cmtl-20200731
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
For the fiscal year ended July 31, 2020
Commission File Number: 0-7928
(Exact name of registrant as specified in its charter)
68 South Service Road, Suite 230,Melville, NY 11747
(Address of principal executive offices) (Zip Code)
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Trading Symbol(s) Name of each exchange on which registered
Common Stock, par value $.10 per share CMTL NASDAQ Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act:
None
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
☐Yes ☒No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of 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 every Interactive Data file required to be submitted 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 such files).
☒Yes☐No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☒ Accelerated filer ☐ Emerging growth company ☐
Non-accelerated filer ☐ Smaller reporting company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report.
☒
Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
☐Yes ☒No
The aggregate market value of the registrant’s voting stock held by non-affiliates of the registrant, computed by reference to the closing sales price as quoted on the NASDAQ Global Select Market on January 31, 2020 was approximately $703,374,000.
The number of shares of the registrant’s common stock outstanding on September 25, 2020 was 24,994,323.
DOCUMENTS INCORPORATED BY REFERENCE.
Certain portions of the document listed below have been incorporated by reference into the indicated Part of this Annual Report on Form 10-K:
Proxy Statement for 2020 Annual Meeting of Stockholders - Part III
INDEX
PART I
ITEM 1. BUSINESS 1
Corporate Strategies 2
Competitive Strengths 2
Business Segments 5
Commercial Solutions Segment 6
Government Solutions Segment 8
Acquisitions 9
Sales, Marketing and Customer Support 10
Manufacturing and Service 12
Research and Development 13
Intellectual Property 13
Competition 14
Employees 14
U.S. Government Contracts and Security Clearances 15
Regulatory Matters 16
ITEM 1A. RISK FACTORS 17
ITEM 1B. UNRESOLVED STAFF COMMENTS 43
ITEM 2. PROPERTIES 44
ITEM 3. LEGAL PROCEEDINGS 46
ITEM 4. MINE SAFETY DISCLOSURES 46
PART II
Stock Performance Graph and Cumulative Total Return 46
Dividends 47
Recent Sales of Unregistered Securities 47
Purchases of Equity Securities by the Issuer and Affiliated Purchasers 47
Approximate Number of Equity Security Holders 47
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA 47
i
Overview 50
Critical Accounting Policies 51
Results of Operations 56
Impact of COVID-19 and Business Outlook for Fiscal 2021 57
Liquidity and Capital Resources 73
Recent Accounting Pronouncements 77
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 79
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 79
ITEM 9A. CONTROLS AND PROCEDURES 80
ITEM 9B. OTHER INFORMATION 80
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 81
ITEM 11. EXECUTIVE COMPENSATION 81
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES 81
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES 82
SIGNATURES 86
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE F-1
ii
Note: As used in this Annual Report on Form 10-K, the terms "Comtech," "we," "us," "our" and "our Company" mean Comtech Telecommunications Corp. and its subsidiaries.
Note About Forward-Looking Statements
This Form 10-K contains "forward-looking statements," including statements concerning the future of our industry, product development, pending litigation, potential transactions, business strategy, continued acceptance of our products, market growth, and dependence on significant customers. These statements can be identified by the use of forward-looking terminology such as "may," "will," "should," "could," "would," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential," "continue," the negative of these terms, or other similar words or comparable terminology. In general, all statements of fact in this report other than statements of historical fact are forward-looking information. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements included in this Form 10-K, because these risks and factors could cause our actual results to differ materially from those described in such forward-looking statements. However, the risks described in this Form 10-K are not the only risks that we face. Additional risks and uncertainties, not currently known to us or that do not currently appear to be material, may also materially adversely affect our business, financial condition and/or operating results in the future. We describe risks and uncertainties that could cause actual results and events to differ materially in "Risk Factors" (Part I, Item 1A of this Form 10-K), "Management’s Discussion and Analysis of Financial Condition and Results of Operations" (Part II, Item 7 of this Form 10-K) and "Quantitative and Qualitative Disclosures about Market Risk" (Part II, Item 7A of this Form 10-K). We do not intend to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise, except as required by law.
PART I
ITEM 1. BUSINESS
We are a leading provider of advanced communications solutions for both commercial and government customers worldwide. Our solutions fulfill our customers’ needs for secure wireless communications in some of the most demanding environments, including those where traditional communications are unavailable or cost-prohibitive, and in mission-critical scenarios where performance is crucial. In recent years, an increase in market demand for global voice, video and data usage has contributed to our growth.
As more fully described elsewhere in this Form 10-K, fiscal 2020 was challenging due to the coronavirus disease 2019 pandemic ("COVID-19"). The impact of COVID-19 on our customers resulted in significant order delays and lower net sales for us as compared to our original business outlook for the year. Despite COVID-19, we achieved fiscal 2020 consolidated net sales of $616.7 million, consolidated net income of $7.0 million and Adjusted EBITDA of $77.8 million. We also generated $52.8 million of cash flows from operations. We completed two small acquisitions and finished fiscal 2020 with a solid backlog. As COVID-19 impacts subside, we believe that our business performance in future periods will improve from current levels. We also currently have two pending strategic acquisitions that we believe will significantly strengthen our company.
On November 21, 2019, we announced that we entered into an agreement to acquire UHP Networks Inc. and its sister company (together, “UHP”), a leading provider of innovative and disruptive satellite ground station technology solutions. With end-markets for high-speed satellite-based networks significantly growing, our acquisition of UHP will allow us to enhance our solution offerings with low cost time division multiple access (“TDMA”) satellite modems which we do not currently offer.
On January 29, 2020, we announced a highly strategic acquisition of Gilat Satellite Networks Ltd. ("Gilat"). Gilat is a worldwide leader in satellite networking technology, solutions and services, with market leading positions in the satellite ground station and in-flight connectivity solutions markets and deep expertise in operating large network infrastructures. After we announced the Gilat acquisition, the COVID-19 pandemic resulted in a sudden and steep decline in the travel and aviation markets in which many of Gilat’s customers operate and a significant slowdown in Gilat's business. In July 2020, we commenced litigation in the Delaware Court of Chancery seeking certain declaratory judgments including a declaratory judgment that Gilat has suffered a Material Adverse Effect (as defined in the Merger Agreement) and that, as a result, we are not obligated to complete the acquisition.
The pending acquisitions of Gilat (and related litigation) and UHP are discussed in more detail in Part II - "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Acquisition Plan Update" and "Notes to Consolidated Financial Statements - Note (13)(a) - Commitments and Contingencies - Legal Proceedings and Other Matters" included in "Part II - Item 8.- Financial Statements and Supplementary Data," included in this Annual Report on Form 10-K.
1
Our Business Outlook for Fiscal 2021 is discussed further in Part II - "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Impact of COVID-19 and Business Outlook for Fiscal 2021." For a definition and explanation of Adjusted EBITDA, see Part II - "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - Comparison of Fiscal 2020 and 2019 - Adjusted EBITDA."
Our Internet website is www.comtechtel.com and we make available on our website: our filings with the Securities and Exchange Commission ("SEC"), including annual reports, quarterly reports, current reports and any amendments to those filings. The reference to our website address does not constitute incorporation by reference of the information contained therein into this Form 10-K. We also use our website to disseminate other material information to our investors (on the Home Page and in the "Investor Relations" section). Among other things, we post on our website our press releases and information about our public conference calls (including the scheduled dates, times and the methods by which investors and others can listen to those calls), and we make available for replay webcasts of those calls and other presentations for a limited time.
We also use social media channels to communicate with customers and the public about our Company, our products, services and other issues, and we use social media and the Internet to communicate with investors, including information about our stockholder meetings. Information and updates about our Annual Meetings will continue to be posted on our website at www.comtechtel.com in the "Investor Relations" section.
We are incorporated in the state of Delaware and were founded in 1967.
Corporate Strategies
We intend to manage our business with the following principal corporate strategies:
•Seek leadership positions in markets where we can provide differentiated products and technology solutions;
•Identify and participate in emerging technologies that enhance or expand our product portfolio;
•Maximize responsiveness to our customers, including offering more integrated systems and solutions;
•Expand and further penetrate our diversified and balanced customer base; and
•Pursue acquisitions of complementary businesses and technologies.
Competitive Strengths
The successful execution of our principal corporate strategies is based on our competitive strengths, including the following:
(1)We Have Significant Exposure to Large, Growing End Markets
We believe we are well positioned to capitalize on some of the most significant long-term technology trends occurring worldwide and that customers around the world will increasingly turn to us to fulfill their needs for secure wireless communications in some of the most demanding environments, including those where traditional communications are unavailable or cost-prohibitive, and in mission-critical scenarios where performance is crucial. These important technology trends include growth in global wireless penetration and consumption, the need for public safety agencies to seamlessly integrate various networks and protocols and utilize precise location to connect individuals with first responders, the rapidly expanding breadth of High Definition ("HD") and 4K broadcasting content and the need for governments to have more modern and mobile communications and transmission equipment to successfully complete mission-critical goals. We believe that all these long-term trends generate growth in global voice, video and data usage that, in turn, drives increased long-term demand for the secure wireless communication solutions that we provide.
2
(2)We Believe We Are a Market Leader in the End-Markets That We Serve
Commercial Solutions Segment
Satellite Ground Station Technologies - We believe we are the leading provider of Single Channel per Carrier ("SCPC") satellite earth station modems, solid-state amplifiers and traveling wave tube amplifiers. Many of our key satellite earth station modems incorporate Turbo Product Code ("TPC") forward error correction technology and bandwidth compression technology which enables our customers to optimize their satellite networks by either reducing their satellite transponder lease costs or increasing data throughput. Our amplifier products are used to amplify signals carrying voice, video or data for air-to-satellite-to-ground communications and are vital to satellite communication applications such as traditional broadcast, direct-to-home ("DTH") broadcast and satellite newsgathering. We differentiate our amplifier product offerings by our ability to develop the most efficient size, weight and power profile. Certain of our amplifiers are DO-160 (an airborne quality standard) certified and when incorporated into an aircraft satellite communication system, can provide passengers, both commercial and military, with email, Internet access and video conferencing.
Public Safety and Location Technologies - We believe that we are a leader in public safety communication and location technologies used for routing 911 calls. We meet the ISO 27001 data security standard and believe we have significant market share in the routing of U.S. wireless 911 calls, Voice over Internet Protocol ("VoIP") 911 calls and Text to 911 messaging. We believe we are one of a limited number of companies fulfilling the Federal Communications Commission ("FCC") requirements for Enhanced 911 ("E911") call-routing to Public Safety Answering Points ("PSAPs") for wireless and VoIP network operators. E911 refers to 911 calls for both wireline and wireless telephones that are enhanced to provide the caller's location information. We are focusing our marketing and research and development efforts to meet system standards for next generation 911 ("NG-911"), which refers to an Internet Protocol ("IP") based system that allows digital information (e.g., voice, photos, videos, text messages) to flow seamlessly from the public, to the PSAPs and on to emergency responders. Our Short-Messaging Service ("SMS") Center software has been used by Mobile Network Operators (“MNOs”) to enable the exchange of text or data messages to and from wireless devices for almost two decades across 2G, 3G and 4G networks. Our flexible and modular platforms enable the MNOs with a wide range of positioning technologies based on Third Generation Partnership Project (“3GPP”) standards. Additionally, we offer Location Studio TM, a complete end-to-end location services platform consisting of maps, geoservices, application programming interfaces ("APIs") and software development kits ("SDKs") enabling MNOs, application developers, public safety customers, and enterprises to build custom and unique applications.
Government Solutions Segment
Mission-Critical Technologies - We are a key supplier to large governments (particularly the U.S. government) and large prime contractors, for mission-critical technologies, primarily tactical satellite-based technology solutions, field support services and satellite component supply chain management. We are a prime contractor under several indefinite delivery, indefinite quantity ("IDIQ") defense contract vehicles, including the: (i) U.S. Army’s Global Tactical Advanced Communications Systems ("GTACS") contract, (ii) U.S. Army’s Global Tactical Advanced Communications Systems (“GTACS II”) contract, (iii) U.S. Navy’s Seaport Next Generation (“SeaPort-Nxg”) contract, (iv) Complex Commercial SATCOM Solutions ("CS3") contract; and (v) Communications Electronics Command ("CECOM") Responsive Strategic Sourcing for Services ("RS3") contract with the U.S. Army Contracting Command - Aberdeen Proving Ground (“ACC-APG”). We provide field support sustainment services, centralized and deployed depot services, and technology insertion services to the U.S. Army’s AN/TSC-198 family of communication systems that are commonly referred to as "SNAP" (Secret Internet Protocol Router ("SIPR") and Non-secure Internet Protocol Router ("NIPR") Access Point) Very Small Aperture Terminals ("VSATs"). We also provide sustainment services for the U.S. Army’s Blue Force Tracking-1 ("BFT-1") system. Our field support services include providing U.S. Department of Defense ("DoD") personnel with curriculum development and training services to support cybersecurity workforce development. We provide high reliability Electrical, Electronic and Electromechanical (“EEE”) parts for use in satellite, launch vehicle and manned space applications.We also provide services encompassing all aspects of ground station life cycle to include requirements definition and analysis; design, development and integration of turnkey systems from antenna to data processing; civil works and construction; station installation and verification; operations and maintenance; and decommissioning at end of life.We also provide to customers worldwide a full line of X/Y satellite tracking antenna systems ranging in sizes from 30cm to 13m, as well as radomes, ideal for LEO, MEO and GEO constellations.
