, and was recorded as Interest Expense in the Consolidated Statement of Income.
| As of December 31, | ||||||||
| 2016 | 2015 | |||||||
| (in thousands) | ||||||||
| Beginning balance |
$ | — | $ | — | ||||
| Additions for current year tax positions |
— | — | ||||||
| Additions for tax positions for prior years |
5,472 | — | ||||||
| Reductions for tax positions of prior years |
— | — | ||||||
| Effects of foreign currency translation settlements |
— | — | ||||||
| Lapse of statute of limitations |
— | — | ||||||
|
|
|
|
|
|||||
| Ending Balance |
$ | 5,472 | $ | — | ||||
The Company is subject to income taxes in the U.S. and various state jurisdictions. Tax statutes and regulations within each jurisdiction are subject to interpretation and require significant judgment to apply. Tax years related to U.S. Federal and various state jurisdictions remain subject to examination for tax periods ended on or after December 31, 2013.
18. Profit Sharing
The Company has a 401(k)-profit-sharing plan that covers substantially all NCI employees meeting certain criteria. The plan is a “defined contribution plan,” whereby participants have the option of contributing to the plan. The plan provides for the Company to contribute 50 cents for each dollar contributed by the employee, up to the first 6% of their contribution. The participants are vested 100% in their employee contributions immediately. The participants become fully vested in the employer contributions ratably over four years of service.
The Company’s contributions for the years ended December 31, 2016, 2015 and 2014 were approximately $3.3 million, $2.8 million and $2.4 million, respectively.
19. Related Party Transactions
The Company purchased services under a subcontract from Renegade Technology, Inc., which is a Government contractor wholly-owned by Rajiv Narang, the son of Charles K. Narang, the Chairman of the Company. The Company purchased services from Renegade Technology, Inc. of approximately $1.1 million, $0.7 million and $1.1 million for the years ended December 31, 2016, 2015 and 2014, respectively. As of December 31, 2016, and 2015, there was $0.1 million due to Renegade Technology, Inc. for each period.
On October 30, 2016, in connection with his resignation from the Company, the former CEO, Brian Clark, agreed to forfeit 390,000 vested stock options in exchange for $2.7 million.
20. Contingencies
Government Audits
Payments to the Company on U.S. Federal Government contracts are subject to adjustment upon audit by various agencies of the U.S. Federal Government. Audits of costs and the related payments have been performed by the various agencies through 2007 for NCI Information Systems, Inc., our primary corporate vehicle for Government contracting. In the opinion of management, the final determination of costs and related payments for unaudited years will not have a material effect on the Company’s financial position, results of operations, or liquidity.
Litigation
Civil Suit Against Former Controller
As previously disclosed on January 23, 2017, the Company commenced an internal investigation upon discovering that its former controller, Jon Frank, had been embezzling money from the Company. Upon completion of the internal investigation, the Company determined that the actual amount of the embezzlement by Mr. Frank during the period from January 2010 through 2017 was approximately $19.4 million. The Company believes that Mr. Frank acted alone and found no evidence that any other NCI employee was aware of or colluded in the embezzlement of Company funds and found no evidence of any unlawful activity apart from that associated with Mr. Frank’s embezzlement of Company funds.
F-21
Table of Contents
On January 23, 2017, we filed a lawsuit against Mr. Frank in the Circuit Court of Fairfax County in the State of Virginia to recover the embezzled funds.
On February 2, 2017, the Honorable Chief Judge White entered an Order for Preliminary Injunction and Asset Freeze (the “Preliminary Injunction”) against Mr. Frank. Among other things, the Preliminary Injunction placed an immediate freeze on all monies and assets of Mr. Frank and ordered Mr. Frank to prepare and deliver to the Company an accounting of his personal assets. In addition, pursuant to the Preliminary Injunction, Mr. Frank agreed to cooperate with the Company to identify, recover and return to the Company all assets that he obtained wrongfully or acquired with wrongfully-obtained funds.