High-Performance Transmission Technologies - We are a world leader in the design and supply of troposcatter equipment, and a key supplier of radio frequency ("RF") solid-state, high-power amplifier and switching technologies. We have designed, manufactured and delivered troposcatter systems (sometimes referred to as over-the-horizon ("OTH") microwave products and systems) for over fifty years and are one of the largest independent suppliers of solid-state, high-power microwave amplifiers, which reproduce signals with high power and are extremely complex and critical to the performance of the systems into which they are incorporated.
3
Our CS67PLUS software defined, adaptive troposcatter radio can operate at over 200 megabits per second ("Mbps"). The radio is MIL-STD 461 EMI and MIL-STD 810G environmentally compliant. Our Modular Tactical Transmission System ("MTTS") provides a high capacity, troposcatter and beyond-line-of-sight modular communications system designed for easy and rapid deployment. Our best-in-class troposcatter solutions led to our equipment being chosen to be used on the U.S. Marine Corps’ next generation troposcatter system Program of Record. These dual frequency systems are designed to operate in harsh environmental conditions and are protected from Electromagnetic Interference and Electromagnetic Pulse (“EMI/EMP”).
Many solid-state power amplifier and switching technologies are produced in-house by large companies; however, our expertise has created a cost-effective and technologically superior alternative to in-house sourcing. Some of the companies who have outsourced amplifier development and production to us include Rockwell Collins, Inc., European Aeronautic Defence and Space Company ("EADS"), Lockheed Martin Corporation, L3Harris Technologies, Inc., Northrop Grumman Corporation, BAE Systems Plc and Raytheon Technologies Corporation. Our amplifiers are also used in oncology treatment systems that allow physicians to give cancer patients higher doses of radiation that are more closely focused on cancerous tissue, thereby minimizing damage to healthy tissue.
(3)We Believe We Provide Industry Leading Innovation, Capabilities and Solutions
We have established a leading position of technology innovation in our fields through internal and customer-funded research and development activities, which have yielded significant advances. Examples of our industry-leading innovation include:
Our HeightsTM Networking Platform –Our HeightsTM networking platform ("Heights") is a cornerstone of our current research and development efforts and a continuing focus of our satellite earth station equipment sales and marketing efforts. HeightsTM is an advanced networking platform that combines our most efficient waveforms, compression engines and the ability to provide dynamic bandwidth and power management to meet the demands of customers operating on traditional fixed satellite service systems ("FSS") while providing advantages for customers who plan to transition to high throughput satellite ("HTS") systems in the future. HeightsTM is ideally suited for cellular backhaul, universal service obligation networks and other applications that require high performance in a hub-spoke environment. HeightsTM solutions are designed to deliver the highest Internet Protocol bits per Hertz in its class.
Our Solacom Software Solutions – In fiscal 2019, we acquired Solacom Technologies, Inc. (“Solacom”), a leading provider of NG-911 solutions for public safety agencies. Solacom has developed a best-in-class call handling solution marketed under the Guardian brand name which provides an integrated text-to-and-from 911 solution on a unified platform. The solution provides a flexible user interface, adapts to varying customer environments and preferences, provides powerful call conferencing capabilities, enhanced reporting capabilities and offers geospatial 911 location call display directly from a customized map. Because of its advanced features, it allows us to offer an immediate upgrade path to existing and new customers and has expanded our presence in the public safety solutions market. We are investing in product enhancements of the Guardian software including developing a cloud-based version so that we can offer software as a service (SaaS) type solutions to our public safety customers.
Our Compact Over-the-horizon Mobile Expeditionary Terminal (“COMET”) – In fiscal 2020, we introduced the Comtech COMET, the world’s smallest OTH microwave troposcatter terminal. COMET, which stands for Compact Over-the-horizon Mobile Expeditionary Terminal, is rapidly deployable, low power and highly portable. Troposcatter technology has long been associated with large antennas and high-power amplifiers that require kilowatts of prime power and large trucks to transport them to the field. The COMET has fundamentally changed this paradigm. The COMET is capable of being transported in a carry case by a single individual and set up in under fifteen minutes. The COMET is ideally suited for situations where high bandwidth backhaul communications are required, extending critical services into areas where there is no communications infrastructure, or the infrastructure has been destroyed. U.S. Special Forces have already begun procuring and deploying the COMET for high reliability, mission essential communications.
Our "XyPoint®" Mobile Location Platform – Our "XyPoint®" Mobile Location Platform is a standards-compliant, commercially available system used for the location of mobile devices connected to 2G, 3G, 4G-LTE, 5G NGC and Wi-Fi networks. Our XyPoint® platform provides device location for both public safety and commercial applications and enables device positioning for smartphones, tablets and internet of things ("IoT") devices connected to an MNO’s 5G cloud network.
4
(4)We Have a Diverse Global Customer Base
We have established long-standing relationships with thousands of customers worldwide, including leading system and network suppliers in the global satellite (such as Intelsat S.A. and SES S.A.), mobile cellular (such as Verizon Wireless), defense, broadcast and aerospace industries, as well as the U.S. federal government (such as the U.S. Army and Navy), U.S. state and local governments, and foreign governments. Our global commercial and government customers are increasingly seeking integrated solutions to meet their operational needs. We believe that our customers recognize our ability to develop improved technologies and to meet stringent program requirements.
Our ability to solve complex problems is well known and we believe we a have strong relationships with our customers. We hold prime positions on several key contracts and have had a long history of servicing key programs.
Business Segments
Fundamentally, we offer advanced secure wireless communication technologies with expertise in the satellite communications and cellular markets. We believe these markets are undergoing a period of significant growth and rapid technological change. We manage our business through two reportable operating segments: Commercial Solutions and Government Solutions. Our corporate senior management team supports the business segments by, among other things, actively seeking to exploit potential synergies that exist between the segments, including in areas such as manufacturing, technology, sales, marketing, customer support and finance.
The diagram below summarizes our key products, systems and services by our two reportable operating segments:
5
Financial information about our business segments, including net sales, operating income, Adjusted EBITDA (a Non-GAAP financial measure), total assets, and our operations outside the United States, is provided in "Notes to Consolidated Financial Statements - Note (12) Segment Information" included in "Part II - Item 8. - Financial Statements and Supplementary Data."
The markets and key technologies for each segment are further described below.
Commercial Solutions Segment
Overview
Our Commercial Solutions segment offers satellite ground station technologies (such as modems and amplifiers) and public safety and location technologies (such as 911 call routing, 911 call handling and mapping solutions) to commercial customers and smaller government customers, such as state and local governments. This segment also serves certain large government customers (including the U.S. government) that have requirements for off-the-shelf commercial equipment.
Key Markets and Technology Solutions
Satellite Ground Station Technologies
We offer our customers one-stop-shopping for satellite ground station technologies including modems, amplifiers, frequency converters and network software for customers who utilize satellite communications. Our products are used to modulate, demodulate and amplify signals, carry voice, video and/or data over networks and are vital to satellite communication applications, including air-to-ground communications, video broadcasting and the backhaul of cellular traffic. Our Commercial Solutions segment manufactures most of the satellite ground station equipment we sell to our customers including equipment sold by our Government Solutions segment.
We believe that the overall satellite ground station equipment industry will grow over the next few years. This growth is expected to occur as a result of widespread deployment and upgrades of ground-based systems, including satellite earth stations, as well as integration of high-performance amplifiers used for high-performance systems necessary to meet long-term demand for high-performance applications of satellite communications technologies, such as satellite-based wireless backhaul, DTH, HD and 4K broadcasting and in-flight connectivity. We believe that Comtech is well positioned to capitalize on this demand through sales of our market leading satellite ground station technologies.
6
Examples of end-market applications that are driving long-term demand for our satellite-based communication technologies include:
•Satellite-Based Cellular Backhaul. Demand for satellite-based cellular backhaul services is anticipated to grow rapidly as a result of the increased penetration of smart cellular phones and network upgrades to 3G and 4G in developing regions of the world. Ultimately, as 5G services continue to be deployed, mobile data services will become more critical. As mobile data penetration expands and mobile data consumption increases, wireless carriers must invest in their mobile network infrastructure and businesses will require back-up communications. In developing regions of the world and in remote areas where terrestrial network infrastructure is lacking, wireless network operators often backhaul, or transport, their wireless data traffic using satellite-based networking technologies. Comtech is well positioned to serve the high-performance, high availability needs of satellite-based cellular backhaul through sales of our satellite modems including our HeightsTM networking platform.
•New High Throughput Satellites. There are more than 100 new High Throughput Satellite ("HTS") payloads expected to launch over the next decade which we believe is expected to lead to increasingly complex satellite networks. As service providers work to offer connectivity to these high-speed, high-bandwidth satellites and expand their networks to handle the demand for new HTS applications, we believe our HeightsTM networking platform will be incorporated into many new installations and necessary upgrades of equipment.
•High Definition and Ultra-High Definition Broadcasting. Reports indicate that in recent years, consumers have purchased millions of HD televisions and Ultra-High Definition or "4K" televisions. We believe this will require a significant amount of satellite bandwidth, which will require satellite service providers to upgrade equipment and find new ways to manage the cost and transmission efficiency of their networks. We believe that these requirements will drive increased demand for our satellite ground station technologies.
Public Safety and Location Technologies
We are a leading provider of public safety and location technologies. Our next generation solutions enable rich, multimedia information to be delivered with 911 calls; our E911 call routing solutions allow cellular carriers and over the Internet ("VoIP") carriers to deliver emergency calls to Public Safety emergency call centers nationwide. When someone places an emergency call, our technologies can identify the call as an emergency call, access the user’s location information from the wireless network and route the call to the assigned public safety jurisdiction. Today, we provide public safety and location technologies to many U.S. telecommunication carriers, the largest being Verizon for which we provide their 911 call routing via cellular service. We believe the largest portion of the market for 911 cellular call routing service is split approximately equally between us and our leading competitor.
In addition to 911 call routing, we provide systems integration, satellite and location infrastructure terminals, and linkage to NG-911 Emergency Services IP Networks ("ESInet"). We also offer best-in-class 911 call handling solutions under the Solacom brand name. We believe state and local governments have a need to upgrade existing call handling systems and old networks to more modern NG-911 systems, including 911 text messaging services, advanced data, real-time photos and other types of information sharing over IP networks.
As the U.S. adopts upgraded call handling and NG-911 solutions, we believe that other countries will do so as well. Our public safety and location technology solutions have been deployed since 2006 and are utilized by MNOs nationally as well as internationally to provide reliable device location determination for public safety and commercial applications. Many of our technologies, such as positioning, mapping and text messaging, are embedded in our public safety and location offerings to help address mapping, routing and geolocations.We address the FCC mandates for emergency services as it relates to location by supporting precise location in our solutions. Our text messaging platforms are used by wireless carriers to provide SMS to their end-customers and are also used to communicate with 911 PSAPs through major network operators.
7
In order to maximize market growth opportunities, we are repositioning certain of our location technology solutions to increase our penetration into the public safety space. Although the market remains very competitive and the sales cycles are long, we believe demand for our public safety and location technologies will continue to grow and customers will continue to look for a more integrated solution. Our Location StudioTM platform enables customers, especially public safety agencies, to build their own applications with end-user functionality, such as maps, search, geocoding, routing and navigation, using their own brand. We believe that customers and prospects are increasingly looking for alternatives to mapping services that are subject to change by the provider and which meet market privacy and security requirements. As such, we are integrating our Trusted OpenStreetMap ("TOSM") technologies into our portfolio which will enhance the value proposition by providing rich maps and data while addressing privacy requirements. Our location technology solutions enable the determination of a mobile phone's geospatial position in a variety of environments leveraging a wide range of signals including Global Positioning System ("GPS"), Global Navigation Satellite Systems ("GNSS") and cellular technologies. For our installed base of systems, we provide ongoing operational support, including administration of system components, system optimization, configuration management, and maintenance services, including tracking customer support issues, troubleshooting and developing and installing maintenance release.
Government Solutions Segment
Overview
Our Government Solutions segment provides mission-critical technologies (such as tactical satellite-based networks and ongoing support for complicated communication networks) and high-performance transmission technologies (such as troposcatter systems and solid-state, high-power amplifiers) to large government end-users (including those of foreign countries), large international customers and domestic prime contractors.
Key Markets and Technology Solutions
Mission-Critical Technologies
With persistent threats from state and non-state actors, governments around the world are increasingly seeking ways to mitigate vulnerabilities using information and more reliable communication systems to increase decision-makers’ situational awareness. In response to this demand, we offer a variety of mission-critical technologies including the supply and field support of tactical satellite-based networks (including satellite modems, ruggedized routers and solid-state drives), sustainment services for the AN/TSC-198A SNAP (Secret Internet Protocol Router ("SIPR") and Non-classified Internet Protocol Router ("NIPR") Access Point), Very Small Aperture Terminals ("VSATs") and sustainment services for the U.S. Army’s Blue Force Tracking-1 ("BFT-1") system. Many of our mission-critical technologies are part of integrated communication infrastructure systems such as the U.S. Military Command, Control, Communications, Computers, Cyber Intelligence, Surveillance and Reconnaissance (also known as "C5ISR") systems and similar complicated networks for international governments. We also provide a variety of in-class and on-line training services, labs and assessments to our customers to help them protect networks from cyber attacks.
We are recognized as an industry leader and global supplier of high reliability products. Our solutions include supply chain management and engineering services for high reliability EEE space parts and satellite and launch vehicle tracking solutions in support of critical National Aeronautics and Space Administration ("NASA") programs and for international space and defense agencies. Through our acquisition of CGC Technology Limited, we are also a leading, world-wide provider of high precision, full motion fixed and mobile X/Y satellite tracking antennas, RF feeds, reflectors, radomes and other ground station equipment.
High-Performance Transmission Technologies
We offer several unique high-performance transmission technologies that are used in sophisticated communication systems, such as electronic warfare, radar and identification friend or foe ("IFF"). As our customers push the envelope for mobility, speed and higher frequency, we believe that demand for high-performance transmission products will grow from current levels.
8
Our troposcatter technologies (sometimes referred to as over-the-horizon or "OTH" microwave systems) are extremely reliable and secure and are a cost-effective alternative or compliment to satellite communication as it does not require the leasing of expensive satellite transponder space with its attendant recurring costs. Our over-the-horizon microwave systems, which include our patented forward error correction technology, can transmit video and other broadband applications at throughputs of up to 200 Mbps. U.S. and foreign governments use our over-the-horizon microwave systems to, among other things, transmit radar tracking, run C4ISR applications and connect to remote border locations. Additionally, energy companies use our systems to enable communication links for offshore oil rigs and other remote locations, as well as for exploration activities. Our MTTS, the first truly modular, rapidly deployable transit case-based troposcatter system, has been purchased by the U.S. Army, incorporated into the SNAP family of products used by the U.S. military and designated the Tactical Transportable TROPO ("SNAP 3T") or AN/TRC 198(V3). We recently introduced the Comtech COMET, a rapidly deployable OTH microwave system. The Comtech COMET has a medium range (up to 60 km) and high bandwidth (up to 210 Mbps) that fills a void in distances that have long been desired by tactical communications planners. It uniquely addresses the special operations command (or “SOCOM”) community’s concern of low probability of intercept and low probability of detection (“LPI/LPD”), while providing high reliability, mission essential communications.
Our solid-state, high-power amplifiers and related switching technologies are utilized in several critical applications including electronic warfare, communications, radar, IFF and medical applications such as oncology cancer treatment systems. In the electronic warfare marketplace, we support a variety of legacy systems and are participating in the ongoing migration to platforms that require smaller and lighter amplifiers. Our solutions increase the flexibility of systems by providing wider bandwidth capabilities to address communication needs. We also believe that the desire for increased situational awareness of the airspace may create increased opportunities for our radar and IFF products, which are used by government customers around the world. Our high power and highly reliable Gallium Nitride ("GaN") amplifier technology is increasingly used both to update existing radar systems for improved sensitivity and range as well as for new radar installations. In addition to technologies that enhance performance of primary radars, we also supply solutions for IFF systems that provide positive identification of radar targets.
Acquisitions
In order to position ourselves to take advantage of additional growth opportunities and meet our strategic objectives, we have followed, and will continue to follow, a disciplined approach in identifying, executing and capitalizing on acquisitions.
Completed Acquisitions
In the past several years, we have acquired businesses and enabling technologies.
On February 23, 2016, we acquired TeleCommunication Systems Inc. ("TCS"), a leading provider of commercial solutions (such as public safety and location technologies) and government solutions (such as mission-critical technologies). The TCS acquisition had an aggregate purchase price for accounting purposes of $340.4 million (also referred to as the transaction equity value) and an enterprise value of $423.6 million. The TCS acquisition, which has been fully integrated into our business, resulted in Comtech entering complementary markets and expanding our domestic and international commercial offerings.
On February 28, 2019, we completed our acquisition of Solacom, a leading provider of Next Generation 911 ("NG-911") solutions for public safety agencies. The acquisition of Solacom was a significant step in our strategy of enhancing our public safety and location technologies. The Solacom acquisition had an aggregate purchase price for accounting purposes of $32.9 million and was fully integrated into our Commercial Solutions segment.
On April 29, 2019, we acquired the state and local government NG-911 business from General Dynamics Information Technology, Inc. (the "GD NG-911 business") and at the same time announced a five-year contract award in excess of $100.0 million to develop, implement and operate a NG-911 emergency communications system for a Northeastern state. The acquisition strengthened Comtech’s position in the growing NG-911 solutions market. The GD NG-911 business had an aggregate purchase price for accounting purposes of $11.0 million and was fully integrated into our Commercial Solutions segment.
9
On January 27, 2020, we completed the acquisition of CGC Technology Limited ("CGC"), a small privately held company located in the United Kingdom. CGC is a leading provider of high precision full motion fixed and mobile X/Y satellite tracking antennas, reflectors, RF feeds, radomes and other ground station equipment around the world. The acquisition brought established relationships with several top-tier European aerospace companies and other government entities, and we expect it to allow us to participate in the anticipated growth in the number of low Earth orbit ("LEO") and medium Earth orbit ("MEO") satellite constellations. The CGC business has a preliminary purchase price for accounting purposes of $23.7 million and was fully integrated into our Government Solutions segment.
On February 21, 2020, we acquired NG-911, Inc. ("NG-911"), a small privately held company based in Iowa, Illinois and Missouri. NG-911 is a pioneer in providing next generation 911 solutions, including those designed by Solacom, to public safety agencies in the Midwest. The acquisition allows us to cost-effectively expand sales of our industry leading Solacom Guardian call management solutions for public safety. The NG product line had a preliminary purchase price for accounting purposes of $1.2 million and was fully integrated into our Commercial Solutions segment.
Pending Acquisitions of UHP and Gilat
On November 21, 2019, we announced that we entered into an agreement to acquire UHP, a leading provider of innovative and disruptive satellite ground station technology solutions. UHP is primarily based in Canada and has developed revolutionary technology that is transforming the Very Small Aperture Terminal (“VSAT”) market. With end-markets for high-speed satellite-based networks significantly growing, our acquisition of UHP will allow us to enhance our solution offerings with low cost TDMA satellite modems which we do not currently offer. In June 2020, we agreed with UHP to amend the terms of our purchase agreement which resulted in the total aggregate purchase price being reduced by approximately 24% from $50.0 million to $38.0 million (of which $5.0 million will be paid in cash, with the remainder in shares of our common stock, cash, or a combination of both, as we may elect at the time of closing). The transaction is subject to customary closing conditions, including regulatory approval to allow us to purchase UHP's sister company which is headquartered in Moscow. If we do not receive approval by December 31, 2020, either we or UHP may terminate the purchase agreement. Additional discussion and information about the pending UHP acquisition can be found in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations – Acquisition Plan Update."
On January 29, 2020, we announced a highly strategic acquisition of Gilat, a worldwide leader in satellite networking technology, solutions and services, with market leading positions in the satellite ground station and in-flight connectivity solutions markets and deep expertise in operating large network infrastructures. After we announced this acquisition, the COVID-19 pandemic resulted in a sudden and steep decline in the travel and aviation markets in which many of Gilat’s customers operate and a significant slowdown in Gilat's business. Based on the terms agreed to on January 29, 2020 and the September 24, 2020 closing price of Comtech Common Stock of $13.32 per share, the total amount payable to Gilat shareholders would have been approximately $465.8 million (consisting of approximately $402.9 million in cash with the remainder in Comtech Common Stock) or $8.30 per Gilat ordinary share.
In July 2020, we commenced litigation in the Delaware Court of Chancery (the “Delaware Court”) seeking certain declaratory judgments, including a declaratory judgment that Gilat has suffered a Material Adverse Effect (as defined in the Merger Agreement) and that, as a result, we are not obligated to complete the acquisition of Gilat. The amended complaint also seeks a declaratory judgment that certain actions, if taken by Gilat, relating to Comtech’s application for Russian regulatory approval, would breach Gilat’s obligations under the Merger Agreement. Gilat subsequently sued in the Delaware Court for declaratory judgments, including that it has not suffered a Material Adverse Effect and that Comtech has not used reasonable best efforts to obtain Russian regulatory approval for the transaction. To-date, we incurred significant amounts of legal expenses and professional fees in connection with the litigation and a trial is scheduled for October 5, 2020. The Delaware Court has indicated that it intends to render a judgment prior to October 29, 2020, the date that we or Gilat may terminate the Merger Agreement. Litigation related to Gilat is further discussed in "Notes to Consolidated Financial Statements - Note (13)(a) - Commitments and Contingencies - Legal Proceedings and Other Matters" included in "Part II - Item 8.- Financial Statements and Supplementary Data," included in this Annual Report on Form 10-K.
Sales, Marketing and Customer Support
Sales and marketing strategies include direct sales through sales, marketing and engineering personnel, indirect sales through independent representatives, value-added resellers, and sales through a combination of the foregoing. We devote resources to evaluating and responding to requests for proposals by governmental agencies around the world and, as needed, we employ the use of specialized consultants to develop our proposals and bids.
10
We intend to continue to expand international marketing efforts by engaging additional independent sales representatives, distributors and value-added resellers and by establishing additional foreign sales offices. In addition, we also leverage our relationships with larger companies (such as prime contractors to the U.S. government and large mobile wireless operators) to market our technology solutions.
We are pre-qualified as an approved vendor for certain government contracts. We collaborate in sales efforts under various arrangements with integrators. Our marketing efforts also include advertising, public relations, speaking engagements and attending and sponsoring industry conferences.
Our management, technical and marketing personnel establish and maintain relationships with customers. Our sales strategies include a commitment to providing ongoing customer support for our systems and equipment. This support involves providing direct access to engineering staff or trained technical representatives to resolve technical or operational issues.
Our products and services in many of our product lines have long sales cycles. Once a product is designed into a system, customers may be reluctant to change the incumbent supplier due to the extensive qualification process and potential redesign required in using alternative sources. In addition, in recent years, we have found that overall sales cycles for each of our product lines have significantly increased.
Sales by geography and customer type, as a percentage of related net sales, are as follows:
Fiscal Years Ended July 31,
Commercial Solutions Government Solutions Consolidated
Sales to U.S. government customers include sales to the U.S. Department of Defense ("DoD"), intelligence and civilian agencies, as well as sales directly to or through prime contractors.
Domestic sales include sales to commercial customers, as well as to U.S. state and local governments. Included in domestic sales, are sales to Verizon Communications Inc. ("Verizon"), which represented 10.0% of consolidated net sales for fiscal 2018. Except for the U.S. government, there were no customers that represented more than 10.0% of consolidated net sales during fiscal 2020 and 2019.
International sales for fiscal 2020, 2019 and 2018 (which include sales to U.S. domestic companies for inclusion in products that are sold to international customers) were $145.1 million, $170.6 million and $145.8 million, respectively. When we sell internationally, we denominate virtually all of our contracts in U.S. dollars. Some of our sales to international customers are paid for by letters of credit or on an open account. From time to time, some of our international customers may require us to provide performance guarantees.
Except for the U.S., no individual country (including sales to U.S. domestic companies for inclusion in products that are sold to a foreign country) represented more than 10% of consolidated net sales for fiscal 2020, 2019 and 2018.
Backlog
Our backlog as of July 31, 2020 was $620.9 million (of which $443.2 million was attributed to the Commercial Solutions segment and $177.7 million was attributed to the Government Solutions segment). We estimate that a substantial portion of the backlog as of July 31, 2020 will be recognized as sales during the next twenty-four month period, with the rest thereafter.
At July 31, 2020, 20.5% of our backlog consisted of orders for use by U.S. commercial customers, 66.8% consisted of U.S. government contracts, subcontracts and government funded programs and 12.6% consisted of orders for use by international customers (including sales to U.S. domestic companies for inclusion in products that will be sold to international customers).
11
Our backlog is defined as orders (sometimes also referred to herein as bookings) that we believe to be firm. Backlog that is derived from U.S. government orders relates to U.S. government contracts that have been awarded, signed and funded. Backlog for our U.S. government customers also includes amounts appropriated by Congress and allotted to the contract by the procuring government agency. Our backlog does not include the value of options that may be exercised in the future on multi-year contracts, nor does it include the value of additional purchase orders that we may receive under indefinite delivery/indefinite quantity ("IDIQ") contracts or basic ordering agreements. In some cases, such as contracts received from large U.S. based telecommunication companies, our backlog is computed by multiplying the most recent month’s contract or revenue by the months remaining under the existing long-term agreements, which we consider to be the best available information for anticipating revenue under those agreements. When we acquire a company with existing contracts, we only record bookings for those contracts that meet our definition. Almost all of the contracts in our backlog (including firm orders previously received from the U.S. government) are subject to modification, cancellation at the convenience of the customer or for default in the event that we are unable to perform under the contract. As of July 31, 2020, we performed a detailed review of our backlog, including assessing the impact of the COVID-19 pandemic, the consolidation of two mobile carriers in the United States and unused contract commitments. Based on such review, we reduced our backlog as of July 31, 2020 by $29.8 million, which represented orders received in prior periods that we no longer believed met our definition of firm.
A significant portion of the backlog from our U.S. commercial customers relates to large, multi-year contracts to provide state and local governments (and their agencies) with public safety and location technology solutions. Although the contracts themselves represent legal, binding obligations of these governments, funding is often subject to the approval of budgets (for example, on an annual or bi-annual basis). Although funding for these multi-year contracts is dependent on future budgets being approved, we include the full estimated value of these large, multi-year contracts in our backlog given the critical nature of the services being provided and the positive historical experience of our state and local government customers passing their respective budgets.