Government Agency Investigations
In connection with the discovery of Mr. Frank’s embezzlement of money from the Company, we self-reported such matter to the U.S. Securities and Exchange Commission (“SEC”) and the civil and criminal divisions of the U.S. Department of Justice (“DOJ”).
By letter to the Company dated February 1, 2017, the DOJ has identified the Company as a possible victim of Mr. Frank’s conduct. On February 8, 2017, the SEC commenced a formal investigation and has served the Company with a subpoena requesting certain documents and information relevant to the embezzlement of Company funds by Mr. Frank. The Company is cooperating fully with the DOJ and the SEC in connection with their respective investigations, which are ongoing.
The United States Attorney’s Office for the Eastern District of Virginia (“USAO EDVA”) has opened a civil fraud investigation into the impact of Mr. Frank’s conduct on the Company’s government contracts. The Company is cooperating fully with the USAO EDVA and the Inspectors General of relevant government agencies in connection with this investigation, which is ongoing. At this time, we do not have an estimate of the financial impact on the Company, if any, of the investigation being conducted by the USAO EDVA.
Other Legal Proceedings
From time to time, we are involved in legal proceedings arising in the ordinary course of business. At this time, the probability is remote that the outcome of any such ordinary course litigation matters currently pending will have a material adverse effect on our financial condition and results of operations.
Misappropriation loss—Costs and Recovery
As discussed above, the Company initiated civil legal proceedings against our former controller seeking to recover assets acquired by him with funds wrongfully obtained by him through his embezzlement of Company funds and that litigation is ongoing. The court has frozen all of our former controller’s assets. The Company carries insurance that could cover up to $5 million of the misappropriation loss. The timing and amount of final recoveries, net of expenses of recovery, is uncertain. The Company has not yet recognized an estimated value of the potential recovery due to the limited amount of information available to it at this time. The Company estimates that it incurred approximately $5 million in costs during the first quarter of 2017 related to the embezzlement, including legal, auditing and forensic accounting fees.
F-22
Table of Contents
21. Supplemental Quarterly Information (unaudited, in thousands)
This data is unaudited, but in the opinion of management, includes and reflects all adjustments that are normal and recurring in nature, and necessary, for a fair presentation of the selected data for these interim periods. Quarterly financial operating results of the Company for the years ended December 31, 2016 and 2015 are presented below. During the fourth quarter of 2016, the Company recorded approximately $1.8 million of additional general and administrative costs related to the transition of named executive officers, and approximately $0.6 million of interest expense for the uncertain tax positions.
The financial results for the first three quarters of 2016 have been restated to correct accounting errors associated with the embezzlement by our former controller. As soon as practicable after the filing of its Annual Report on Form 10-K for the fiscal year ended December 31, 2016, the Company will file amended quarterly reports on Form 10-Q/A for the periods ended March 31, June 30 and September 30, 2016.