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 amount and timing of any revenue is subject to various contingencies, many of which are beyond our control. The actual recognition of revenue on contracts included in backlog may never occur or may change because a program schedule could change, a customer may not follow up with order details (e.g., delivery instructions), fluctuations in currency exchange rates after an order is placed could cause our products to become too expensive for a foreign customer, a customer’s program could be canceled, a contract could be reduced, modified or terminated early due to changes in a customer’s priorities, funding may not be included in future budgets, actual indirect rates being reimbursed on U.S. government contracts may ultimately be less than those indirect rates included in our initial proposals, or an option that we had assumed would be exercised is not exercised. As a result of these contingencies, we may adjust our backlog if we determine that such orders are no longer firm and or funded. In addition to adjustments from these types of contingencies, variations in backlog from time to time are attributable, in part, to changes in sales mix, the timing of contract proposals, the timing of contract awards, delivery schedules on specific contracts and new bookings obtained through acquisitions. A large majority of the solutions in our satellite ground station technologies product line operate under short lead times. Our Government Solutions segment backlog is highly influenced by the nature and timing of orders received from the U.S. government, which is subject to unpredictable funding, deployment and technology decisions. As a result, we believe our backlog and orders, at any point in time, are not necessarily indicative of the total sales anticipated for any future period.
Manufacturing and Service
Our manufacturing operations consist principally of the assembly and testing of electronic products that we design and build from purchased fabricated parts, printed circuits and electronic components. We consider our facilities to be well maintained and adequate for current and planned production requirements. All our manufacturing facilities, including those that serve the military market, must comply with stringent customer specifications. We employ formal quality management programs and other training programs, including the International Standard Organization’s quality procedure registration programs.
We operate a high-volume technology manufacturing center located in Tempe, Arizona. This manufacturing center is operated by our Commercial Solutions segment and can be utilized, in part, by our Government Solutions segment and by third-party commercial customers, including prime contractors to the U.S. government, who can outsource a portion of their product manufacturing to us. Increased usage of our high-volume technology manufacturing center allows us to secure volume discounts on key components, better control the quality of our manufacturing process and maximize the utilization of our manufacturing capacity.
12
To support our long-term business goals for our satellite earth station product line, in September 2020, we signed a 15-year lease for a 146,000 square foot facility in Chandler, Arizona. This facility is located less than 10 miles from our existing facility, and we anticipate that that we will be fully relocated to this new facility by February 2021.
All of our other manufacturing facilities are located in the United States except for a facility in the United Kingdom which manufactures our high precision X/Y satellite tracking antenna product line.
Our ability to deliver products to customers on a timely basis is dependent, in part, upon the availability and timely delivery by subcontractors and suppliers (including, at times, the U.S. government) of the components and subsystems that we use in manufacturing our products. Electronic components and raw materials used in our products are generally obtained from independent suppliers. Some components are standard items and are available from several suppliers. Others are manufactured to our specifications by subcontractors. Although we obtain certain components and subsystems from a single source or a limited number of sources, we believe that most components and equipment are available from multiple sources. Certain U.S. government contracts may require us to incorporate government furnished parts into our products. Delays in receipt of such parts can adversely impact the timing of our performance on the related contracts.
Research and Development
We have established a leading technology position in our fields through internal and customer-funded research and development activities.
Internal research and development expenses are reported as research and development expenses for financial reporting purposes and were $52.2 million, $56.4 million and $53.9 million in fiscal 2020, 2019 and 2018, respectively, representing 8.5%, 8.4% and 9.4% of total consolidated net sales, respectively, for these periods. Customer-funded research and development activities relate to the adaptation of our basic technology to specialized customer requirements which is recoverable under contracts and is reflected in net sales with the related costs included in cost of sales. Certain of our government customers contract with us from time to time to conduct research on telecommunications software, equipment and systems. During fiscal 2020, 2019 and 2018, we were reimbursed by customers for such activities in the amounts of $11.9 million, $14.7 million and $16.9 million, respectively.
Intellectual Property
We rely upon trade secrets, technical know-how, continuing technological innovation and, with respect to certain technologies, patents to develop and maintain our competitive position. The products we sell require significant engineering design and manufacturing expertise. For these technological capabilities that are not protected by patents or licenses, we generally rely on the expertise of our employees and our learned experiences in both the design and manufacture of our products and the delivery of our services.
Some of our key Commercial Solutions segment technology is protected by patents that are significant to protecting our proprietary technology. We have been issued several U.S. patents relating to forward error correction technology that is utilized in our TPC-enabled satellite modems. Due to our market leadership position, we do not expect that upon expiration of these patents, our future results will be negatively impacted.
We have a portfolio of several hundred patents worldwide relating to wireless location services, text messaging, GPS ephemeris data, emergency public safety data routing, electronic commerce and other areas. To-date, our strategy has been to avoid offensive and defensive patent litigation and focus on building meaningful partnerships with other companies through direct licensing, cross licensing, and other forms of agreements. We do not believe that any single patent or group of patents, patent application or patent license agreement is material to the Company’s operations.
We have filed additional patent applications for certain apparatus and processes we believe we have invented covering key features of the location services, wireless text alerts, SMS Center, mobile-originated data and E911 network software. There is no assurance that any patent application will result in a patent being issued by the U.S. Patent and Trademark Office or other patent offices, nor is there any guarantee that any issued patent will be valid and enforceable. Additionally, foreign patent rights may or may not be available or pursued in any technology area for which U.S. patent applications have been filed.
13
Almost all the products and services we sell to the U.S. government include technology and other technical know-how that we have internally developed. In past instances where we have provided government-purpose rights, to our knowledge, the U.S. government has not exercised any of these rights. To the extent that we have provided or will provide government-purpose rights in the future, we believe that given the rapidly changing nature of our technology, our future success will depend primarily on the technical competence and creative skill of our personnel, rather than any contractual protection.
Competition
Our businesses are highly competitive and are characterized by rapid technological change. Some of our competitors are substantially larger, have significantly greater financial, marketing, research and development, technological and operating resources and broader product lines than we have. Other companies are developing new technologies and the shift towards open standards such as IP-based satellite networks will likely result in increased competition. A significant technological breakthrough by others, including new companies, our existing competitors and our customers, could have a material adverse effect on our business. Our future success depends on, among other things, our ability to keep pace with such changes and developments and to respond to the increasing variety of electronic equipment users and transmission technologies.
Some large defense-based companies, such as Northrop Grumman Corporation, have subsidiaries or divisions that compete against us in one or more business segments. In addition, new and potential competitors are always emerging. Certain of our customers, such as prime contractors who currently outsource their engineering and manufacturing requirements to us, have technological capabilities in our product areas and could choose to replace our products with products they develop. In some cases, we partner or team with companies (both large and mid-tier) to compete against other teams for large defense programs. In some cases, these same companies may be among our competitors.
Listed below, in alphabetical order, are some of our competitors in each of our two business segments:
Commercial Solutions - ACTIA Group, Advantech Co., Ltd., Agilis Satcom, AnaCom, Inc., Bandwidth.com, CalAmp Corp., Codan Limited, CPI International, Inc., Datum Systems, Inc., dB Control Corp. (a subsidiary of HEICO Corp.), 8x8, Inc., ENENSYS Technologies, ETM, Inc., Gilat Satellite Networks Ltd., Google Inc. (a subsidiary of Alphabet Inc.), Here Technologies, Honeywell Aerospace (a subsidiary of Honeywell International Inc.), Infinite Convergence Solutions, Inc., Intermap Technologies Corporation, Intrado Corporation, Iridium Communications Inc., ITS Electronics Inc., KVH Industries Inc., LM Ericsson Telephone Company, L3Harris Technologies, Inc., Mission Microwave Technologies, LLC., Motorola Solutions, Inc., ND Satcom GmbH, Nokia Networks (a subsidiary of Nokia Corporation), NOVELSAT, Novra Technologies Inc., Orbcomm Inc., Panasonic Corporation, Paradise Datacom Ltd. (a subsidiary of Teledyne Technologies Incorporated), Polarity Inc., SatixFy Israel Ltd., SatPath Systems, Inc., Spacepath Communications Limited, Speedcast International Limited, ST Engineering iDirect, Inc. (including Newtec), Telenav, Inc., Terrasat Communications Inc, TMD Technologies LLC., TomTom N.V. and ViaSat Inc.
Government Solutions - Aethercomm Inc., AMERGINT Technologies, Inc., CACI International Inc., CalAmp Corp., CPI International, Inc., Cubic Corporation, dB Control Corp. (a subsidiary of HEICO Corp.), DXC Technology, Empower RF Systems, Inc., Envistacom, LLC, Escape Communications, Inc., General Dynamics Corporation, International Datacasting Corporation (a subsidiary of Novra Technologies Inc.), Kratos Defense & Security Solutions, Inc., L3Harris Technologies, Inc., Mercury Systems, Inc., NeuStar, Inc., Northrop Grumman Corporation (including the former Orbital ATK, Inc.), Raytheon Technologies Corporation, Teledyne Technologies Incorporated, The KeyW Holding Corporation, Ultra Electronics Holdings plc. and ViaSat Inc.
We believe that competition in all our markets is based primarily on technology innovation, product performance, reputation, delivery times, customer support and price. Due to our proprietary know-how, we believe we can develop, produce and deliver products and services on a cost-effective basis faster than many of our competitors.
Employees
At July 31, 2020, we had 2,034 employees (including temporary employees and contractors), 1,274 of whom were engaged in production and production support, 382 in research and development and other engineering support, and 378 in marketing and administrative functions. None of our U.S. based employees are represented by a labor union. Of our 2,034 employees, 326 employees are based outside of the United States including 141 employees in the United Kingdom. We believe that our employee relations are good.
14
U.S. Government Contracts and Security Clearances
The U.S. government operates on an October-to-September fiscal year. Generally, in February of each year, the President of the United States presents to the U.S. Congress ("Congress") the proposed budget for the upcoming fiscal year and from February through September of each year, the appropriations and authorization committees of Congress review the President’s budget proposals and establish the funding levels for the upcoming fiscal year. Once these levels are enacted into law, the Executive Office of the President administers the funds to the agencies. Thereafter, we can receive orders pursuant to sole-source or competitively awarded contracts, which we describe below.
The U.S. government may be unable to complete its budget process before the end of any given government fiscal year and when the fiscal budget is not approved in a timely manner, the U.S. government is required either to shut down or be funded pursuant to a so-called "continuing resolution" that authorizes agencies of the U.S. government to continue operations but does not authorize new spending initiatives, either of which could result in reduced or delayed orders or payments for products and services we provide.
Sole-source contracts are generally awarded to a single contractor without a formal competition when a single contractor is deemed to have an expertise or technology superior to that of competing contractors or when there is an urgent need by the U.S. government that cannot wait for a full competitive process. Potential suppliers compete informally through research and development and marketing efforts. Competitively-bid contracts are awarded based on a formal proposal evaluation established by the procuring agency and interested contractors prepare bids. Competitively-bid contracts are awarded after a formal bid and proposal competition among suppliers.
The U.S. government has a stated policy direction to reduce the number of sole-source contract awards across all procuring agencies. In addition, the U.S. government is increasing the use of multiple-award IDIQ contracts to increase its procurement options. IDIQ contracts allow the U.S. government to select a group of eligible contractors for the same program. When the government awards IDIQ contracts to multiple bidders under the same program, a company that has already competed to be selected as a participant in the program must subsequently compete for individual delivery orders. As a result of this U.S. government shift toward multiple award IDIQ contracts, we expect to face greater competition for future U.S. government contracts and, at the same time, greater opportunities for us to participate in program areas that we do not currently participate in.
As a U.S. government contractor and subcontractor, we are subject to a variety of rules and regulations, such as the Federal Acquisition Regulations ("FAR"). Individual agencies can also have acquisition regulations. For example, the Department of Defense implements the FAR through the Defense Federal Acquisition Regulation supplement (commonly known as "DFARs"). For all Federal government entities, the FAR regulates the phases of any product or service acquisition, including: acquisition planning, competition requirements, contractor qualifications, protection of source selection and vendor information, and acquisition procedures. In addition, the FAR addresses the allowability of supplier costs, while Cost Accounting Standards address how those costs can be allocated to contracts. The FAR also subjects suppliers to audits and other government reviews. These reviews cover issues such as cost, performance and accounting practices relating to our contracts. The government may challenge a supplier's costs and fees. Suppliers are also required to comply with the National Industrial Security Program Operating Manual which relates to requirements regarding classified materials and programs. Suppliers who do not comply with these various regulations may lose and/or become ineligible for facility security clearances and/or participation in classified programs.
Under firm fixed-price contracts, we perform for an agreed-upon price and we can derive benefits from cost savings, but bear the risk of cost overruns. Our cost-reimbursable type contracts typically provide for reimbursement of allowable costs incurred plus a negotiated fee. Cost-plus-incentive-fee orders typically provide for sharing with the U.S. government savings accrued from orders performed for less than the target costs and costs incurred in excess of targets up to a negotiated ceiling price (which is higher than the target cost), and for the supplier to carry the entire burden of costs exceeding the negotiated ceiling price.
In fiscal 2020, $223.4 million or 36.2% of our consolidated net sales were to the U.S. government (including sales to prime contractors to the U.S. government). Of this amount, firm fixed-price and cost-reimbursable type contracts (including fixed-fee, incentive-fee and time and material type contracts) accounted for approximately $139.6 million and $83.7 million, respectively.
15
Regulatory Matters
In addition to the rules and regulations that pertain to us as a U.S. government contractor and subcontractor, we are also subject to a variety of local, state and federal governmental regulations.
Our products that are incorporated into wireless communications systems must comply with various government regulations, including those of the FCC. Our manufacturing facilities, which may store, handle, emit, generate and dispose of hazardous substances that are used in the manufacture of our products, are subject to a variety of local, state and federal regulations, including those issued by the Environmental Protection Agency. Our products are also subject to European Union directives related to the recycling of electrical and electronic equipment.
Our international sales are subject to U.S. and foreign regulations such as the Arms Export Control Act, the International Emergency Economic Powers Act ("IEEPA"), the International Traffic in Arms Regulations ("ITAR"), the Export Administration Regulations ("EAR") and the trade sanctions laws and regulations administered by the U.S. Department of the Treasury’s Office of Foreign Assets Control ("OFAC"), the Department of Commerce ("DoC") as well as other applicable laws relating to trade, export controls and foreign corrupt practices, the violation of which could adversely affect our operations. We cannot be certain that we will be able to obtain necessary export licenses, and such failure would materially adversely affect our operations. If we are unable to receive appropriate export authorizations in the future, we may be prohibited from selling our products and services internationally, which may limit our sales and have a material adverse effect on our business, results of operations and financial condition. We must comply with all applicable export control laws and regulations of the U.S. and other countries. Certain of our products and systems may require licenses from U.S. government agencies for export from the U.S., and some of our products are not permitted to be exported. In addition, in certain cases, U.S. export controls also severely limit unlicensed technical discussions, such as discussions with any persons who are not U.S. citizens or permanent residents. As a result, in cases where we may need an export license, our ability to compete against a non-U.S. domiciled foreign company that may not be subject to the same U.S. laws may be materially adversely affected. In addition, we are subject to the Foreign Corrupt Practices Act ("FCPA") and other local laws that generally bar bribes or unreasonable gifts to foreign governments or officials. Violations of these laws or regulations could result in significant sanctions, including disgorgement of profits, fines, and criminal sanctions against us, our officers, our directors, or our employees, more onerous compliance requirements, more extensive debarments from export privileges or loss of authorizations needed to conduct aspects of our international business. A violation of any of the regulations enumerated above could materially adversely affect our business, financial condition and results of operations. Additionally, changes in regulatory requirements which could further restrict our ability to deliver services to our international customers, including the addition of a country to the list of sanctioned countries under the IEEPA or similar legislation could negatively impact our business.
In the past, we have self-reported violations of export control laws or regulations to the U.S. Department of State, Directorate of Defense Trade Controls ("DDTC"), DoC and OFAC. In addition, we have made various commitments to U.S. government agencies that oversee trade and export matters that we will maintain certain policies and procedures including maintaining a company-wide Office of Trade Compliance. Also, we have agreed to have independent audits in future periods and will report any future violations to those agencies.
On September 17, 2020, we reported that we reached an agreement with OFAC resolving an investigation pending since 2014. In October 2014, as previously disclosed in our SEC filings, we reported to OFAC following a self-assessment of our export transactions that a shipment of modems sent to a Canadian customer by Comtech’s subsidiary, Comtech EF Data Corp., was incorporated into a communication system, the ultimate end user of which was the Sudan Civil Aviation Authority. The sales value of our equipment was approximately $288,000. At the time of shipment, OFAC regulations prohibited U.S. persons from doing business directly or indirectly with Sudan. Most of the U.S. sanctions related to Sudan were removed in 2017. After we reported the matter to OFAC, we responded to administrative subpoenas and OFAC initiated an investigation into the matter. Pursuant to the agreement, we will make a payment to OFAC of $894,111 and implement additional internal compliance commitments, a number of which were already in process. Additionally, we committed to creating a new position of Chief Trade Compliance Officer. Even though we take precautions to avoid engaging in transactions that may violate U.S. export control laws or regulations, including trade sanctions, those measures may not be effective in every instance. If it is determined that we have violated U.S. export control laws, civil and criminal penalties could apply, and we may suffer reputational harm.
16
Our financial reporting, corporate governance, public disclosure and compliance practices are governed by laws such as the Sarbanes-Oxley Act of 2002, Dodd-Frank Act of 2010, and rules and regulations issued by the SEC. The SEC has adopted rules which require, among other things, public companies to conduct certain inquiries to determine whether or not Conflict Minerals (as that term is defined in the SEC rules) that are necessary to the functionality of their manufactured products or their product's production processes originated in a Covered Country (as that term is defined in the SEC rules) and ultimately file a report with the SEC. Conflict Minerals are widely used in many industries, including the telecommunications industry and almost all of our products include component parts purchased from third-party suppliers and we must rely heavily on information received from suppliers to determine the origin of those materials. We have implemented a due diligence program consistent with the Organization for Economic Co-operation and Development guidelines to collect information concerning the country of origin of Conflict Minerals and in that regard, have adopted a policy that requires our suppliers (both public and private) to commit to a code of conduct relating to the responsible sourcing of minerals and to establish a policy to reasonably assure that the products they manufacture do not contain Conflict Minerals that originated in a Covered Country. Efforts to comply with this SEC rule have resulted in additional costs to us and, we believe, to our suppliers. As such, the availability of raw materials used in our operations could be negatively impacted and/or raw material prices could increase. Further, if we are unable to certify that our products are conflict free, we may face challenges with our customers, which could place us at a competitive disadvantage and could harm our reputation.
Laws and regulations have been enacted that affect companies conducting business on the Internet, including the European General Data Protection Regulation ("GDPR"). The GDPR imposes certain privacy related requirements on companies that receive or process personal data of residents of the European Union that are currently different than those in the United States and include significant penalties for non-compliance. Similarly, there are several legislative proposals in the United States, at both the federal and state level, that could impose new obligations in areas affecting our business, such as liability for personal data protection. In addition, some countries are considering or have passed legislation implementing data protection requirements or requiring local storage and processing of data or similar requirements that could increase the cost and complexity of delivering our services. Our costs to comply with the GDPR as well any other similar laws and regulations that emerge may negatively impact our business.
ITEM 1A. RISK FACTORS
Forward-Looking Statements
The following describes major risks to our business and should be considered carefully. Any of these factors could significantly and negatively affect our business, prospects, financial condition, or operating results, which could cause the trading prices of our equity securities to decline. The risks described below are not the only risks we may face. Additional risks and uncertainties not presently known to us, or risks that we currently consider immaterial, could also negatively affect us.
Risks Related to our Business
Despite our belief that Gilat Satellite Networks Ltd. ("Gilat") suffered a material adverse effect and that we are not obligated to close on our pending acquisition of Gilat, we may be required to complete such acquisition. If such event occurs, the merger with Gilat may not be successful, as we may not realize the anticipated benefits from the merger, the merger may divert our resources and management attention causing our operating results to fall short of expectations and we would incur substantial indebtedness which we may not be able to service in the future.
On January 29, 2020, we entered into an Agreement and Plan of Merger (the "Merger Agreement") with Gilat Satellite Networks, Ltd. Under the terms of the Merger Agreement, Comtech would acquire Gilat by way of a merger of Comtech's newly formed subsidiary with and into Gilat, with Gilat surviving the merger as a wholly-owned subsidiary of Comtech. Gilat is a worldwide leader in satellite networking technology, solutions and services, with market leading positions in the satellite ground station and in-flight connectivity solutions markets and deep expertise in operating large network infrastructures.
Pursuant to the Merger Agreement, each Gilat ordinary share would be converted into the right to receive consideration of (i) $7.18 in cash, without interest, plus (ii) 0.08425 of a share of Comtech common stock (worth approximately $1.12 per Gilat ordinary share as of September 24, 2020), with cash payable in lieu of fractional shares. Based on the terms agreed to on January 29, 2020 and the September 24, 2020 closing price of Comtech common stock of $13.32 per share, the total amount payable to Gilat shareholders would have been approximately $465.8 million (consisting of approximately $402.9 million in cash with the remainder in Comtech Common Stock) or $8.30 per Gilat ordinary share.
17
Our intention would be to fund the $402.9 million cash portion of the acquisition by redeploying a large portion of both our and Gilat's unrestricted cash and cash equivalents, with the remaining funds provided by a new secured credit facility (the "Gilat Acquisition Related Credit Facility") that would replace our existing Credit Facility, allow us to refinance our existing debt of approximately $149.5 million as of July 31, 2020, and allow us to fund a $5.0 million commitment related to a small pending acquisition of UHP Networks Inc. and its sister company (together, “UHP”), a leading provider of innovative and disruptive satellite ground station technology solutions..
Our obligation to acquire Gilat remains subject to certain closing conditions, including (a) regulatory approval in Russia to purchase Gilat’s Russian subsidiary and (b) the absence of any Material Adverse Effect (as defined in the Merger Agreement) on Gilat. After we announced this acquisition, the COVID-19 pandemic resulted in a sudden and steep decline in the travel and aviation markets in which many of Gilat’s customers operate and a significant slowdown of Gilat's business.
In July 2020, we commenced litigation in the Delaware Court of Chancery (the “Delaware Court”) seeking certain declaratory judgments including a declaratory judgment that Gilat has suffered a Material Adverse Effect and that, as a result, we are not obligated to complete the acquisition of Gilat. The amended complaint also seeks a declaratory judgment that certain actions, if taken by Gilat, relating to Comtech’s application for Russian regulatory approval, would breach Gilat’s obligations under the Merger Agreement. Gilat subsequently sued in the Delaware Court for declaratory judgments, including that it has not suffered a Material Adverse Effect and that Comtech has not used reasonable best efforts to obtain Russian regulatory approval for the transaction. To-date, we incurred significant amounts of legal expenses and professional fees in connection with the litigation and a trial is scheduled for October 5, 2020. The Delaware Court has indicated that it intends to render a judgment prior to October 29, 2020, the date that we or Gilat may terminate the Merger Agreement. If we are required to close the Gilat acquisition, total net debt of the combined companies would be expected to approximate $525.0 million. The acquisition of Gilat, the status of Russian regulatory approval and related litigation is discussed in detail in Part II - "Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Acquisition Plan Update" and "Notes to Consolidated Financial Statements - Note (13)(a) - Commitments and Contingencies - Legal Proceedings and Other Matters" included in "Part II - Item 8.- Financial Statements and Supplementary Data," included in this Annual Report on Form 10-K.
If our acquisition with Gilat is consummated, it will pose certain risks to our business.
In August 2020, Gilat publicly reported a net loss of $16.0 million and negative Adjusted EBITDA (as Gilat defines it) of $4.9 million for the six-month period ended June 30, 2020. The acquisition of Gilat would significantly increase our exposure to the global in-flight connectivity solutions market, which has suffered and is expected to continue to suffer, from a material and prolonged downturn as a result of the COVID-19 pandemic. If Gilat continues to experience net losses and negative Adjusted EBITDA (as it defines it), future cash flows of the combined entities will be less than currently expected and we may be unable to meet future debt service obligations, resulting in potentially material adverse consequences.
Contemporaneously with entering into the agreement to acquire Gilat, we and our banking partners entered into a commitment letter with respect to the Gilat Acquisition Related Credit Facility. Under the terms of the commitment letter, the lender's commitment to fund the facility is subject to the condition that no Material Adverse Effect has occurred with respect to Gilat or Comtech. We face the risk that our banking partners would independently determine that a Material Adverse Effect has occurred with respect to Gilat and terminate their commitments. As a result, if we are compelled to complete the acquisition of Gilat, we may have to seek alternative financing, which may not be available on favorable terms, or at all.
If our banking partners do not terminate their commitment, under the terms of the Gilat Acquisition Related Credit Facility we would be required to grant the lenders a security interest in substantially all our assets as collateral security for our payment obligations. Accordingly, if we are unable to meet our debt service obligations, we could be forced to dispose of some or all of our assets on disadvantageous terms. We may not be able to refinance our indebtedness under the Gilat Acquisition Related Credit Facility on favorable terms, or at all. Moreover, borrowings under the Gilat Acquisition Related Credit Facility following completion of the Gilat acquisition would be significantly greater than our outstanding indebtedness under our existing Credit Facility.
The prospective merger with Gilat would significantly expand the types of products that we sell, expand the businesses in which we are engaged and expand our global footprint including increasing the number of facilities we operate, thereby presenting us with significant challenges as we will need to manage the substantial increase in scale resulting from the acquisition. The success of the acquisition, if completed, will depend, in part, on our ability to integrate Gilat’s workforce and complex operations (concentrated in large part in Israel and Peru), with Comtech’s business. That integration will be more difficult given the international travel restrictions still in place in many parts of the world as a result of the global COVID-19 pandemic.
18
The operational and administrative challenges we will face as we integrate Gilat’s operations into our business include maintaining our focus on meeting all customer commitments and expectations, including supporting all existing products, services and agreements.
Delays in the integration process could have a material adverse impact on our business, results of operation and financial condition. Also, the diversion of our management’s attention to these matters and away from other business concerns could have an adverse effect on our business and operating results may fall short of expectations. Ultimately, we may not be successful.
The ongoing COVID-19 pandemic has impacted our business, operating results and financial condition, as well as the operations and financial performance of many of the customers and suppliers in industries that we serve. We are unable to predict the extent to which the pandemic and related effects will adversely impact our business operations, financial performance, results of operations, financial position and the achievement of our strategic objectives.
Comtech’s second half of fiscal 2020, running from February 1 through July 31, 2020, corresponded almost precisely with the period in which significant worldwide restrictions on business activities were in force due to the COVID-19 pandemic. Most if not all of our sales and marketing personnel were unable to travel and/or meet with customers. As a result, Comtech experienced significant order delays and lower net sales during such period.