| For the quarter ended | ||||||||||||||||||||||||||||||||
| Dec. 31, 2016 |
Sept. 30, 2016 |
June 30, 2016 |
Mar. 31, 2016 |
Dec. 31, 2015 |
Sept. 30, 2015 |
June 30, 2015 |
Mar. 31, 2015 |
|||||||||||||||||||||||||
| Statement of Operations Data: |
||||||||||||||||||||||||||||||||
| Revenue |
$ | 77,460 | $ | 79,394 | $ | 81,900 | $ | 83,655 | $ | 84,018 | $ | 82,310 | $ | 85,799 | $ | 80,968 | ||||||||||||||||
| Operating income |
2,824 | 5,090 | 4,372 | 4,522 | 5,574 | 5,388 | 5,296 | 4,418 | ||||||||||||||||||||||||
| Net income |
$ | 1,100 | $ | 3,239 | $ | 2,553 | $ | 2,589 | $ | 3,550 | $ | 3,171 | $ | 3,046 | $ | 2,405 | ||||||||||||||||
| Earnings per share |
||||||||||||||||||||||||||||||||
| Basic |
$ | 0.08 | $ | 0.25 | $ | 0.19 | $ | 0.20 | $ | 0.27 | $ | 0.24 | $ | 0.23 | $ | 0.19 | ||||||||||||||||
| Diluted |
$ | 0.08 | $ | 0.23 | $ | 0.18 | $ | 0.19 | $ | 0.26 | $ | 0.23 | $ | 0.22 | $ | 0.18 | ||||||||||||||||
The following table summarizes the effect of the restatement on the previously reported supplemental quarterly information:
| For the quarter ended, | ||||||||||||||||||||||||||||
| September 30, 2016 | June 30, 2016 | March 31, 2016 | ||||||||||||||||||||||||||
| December 31, 2016 |
As Reported | As Restated | As Reported | As Restated | As Reported | As Restated | ||||||||||||||||||||||
| Revenue |
$ | 77,460 | $ | 79,753 | $ | 79,394 | $ | 81,900 | $ | 81,900 | $ | 83,655 | $ | 83,656 | ||||||||||||||
| Operating income |
2,824 | 5,278 | 5,090 | 5,483 | 4,372 | 5,746 | 4,522 | |||||||||||||||||||||
| Net Income |
1,100 | 3,261 | 3,239 | 3,230 | 2,553 | 3,332 | 2,589 | |||||||||||||||||||||
| Earnings per share |
||||||||||||||||||||||||||||
| Basic |
$ | 0.08 | $ | 0.25 | $ | 0.25 | $ | 0.24 | $ | 0.19 | $ | 0.25 | $ | 0.20 | ||||||||||||||
| Diluted |
$ | 0.08 | $ | 0.24 | $ | 0.23 | $ | 0.23 | $ | 0.18 | $ | 0.24 | $ | 0.19 | ||||||||||||||
22. Embezzlement and Restatement
In January 2017, the Company identified a misappropriation of company funds by the former controller. The Audit Committee engaged independent legal counsel and forensic consultants to investigate the fraud. The investigation was completed in March 2017, and revealed that the former controller had embezzled $19.4 million through a circumvention of controls, which included transfers from the payroll account to his personal account, creating fictitious invoices, and altering bank account statements to conceal the misappropriations. The Company believes that the former controller acted alone and found no evidence that any other NCI employee was aware of, or colluded in, the embezzlement of Company funds or that there was any unlawful activity apart from that associated with the former controller’s embezzlement of Company funds. The amounts embezzled were primarily classified as expenses and were included as fringe benefits costs in costs of revenue and selling, general and administrative expenses and was originally allocated to contracts as allowable costs. After discovery of the embezzlement these costs were restated as misappropriation loss, which is an unallowable cost. The Company had sufficient allowable, but previously unbilled costs allocated to its contracts in fiscal years 2010 through 2015 to offset the unallowable costs related to the embezzlement, such that there was no material change in revenue recognized on its cost reimbursable contracts. The Company has restated the Consolidated Statements of Income for the years ended December 31, 2015 and 2014 to classify the embezzled amounts as “misappropriation loss.” In 2016, the Company has restated the quarterly results as shown in Note 21. The Consolidated Statements of Income for the years ended December 31, 2015 and 2014 were restated to reclassify the embezzled amounts as a misappropriation loss as follows:
F-23
Table of Contents
| Year ended December 31, 2015 |
Year ended December 31, 2014 |
|||||||||||||||||||||||
| As reported | Adjustments | As restated | As reported | Adjustments | As restated | |||||||||||||||||||
| Cost of revenue |
$ | 278,316 | $ | (2,987 | ) | $ | 275,329 | $ | 270,855 | $ | (3,019 | ) | $ | 267,836 | ||||||||||
| General and administrative expenses |
26,016 | (251 | ) | 25,765 | 25,850 | (266 | ) | 25,585 | ||||||||||||||||
| Misappropriation loss |
3,238 | 3,238 | 3,285 | 3,285 | ||||||||||||||||||||
F-24