These poor business conditions have resulted in the immediate suppression of end-market demand for many of our products such as satellite ground station technologies and other short-lead time products. Because the timing, impact, severity and duration of these conditions are impossible to predict and remain ongoing, there is a risk that such conditions will have a material adverse effect on our future consolidated results of operations. Further, the COVID-19 pandemic has resulted in a widespread health crisis and numerous disease control measures being taken to limit its spread. The impact of the pandemic on our business has included or could in the future include:
•disruptions to or restrictions on our ability to ensure the continuous manufacture and supply of our products and services, including insufficiency of our existing inventory levels;
•temporary closures or reductions in operational capacity of our facilities or the facilities of our direct or indirect suppliers or customers;
•permanent closures of our direct and indirect suppliers, resulting in adverse effects to our supply chain;
•temporary shortages of skilled employees available to staff manufacturing, production and assembly facilities due to stay at home orders and travel restrictions within as well as into and out of countries;
•increases in operational expenses and other costs related to requirements implemented to mitigate the impact of the pandemic;
•supply chain disruptions;
•delays or limitations on the ability of our customers to perform or make timely payments;
•cancellations in our backlog;
•reductions in short- and long-term demand for our products, or other disruptions in technology buying patterns;
•adverse effects on economies and financial markets globally or in various markets throughout the world, potentially leading to a prolonged economic downturn or reductions in business and consumer spending, which may result in decreased net revenue, gross margins, or earnings and/or in increased expenses and difficulty in managing inventory levels;
•delays to and/or lengthening of our sales or development cycles or qualification activity;
•challenges for us, our direct and indirect suppliers and our customers in obtaining financing due to turmoil in financial markets;
19
•workforce disruptions due to illness, quarantines, governmental actions, other restrictions, and/or the social distancing measures we have taken to mitigate the impact of COVID-19 at certain of our locations around the world in an effort to protect the health and well-being of our employees, customers, suppliers and of the communities in which we operate (including working from home, restricting the number of employees attending events or meetings in person, limiting the number of people in our buildings and factories at any one time, further restricting access to our facilities, suspending employee travel and inability to meet in person with customers);
•increased vulnerability to cyberattacks due to the significant number of employees working remotely; and
•our management team continuing to commit significant time, attention and resources to monitoring the COVID-19 pandemic and seeking to mitigate its effects on our business and workforce.
The ultimate extent of the impact of COVID-19 on our business, financial condition and results of operations will depend on future developments, which are highly uncertain and cannot be predicted at this time. These impacts, individually or in the aggregate, could have a material and adverse effect on our business, results of operations and financial condition. Such effect may be exacerbated in the event the pandemic and the measures taken in response to it, and their effects, persist for an extended period of time, or if there is a resurgence of the outbreak. Under any of these circumstances, the resumption of normal business operations may be delayed or hampered by lingering effects of COVID-19 on our operations, direct and indirect suppliers, partners, and customers.
Our fiscal 2021 business outlook is difficult to forecast and operating results are subject to significant fluctuations and are likely to be volatile.
Historically, our business outlook is difficult to forecast and backlog (sometimes referred to herein as orders or bookings), net sales and operating results may vary significantly from period to period due to a number of factors including: sales mix; fluctuating market demand; price competition; new product introductions by our competitors; customer bankruptcies; changing customer partnering procurement strategies; fluctuations in foreign currency exchange rates; unexpected changes in the timing of delivery of components or subsystems; the financial performance and impact of acquisitions; new accounting standards; political instability; regulatory developments; changes in income tax rates or tax credits; the price and expected volatility of our stock (which will impact, among other items, the amount of stock-based compensation expense we may record); general global economic conditions, and the impact of natural disasters or global pandemics.
During fiscal 2020, largely as a result of the adverse impact of COVID-19 on business conditions, we ceased providing specific financial targets. Although we have now reinstated providing specific forward-looking financial targets in fiscal 2021, it remains difficult to predict the timing of customer awards and related shipments and we may not meet our targets.
We have experienced, and will experience in the future, significant fluctuations in bookings, net sales and operating results from period to period. For example, a sudden change in global economic conditions (or a worsening of the COVID-19 pandemic as described above) could have an immediate impact on a large portion of our net sales, a large amount of which are derived from products such as satellite ground station technologies, amplifier products and mission-critical technologies that generally have short order and lead times. Similarly, sales of certain of our public safety and location technologies are subject to sudden changes in wireless carrier procurement strategies, including decisions to sole-source such solutions or to perform such solutions internally. As a result of any such conditions or changes, bookings and backlog related to these solutions are extremely sensitive to short-term fluctuations in customer demand.
In addition, a large portion of our Government Solutions segment's net sales are derived in part from large U.S. government programs or large foreign government opportunities that are subject to lengthy sales cycles (including funding requirements) and are therefore difficult to predict.
20
If global economic business and political conditions deteriorate as compared to the current environment it could have a material adverse impact on our business outlook and our business, operating results and financial condition.
In addition to the unique business risks related to COVID-19, many of the end-markets for our products and services may be significantly impacted for other issues that result in adverse global economic conditions. For example, many of our international end-customers are in emerging and developing countries that are subject to sweeping economic and political changes. Many governments around the world are under pressure to reduce their spending. In recent years, global oil and natural gas prices have been volatile and significantly impaired the ability of certain of our government customers in the oil and gas producing regions of the world to invest in telecommunications products and infrastructure. Additionally, the relative strength of the U.S. dollar against many international currencies has negatively impacted the purchasing power for many of our international end-customers because virtually all of our sales are denominated in U.S. dollars. We generate significant sales from many emerging and developing countries.
We believe that the current global economic business environment is unstable and sudden negative changes could result in the immediate suppression of end-market demand for many of our products such as satellite ground station technologies and other short-lead time products. The timing, impact, severity and duration of these conditions are impossible to predict. In addition, many of our international customers (including our Middle Eastern and African customers) rely on European bank financing to procure funding for large systems, many of which include our equipment.
We believe that European financing has been and continues to be difficult to obtain. Volatility of financing conditions may cause our customers to be reluctant to spend funds required to purchase our equipment or projects could be postponed or canceled.
The United Kingdom ("U.K.") exited from the European Union ("E.U.") on January 31, 2020. Such exit is commonly referred to as "Brexit". During its 11 month transition period, the U.K. and the E.U. are expected to negotiate a free trade agreement which will (i) allow U.K. goods to move around the E.U. without extra charges and (ii) keep other barriers (such as border checks) to a minimum. However, there is no guarantee that the U.K. will reach an agreement with the E.U. by December 31, 2020. If a free trade agreement is not reached, then tariffs (taxes) and full border checks will be applied to U.K. goods travelling to the E.U. We maintain production, engineering and sales facilities in the U.K. and adverse consequences concerning Brexit could result in a deterioration in global economic conditions, instability in global financial markets, political uncertainty, volatility in currency exchange rates, or adverse changes in the cross-border agreements currently in place, any of which could have an adverse impact on our financial results in the future.
In the past, our overall business has not been immune from adverse economic conditions. If U.S. or global economic conditions deteriorate further, or political conditions become unstable, or additional economic sanctions are imposed on some of our end-customers, it could adversely impact our business in a number of ways, including:
•Difficulty in forecasting our results of operations - It is difficult to accurately forecast our results of operations during periods of adverse conditions as we cannot predict the severity or the duration of such conditions or the impact it could have on our current and prospective customers. If our current or prospective customers materially postpone, reduce or even forgo purchases of our products and services to a greater extent than we anticipate, our business outlook will prove to be inaccurate.
•Additional reductions in telecommunications equipment and systems spending may occur - In the past, our businesses have been negatively affected by uncertain economic environments in the overall market and, more specifically, in the telecommunications sector. Our customers have reduced their budgets for spending on telecommunications equipment and systems and in some cases postponed or reduced the purchase of our products and systems. In the future, our customers may again reduce their spending on telecommunications equipment and systems which would negatively impact both of our operating segments. If this occurs, it would adversely affect our business outlook, net sales, profitability and the recoverability of our assets, including intangible assets such as goodwill.
21
•Our customers may not be able to obtain financing - Although many of our products are relatively inexpensive when compared to the total systems or networks that they are incorporated into, our sales are affected by our customers' ability to obtain the financing they may require to build out their total systems or networks and fund ongoing operations. Many of our emerging market customers obtain financing for network buildouts from European commercial banks and/or governments. Our customers' inability to obtain adequate financing would adversely affect our net sales. In addition, if the economic environment and lack of financing results in insolvencies for our customers, it would adversely impact the recoverability of our accounts receivable which would, in turn, adversely impact our results of operations.
Our backlog is subject to customer cancellation or modification and such cancellations could result in a decline in sales and increased provisions for excess and obsolete inventory.
We currently have a backlog of orders, mostly under contracts that our customers may modify or terminate. Almost all of the contracts in our backlog (including firm orders previously received from the U.S. government) are subject to cancellation at the convenience of the customer or for default in the event that we are unable to perform under the contract.
In some cases, such as contracts received from large U.S. based telecommunication companies, our backlog is computed by multiplying the most recent month’s contract or revenue by the months remaining under the existing long-term agreements, which we consider to be the best available information for anticipating revenue under those agreements. Also, a significant portion of the backlog from our U.S. commercial customers relates to large, multi-year contracts to provide state and local governments (and their agencies) with public safety and location technology solutions. Although the contracts themselves represent legal, binding obligations of these governments, funding is often subject to the approval of budgets (for example, on an annual or bi-annual basis). Although funding for these multi-year contracts are dependent on future budgets being approved, we include the full estimated value of these large, multi-year contracts in our backlog given the critical nature of the services being provided and the positive historical experience of our state and local government customers passing their respective budgets.
There can be no assurance that our backlog will result in actual revenue in any particular period, or at all, particularly during periods of macroeconomic instability. Nor can there be any assurance that any contract included in backlog will be profitable. The actual amount and timing of any revenue is subject to various contingencies, many of which are beyond our control. The actual recognition of revenue on contracts included in backlog may never occur or may change because a program schedule could change, a customer may not follow up with order details (e.g., delivery instructions), fluctuations in currency exchange rates after an order is placed could cause our products to become too expensive for a foreign customer, a customer’s program could be canceled, a contract could be reduced, modified or terminated early due to changes in a customer’s priorities, funding may not be included in future budgets, actual indirect rates being reimbursed on U.S. government contracts may ultimately be less than those indirect rates included in our initial proposals, or an option that we had assumed would be exercised is not exercised.
We record a provision for excess and obsolete inventory based on historical and projected usage trends and other factors, including the consideration of the amount of backlog we have on hand at any particular point in time. If orders in our backlog are canceled or modified, our estimates of future product demand may prove to be inaccurate, in which case we may have understated the provision required for excess and obsolete inventory. In the future, if we determine that our inventory is overvalued, we will be required to recognize such costs in our financial statements at the time of such determination. Any such charges could be materially adverse to our results of operations and financial condition.
We have incurred indebtedness under a Credit Facility, and may incur substantial additional indebtedness in the future, and may not be able to service that debt in the future and we must maintain compliance with various covenants that impose restrictions on our business.
On October 31, 2018, we entered into a First Amended and Restated Credit Agreement (the "Credit Facility") with a syndicate of lenders, replacing our prior Credit Agreement dated as of February 23, 2016. The Credit Facility provides a senior secured loan facility of up to $550.0 million consisting of: (i) a revolving loan facility with a borrowing limit of $300.0 million; (ii) an accordion feature allowing us to borrow up to an additional $250.0 million; (iii) a $35.0 million letter of credit sublimit; and (iv) a swingline loan credit sublimit of $25.0 million. The obligations under the Credit Facility are secured by substantially all of our tangible and intangible assets.
22
As of July 31, 2020, the amount outstanding under our Credit Facility was $149.5 million, which is reflected in the non-current portion of long-term debt on our Consolidated Balance Sheet. At July 31, 2020, we also had $3.1 million of standby letters of credit outstanding under our Credit Facility related to guarantees of future performance on certain customer contracts.
The Credit Facility matures on October 31, 2023. If we do not have sufficient funds to repay our debt when due, it may be necessary to refinance our debt through additional debt or equity financings. If, at the time of any refinancing, prevailing interest rates or other factors result in higher interest rates on such refinancing, increases in interest expense could have a material adverse effect on our business, results of operations and financial condition.
Our Credit Facility contains various affirmative and negative covenants that may restrict our ability to, among other things, permit liens on our property, change the nature of our business, transact business with affiliates and/or merge or consolidate with any other person or sell or convey certain of our assets to any one person.
As of July 31, 2020, our Secured Leverage Ratio (as defined in the Credit Facility) was 1.99x trailing twelve month ("TTM") Consolidated EBITDA (as defined in the Credit Facility) compared to the maximum allowable Leverage Ratio of 3.75x TTM Consolidated EBITDA. Our Interest Expense Coverage Ratio as of July 31, 2020 was 14.40x TTM Adjusted EBITDA compared to the Minimum Interest Expense Coverage Ratio of 3.25x TTM Adjusted EBITDA.
Assuming we are not obligated to complete the Gilat acquisition, we anticipate maintaining compliance with the terms and financial covenants in our Credit Facility for the foreseeable future. If we complete the Gilat acquisition, we expect to replace our Credit Facility with a new Gilat Acquisition Related Credit Facility, for which terms are still being negotiated. As such, there can be no assurance that we will be able to meet covenants in this new facility.
Further, our ability to comply with covenants, terms of and conditions of either facility may be affected by events beyond our control. Failure to comply with covenants could result in an event of default, which, if not cured or waived, could accelerate our repayment obligations. Our substantial debt obligations could impede, restrict or delay the implementation of our business strategy or prevent us from entering into transactions that would otherwise benefit our business. For example:
•we may be required to dedicate a substantial portion of our cash flows from operations to payments on our indebtedness, thereby reducing the availability of our cash flows for other purposes, including business development efforts, capital expenditures, dividends or strategic acquisitions;
•if we are not able to generate sufficient cash flows to meet our substantial debt service obligations or to fund our other liquidity needs, we may have to take actions such as selling assets or raising additional equity or reducing or delaying capital expenditures, strategic acquisitions, investments and joint ventures, or restructuring our debt;
•we may not be able to fund future working capital, capital investments and other business activities;
•we may not be able to pay dividends or make certain other distributions;
•we may become more vulnerable in the event of a downturn in our business or a worsening of general economic or industry-specific conditions; and
•our flexibility in planning for, or reacting to, changes in our business and industry may be limited, thereby placing us at a competitive disadvantage compared to our competitors that have less indebtedness.
Moreover, we may incur substantial additional indebtedness in the future to fund acquisitions or to fund other activities for general business purposes. If additional new debt is added to the current or planned debt levels, the related risks that we now face could intensify. A substantial increase in our indebtedness could also have a negative impact on our credit ratings. In this regard, failure to maintain our credit ratings could adversely affect the interest rate available to us in future financings, as well as our liquidity, competitive position and access to capital markets. Any decision regarding future borrowings will be based on the facts and circumstances existing at the time, including market conditions and our credit ratings.
In addition to the pending UHP and Gilat acquisitions, future acquisitions of companies and investments could prove difficult to integrate, disrupt our business, dilute stockholder value or adversely affect operating results or the market price of our common stock.
We expect to continue to evaluate other acquisitions and investments as part of our growth plans. Such efforts may not result in an acquisition or ultimately be beneficial to us.
23
Future acquisitions or investments may result in the use of significant amounts of cash, potentially dilutive issuances of equity securities, incurrence of large amounts of debt, increases to amortization expense and future write-offs of the acquired intangibles. Acquisitions and investments involve risks that include failing to:
•properly evaluate the technology;
•accurately forecast the financial impact of the transaction, including accounting charges and transaction expenses;
•integrate the technologies, products and services, research and development, sales and marketing, support and other operations;
•integrate and retain key management personnel and other key employees;
•retain and cross-sell to acquired customers; and
•combine potentially different corporate cultures.
Acquisitions and investments could also:
•divert management’s attention away from the operation of our businesses;
•result in significant goodwill and intangibles write-offs in the event an acquisition or investment does not meet expectations; and
•increase expenses, including expenses of managing the growth of such acquired businesses.
There can be no assurance that any future acquisition or investment will be successful within the anticipated time frame, or at all, will be as valuable as the amount we eventually pay to acquire it, and will not adversely affect our business, results of operations or financial condition. In addition, if we consummate future acquisitions using our equity securities or securities convertible into our equity securities, existing stockholders may be diluted, which could have a material adverse effect on the market price of our common stock.
Our business is highly dependent on the budgetary decisions of our government customers, including the U.S. government (including prime contractors to the U.S. government), and changes in the U.S. government’s fiscal policies or budgetary priorities may have a material adverse effect on our business, operating results and financial condition.
During our fiscal years ended July 31, 2020, 2019 and 2018, sales to the U.S. government (including sales to prime contractors to the U.S. government) were $223.4 million, $269.2 million and $202.7 million or 36.2%, 40.1% and 35.5% of our consolidated net sales, respectively. In addition, a large portion of our existing backlog consists of orders related to U.S. government contracts and our Business Outlook for Fiscal 2021 and beyond depends, in part, on significant new orders from the U.S. government, which undergoes extreme budgetary pressures from time to time.
We rely on particular levels of U.S. government spending on our communication solutions, and our receipt of future orders depends in large part on continued funding by the U.S. government for the programs in which we participate. These spending levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general public policy and political support for this type of spending. Government contracts are conditioned upon the continuing availability of congressional appropriations and Congress’s failure to appropriate funds, or Congress’s actions to reduce or delay spending on, or reprioritize its spending away from, U.S. government programs which we participate in, could negatively affect our results of operations. Because many of the items we sell to the U.S. government are included in large programs realized over a period of several years, it is difficult, if not impossible, to determine specific amounts that are or will be appropriated for our products and services. As such, our assessments relating to the impact of changes in U.S. government spending may prove to be incorrect.The outcome of the national elections to be held in the U.S. in 2020 may also impact the levels of U.S. government spending.
24
The federal debt limit continues to be actively debated as plans for long-term national fiscal policy are discussed. The outcome of these discussions could have a significant impact on defense spending broadly and programs we support in particular. The failure of Congress to approve future budgets and/or increase the debt ceiling of the U.S. on a timely basis could delay or result in the loss of contracts for the procurement of our products and services and we may be asked or required to continue to perform for some period of time on certain of our U.S. government contracts, even if the U.S. government is unable to make timely payments. A decrease in Department of Defense or Department of Homeland Security expenditures, the elimination or curtailment of a material program in which we are involved, or changes in payment patterns of our customers as a result of changes in U.S. government spending could have a material adverse effect on our business, results of operations and financial condition.
Ultimately, the U.S. government may be unable to timely complete its budget process or fully agree upon spending priorities. As such, it is possible that a shutdown of the U.S. government may occur, or interim budgets may be adopted. As such, we may experience delayed orders, delayed payments and declines in net sales, profitability and cash flows. We may experience related supply chain delays, disruptions or other problems associated with financial constraints faced by our suppliers and subcontractors. Moreover, an outbreak of a pandemic such as the COVID-19 pandemic and associated quarantines, closures and travel restrictions may cause temporary or long-term disruptions in our supply chain and distribution systems. All of the aforementioned conditions and factors could, in the aggregate, have a material adverse effect on our business, results of operations and financial condition. Additionally, cost cutting, efficiency initiatives, reprioritization, other affordability analyses, and changes in budgetary priorities by our governmental customers, including the U.S. government, could adversely impact both of our operating segments. We are unable to predict the impact these or similar events could have on our business, financial position, results of operations or cash flows.
Our contracts with the U.S. government are subject to unique business, commercial and government audit risks.
We depend on the U.S. government for a significant portion of our revenues. Our contracts with the U.S. government are subject to unique business and commercial risks, including:
•unexpected contract or project terminations or suspensions;
•unpredictable order placements, reductions, accelerations, delays or cancellations;
•higher than expected final costs, particularly relating to software and hardware development, for work performed under contracts where we commit to specified deliveries for a fixed-price; and
•unpredictable cash collections of unbilled receivables that may be subject to acceptance of contract deliverables by the customer and contract close out procedures, including government audit and approval of final indirect rates.
Although we take steps to mitigate our risk with respect to contracts with the U.S. government, we may not be able to do so in every instance for any of the following reasons, among others:
•Our U.S. government contracts can easily be terminated by the U.S. government - Our U.S. government contracts can be terminated by the U.S. government for its convenience or upon an event of default by us. Termination for convenience provisions provide us with little to no recourse related to: our potential recovery of costs incurred or costs committed, potential settlement expenses and hypothetical profit on work completed prior to termination.
•Our U.S. government contracts are subject to funding by the U.S. Congress - Our U.S. government contracts are conditioned upon the continuing approval by Congress of the necessary funding. Congress usually appropriates funds for a given program on a fiscal year basis even though contract performance may take more than one year. Consequently, at the beginning of a major program, the contract may not be fully funded, and additional monies are normally committed to the contract only if, and when, appropriations are made by Congress for future fiscal years. Delays or changes in funding can impact the timing of awards or lead to changes in program content. We obtain certain of our U.S. government contracts through a competitive bidding process. There can be no assurance that we will win additional contracts or that actual contracts that are awarded will ultimately be profitable.
25
•We can be disqualified as a supplier to the U.S. government - As a supplier to the U.S. government, we must comply with numerous regulations, including those governing security, contracting practices and classified information. Failure to comply with these regulations and practices could result in fines being imposed against us or our suspension for a period of time from eligibility for bidding on, or for award of, new government contracts. If we are disqualified as a supplier to government agencies, we would lose most, if not all, of our U.S. government customers and revenues from sales of our products would decline significantly.
In addition, all of our U.S. government contracts can be audited by the Defense Contract Audit Agency ("DCAA") and other U.S. government agencies and we can be subject to penalties arising from post-award contract audits (sometimes referred to as a Truth in Negotiations Act or "TINA" audit) or cost audits in which the value of our contracts may be reduced. If costs are found to be improperly allocated to a specific contract, those costs will not be reimbursed, and any such costs already reimbursed would be required to be refunded. TCS underwent audits by the DCAA for periods prior to Comtech’s fiscal 2016 acquisition of TCS. The DCAA has informed us that it is proposing retroactive contracts adjustments that, if finalized and issued, would result in the need for us to provide a refund to the U.S. government of approximately $2.4 million. We disagree with the DCAA’s assessment and would vigorously protest any adjustment. We have not recorded any reserve related to these audits but ultimately an adjustment may be issued. Although we record contract revenues based upon costs we expect to realize upon final audit, we cannot predict the outcome of any such future audits and adjustments, and we may be required to materially reduce our revenues or profits upon completion and final negotiation of audits. Negative audit findings could also result in termination of a contract, forfeiture of profits, suspension of payments, fines and suspension or debarment from U.S. government contracting or subcontracting for a period of time.
Our dependence on sales to international customers exposes us to unique business, commercial and export compliance audit risks.
Sales for use by international customers (including sales to U.S. companies for inclusion in products that will be sold to international customers) represented approximately 23.5%, 25.4% and 25.6% of our consolidated net sales for the fiscal years ended July 31, 2020, 2019 and 2018, respectively, and we expect that international sales will continue to be a significant portion of our consolidated net sales for the foreseeable future. These sales expose us to certain risks, including barriers to trade, fluctuations in foreign currency exchange rates (which may make our products less price-competitive), political and economic instability, exposure to public health epidemics, availability of suitable export financing, tariff regulations, and other U.S. and foreign regulations that may apply to the export of our products. Although we take steps to mitigate our risk with respect to international sales, we may not be able to do so in every instance for any of the following reasons, among others:
•We may not be able to continue to structure our international contracts to reduce risk - We attempt to reduce the risk of doing business in foreign countries by seeking subcontracts with large systems suppliers, contracts denominated in U.S. dollars, advance or milestone payments and irrevocable letters of credit in our favor. However, we may not be able to reduce the economic risk of doing business in foreign countries in all instances. In such cases, billed and unbilled receivables relating to international sales are subject to increased collectability risk and may result in significant write-offs, which could have a material adverse effect on our business, results of operations and financial condition. In addition, foreign defense contracts generally contain provisions relating to termination at the convenience of the government.
•We rely on a limited number of international sales agents - In some countries, we rely upon one or a small number of sales agents, exposing us to risks relating to our contracts with, and related performance of, those agents. We attempt to reduce our risk with respect to sales agents by establishing additional foreign sales offices where it is practical and by engaging, where practicable, more than one independent sales representative in a territory. It is our policy to require all sales agents to operate in compliance with applicable laws, rules and regulations. Violations of any of these laws, rules or regulations, and other business practices that are regarded as unethical, could interrupt the sales of our products and services, result in the cancellation of orders or the termination of customer relationships, and could damage our reputation, any of which developments could have a material adverse effect on our business, results of operations and financial condition.
26
•We currently price virtually all of our products in U.S. dollars - Today, virtually all of our sales are denominated in U.S. dollars. Over the last few years, the U.S. dollar has strengthened significantly against many international currencies. As such, many of our international customers experienced a drop in their purchasing power as it relates to their ability to purchase our products. To date, we have not materially changed our selling prices and have experienced lower sales volumes in certain cases. If the U.S. dollar strengthens from current levels against many international currencies, our customers may reduce their spending or postpone purchases of our products and services to a greater extent than we currently anticipate which could have a material adverse effect on our business, results of operations and financial condition.
•We must comply with all applicable export control laws and regulations of the U.S. and other countries - Certain of our products and systems may require licenses from U.S. government agencies for export from the U.S., and some of our products are not permitted to be exported. In addition, in certain cases, U.S. export controls also severely limit unlicensed technical discussions, such as discussions with any persons who are not U.S. citizens or permanent residents. As a result, in cases where we may need a license, our ability to compete against a non-U.S. domiciled foreign company that may not be subject to the same U.S. laws may be materially adversely affected. U.S. laws and regulations applicable to us include the Arms Export Control Act, the IEEPA, the ITAR, the EAR and the trade sanctions laws and regulations administered by the U.S. Treasury Department's OFAC.
•We must comply with the FCPA and similar laws elsewhere - We are subject to the FCPA and other foreign laws prohibiting corrupt payments to government officials, which generally bar bribes or unreasonable gifts to foreign governments or officials. Violations of these laws or regulations could result in significant sanctions, including disgorgement of profits, fines, criminal sanctions against us, our officers, our directors, or our employees, more onerous compliance requirements, more extensive debarments from export privileges or loss of authorizations needed to conduct aspects of our international business. A violation of any of the regulations enumerated above could materially adversely affect our business, financial condition and results of operations. Although we have implemented policies and procedures designed to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors, agents, or subsidiaries will not violate our policies. Additionally, changes in regulatory requirements which could restrict our ability to deliver services to our international customers, including the addition of a country to the list of sanctioned countries under the IEEPA or similar legislation could negatively impact our business. For the fiscal years ended July 31, 2020, 2019 and 2018, we have conducted no business with states designated as sponsors of terrorism.
•We must maintain a company-wide Office of Trade Compliance - In the past, we have self-reported violations of export control laws or regulations to the U.S. Department of State, Directorate of Defense Trade Controls ("DDTC"), DoC and OFAC. In addition, we have made various commitments to U.S. government agencies that oversee trade and export matters and have committed that we will maintain certain policies and procedures including maintaining a company-wide Office of Trade Compliance. Additionally, we have agreed to have independent audits in future periods and will report any future violations to those agencies. Even though we take precautions to avoid engaging in transactions that may violate U.S. export control laws or regulations, including trade sanctions, those measures may not be effective in every instance. If it is determined that we have violated U.S. export control laws or regulations or trade regulations, civil and criminal penalties could apply, and we may suffer reputational harm.
•We are subject to future export compliance audits - We continue to implement policies and procedures to ensure that we comply with all applicable export control laws and regulations. We are subject to future compliance audits that may uncover improper or illegal activities that would subject us to material remediation costs, civil and criminal fines and/or penalties and/or an injunction. In addition, we could suffer serious reputational harm if allegations of impropriety were made against us. Each of these outcomes could, individually or in the aggregate, have a material adverse effect on our business, results of operations and financial condition. The absence of comparable restrictions on competitors in other countries may adversely affect our competitive position. In addition, in order to ship our products into and implement our services in some countries, the products must satisfy the technical requirements of that particular country. If we were unable to comply with such requirements with respect to a significant quantity of our products, our sales in those countries could be restricted, which could have a material adverse effect on our business, results of operations and financial condition.
27
•We may be affected by the future imposition of tariffs and trade restrictions - The current U.S. administration has signaled support for, and in some instances has taken action with respect to, major changes to certain trade policies, such as the imposition of additional tariffs on imported products, the withdrawal from or renegotiation of certain trade agreements and the imposition of certain export sanctions. Such changes could result in retaliatory actions by the United States’ trade partners. For example, over the last several months, the U.S. has increased tariffs on certain imports from China, as well as on steel and aluminum products imported from various countries and imposed export sanctions on certain Chinese entities. In response, China, the European Union, and several other countries have imposed or proposed additional tariffs on certain exports from the U.S. Our inability to effectively manage the negative impacts of changing U.S. and foreign trade policies, including, in connection with our business with customers outside of the United States or with newly sanctioned entities could adversely affect our business and financial results.
Our investments in recorded goodwill and other intangible assets could be impaired as a result of future business conditions, a deterioration of the global economy or if we change our reporting unit structure.
As of July 31, 2020, goodwill recorded on our Consolidated Balance Sheet aggregated $330.5 million. Additionally, as of July 31, 2020, net intangibles recorded on our Consolidated Balance Sheet aggregated $258.0 million.
For purposes of reviewing impairment and the recoverability of goodwill and other intangible assets, our Government Solutions and Commercial Solutions segment each constitute a reporting unit and we must make various assumptions in determining their estimated fair values. Reporting units are defined by how our Chief Executive Officer ("CEO") manages the business, which includes resource allocation decisions. We may, in the future, change our management approach which in turn may change the way we define our reporting units, as such term is defined by Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 350 "Intangibles - Goodwill and Other." A change to our management approach may require us to perform an interim goodwill impairment test and possibly record impairment charges in a future period.
In accordance with FASB ASC 350, "Intangibles - Goodwill and Other," we perform a goodwill impairment analysis at least annually (in the first fiscal quarter of each fiscal year), unless indicators of impairment exist in interim periods. If we fail the quantitative assessment of goodwill impairment ("quantitative assessment"), we would be required to recognize an impairment loss equal to the amount that a reporting unit's carrying value exceeded its fair value; however, any loss recognized should not exceed the total amount of goodwill allocated to that reporting unit.
On August 1, 2020 (the first day of our fiscal 2021), we performed our annual quantitative assessment and estimated the fair value of each of our reporting units using a combination of the income and market approaches, and taking into consideration both the potential short-term and long-term effects of the COVID-19 pandemic. Based on our quantitative evaluation, we determined that our Commercial Solutions and Government Solutions reporting units had estimated fair values in excess of their carrying values of at least 8.4% and 78.0%, respectively, and concluded that our goodwill was not impaired and that neither of our two reporting units was at risk of failing the quantitative assessment.
However, it is possible that, during fiscal 2021 or beyond, business conditions (both in the U.S. and internationally) could deteriorate from the current state, our current or prospective customers could materially postpone, reduce or even forgo purchases of our products and services to a greater extent than we currently anticipate, or our common stock price could decline further. Such deterioration could be caused by uncertainty about the severity and length of the COVID-19 pandemic, and its impact on global business activity.
A significant decline in our customers' spending that is greater than we anticipate or a shift in funding priorities may also have a negative effect on future orders, sales, income and cash flows and we might be required to perform a quantitative assessment during fiscal 2021 or beyond. If assumed net sales and cash flow projections are not achieved in future periods or our common stock price significantly declines from current levels, our Commercial Solutions or Government Solutions reporting units could be at risk of failing the quantitative assessment and goodwill and intangibles assigned to the respective reporting units could be impaired.
28
In any event, we are required to perform the next annual goodwill impairment analysis on August 1, 2021 (the start of our fiscal 2022). If our assumptions and related estimates change in the future, or if we change our reporting unit structure or other events and circumstances change (e.g., a sustained decrease in the price of our common stock (considered on both absolute terms and relative to peers)), we may be required to record impairment charges when we perform these tests, or in other future periods. In addition to our impairment analysis of goodwill, we also review net intangibles with finite lives when an event occurs indicating the potential for impairment. We believe that the carrying values of our net intangibles were recoverable as of July 31, 2020. Any impairment charges that we may record in the future could be material to our results of operations and financial condition.
We could be negatively impacted by a system failure, lack of or failure of redundant system components, security breach through cyber-attack, cyber intrusion or otherwise, by other significant disruption of our IT networks or those we operate for certain customers, or third-party data center facilities, servers and related systems. If such occurs, in some cases, we may have to reimburse our customers for damages that they may have incurred, pay contract penalties, or provide refunds.
Similar to all companies in our industry, we are under constant cyber-attack and are subject to an ongoing risk of security breaches and disruptions of our IT networks and related systems, including third-party data center facilities, whether through actual breaches, cyber-attacks or cyber intrusions via the Internet, malware, computer viruses, attachments to e-mails, persons inside our organization or persons with access to systems inside our organization. Actual security breaches or disruption, particularly through cyber-attack or cyber intrusion, including by computer hackers, foreign governments and cyber terrorists, have increased in recent years and have become more complex. Our IT networks and systems, as well as third-party data center facilities, have been and, we believe, continue to be under constant attack. We face an added risk of a security breach or other significant disruption to certain of our equipment used on some of our customers' IT networks and related systems which may involve managing and protecting information relating to public safety agencies, wireless carriers as well as national security and other sensitive government functions. Many of our systems have, or are required to have, system redundancies and back-up; in some cases, we may not have sufficient redundancy and/or redundancy and/or back-ups may fail. We may incur significant costs to prevent and respond to system failures, failure of redundant system components, actual breaches, cyber-attacks and other systems disruptions.
As a communications company, and particularly as a government contractor and a provider of public safety and location technologies (including 911 hosted systems), we face a heightened risk of a security breach or disruption from actual breaches, cyber-attacks and other threats to gain unauthorized access to our and our customers' proprietary or classified information on our IT networks, third-party data center facilities and related systems and to certain of our equipment used on some of our customers' IT networks and related systems. These types of information, IT networks and related systems are critical to the operation of our business and essential to our ability to perform day-to-day operations, and, in some cases, are critical to the operations of certain of our customers. Although we make significant efforts to maintain the security and integrity of these types of information, IT networks and related systems, and we have implemented various measures to manage the risk of a security breach or disruption, there can be no assurance that our security efforts and measures will be effective or that actual security breaches or disruptions will not be successful or damaging. Even the most well protected information, networks, data centers, systems and facilities remain potentially vulnerable because security breaches, particularly cyber-attacks and intrusions, and disruptions have occurred and will occur again in the future. Techniques used in such breaches and cyber-attacks are constantly evolving and generally are not recognized until launched against a target, and in some cases are designed not to be detected and, in fact, may not be detected. In some cases, the resources of foreign governments may be behind such attacks. Accordingly, we may be unable to anticipate these techniques or to implement adequate security barriers or other preventative measures, and thus it is virtually impossible for us to entirely mitigate this risk.
A security breach or other significant disruption (including as a result of a lack of redundancy and/or failure of such redundancy) involving these types of information, IT networks and related systems could:
•Disrupt the proper functionality of these networks, data center facilities and systems and therefore our operations and/or those of certain of our customers;
•Result in the unauthorized access to, and destruction, loss, theft, misappropriation or release of proprietary, confidential, sensitive or otherwise valuable information of ours or our customers, including trade secrets, which others could use to compete against us or for disruptive, destructive or otherwise harmful purposes and outcomes;
•Compromise national security and other sensitive government functions;
29
•Require significant management attention and resources to remedy the damage that results;
•Make payments to our customers to reimburse them for damages, pay them penalties or provide refunds; and
•Damage our reputation with our customers (particularly agencies of the U.S. government) and the public generally.
In addition, the cost of continually defending against cyber-attacks and actual breaches has increased in recent years and future costs and any or all of the foregoing could have a material adverse effect on our business, results of operations and financial condition.
The measures we have implemented to secure information we collect and store or enable access to may be breached, which could cause us to breach agreements with our partners and expose us to potential investigation and penalties by authorities and potential claims for contract breach, product liability damages, credits, penalties or termination by persons whose information was disclosed.
We take reasonable steps to protect the security, integrity and confidentiality of the information we collect and store and to prevent unauthorized access to third-party data to which we enable access through our products, but there is no guarantee that inadvertent or unauthorized disclosure will not occur or that third parties will not gain unauthorized access despite our efforts. If such unauthorized disclosure or access does occur, we may be required to notify persons whose information was disclosed or accessed under existing and proposed laws. Because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and are often not recognized until launched against a target, we may be unable to anticipate these techniques or implement adequate preventative measures. In the event of such disclosure, we also may be subject to claims of breach of contract, investigation and penalties by regulatory authorities and potential claims by persons whose information was disclosed. If there is a security breach or if there is an inappropriate disclosure of any of these types of information, we could be exposed to investigations, litigation, fines and penalties. Remediation of and liability for loss or misappropriation of end user or employee personal information could have a material adverse effect on our business, results of operations and financial condition. Even if we were not held liable for such event, a security breach or inappropriate disclosure of personal, private or confidential information could harm our reputation and our relationships with current and potential customers and end users. Even the perception of a security risk could inhibit market acceptance of our products and services. We may be required to invest additional resources to protect against damage caused by any actual or perceived disruptions of our services. We may also be required to provide information about the location of an end user’s mobile device to government authorities, which could result in public perception that we are providing the government with intelligence information and deter some end users from using our services. Any of these developments could have a material adverse effect on our business, results of operations and financial condition.
Our U.S. federal, state and foreign tax returns are subject to audit and a resulting tax assessment or settlement could have a material adverse effect on our business, results of operations and financial condition. Significant judgment is required in determining the provision for income taxes.
The final determination of tax examinations and any related litigation could be materially different than what is reflected in historical income tax provisions and accruals.
Our federal income tax returns for fiscal 2017 through 2019 are subject to potential future Internal Revenue Service ("IRS") audit. None of our state income tax returns prior to fiscal 2016 are subject to audit. None of TCS' state income tax returns prior to calendar year 2015 are subject to audit. In addition to income tax audits, TCS is subject to ongoing state excise tax audits by the Washington State Department of Revenue. Although adjustments relating to past audits of our federal income tax returns were immaterial, a resulting tax assessment or settlement for other periods or other jurisdictions that may be selected for future audit could have a material adverse effect on our business, consolidated results of operations and financial condition.
We have significant operations in Arizona, Florida, California, Washington State, Maryland, New York and other locations which could be materially and adversely impacted in the event of a terrorist attack and government responses thereto or significant disruptions (including natural disasters) to our business.
Terrorist attacks, the U.S. and other governments' responses thereto, and threats of war could materially adversely impact our business, results of operations and financial condition. For example, our 911 hosted location-based services and satellite teleport services operations depend on our ability to maintain our computer and equipment and systems in effective working order, and to protect our systems against damage from fire, natural disaster, power loss, telecommunications failure, sabotage, unauthorized access to our system or similar events.
30
Although many of our mission-critical systems and equipment are designed with built-in redundancy and security, any unanticipated interruption or delay in our operations or breach of security could have a material adverse effect on our business, results of operations and financial condition. Our property and business interruption insurance may not be adequate to compensate us for any losses that may occur in the event of a terrorist attack, threat, system failure or a breach of security. Insurance may not be available to us at all or, if available, may not be available to us on commercially reasonable terms.
We currently, and intend to continue to, operate a high-volume technology manufacturing center located in Arizona. The COVID-19 pandemic, a terrorist attack or similar future event may disrupt our operations or those of our customers or suppliers and may affect the availability of materials needed to manufacture our products or the means to transport those materials to manufacturing facilities and finished products to customers. If a natural disaster or other business interruption occurred with respect to our high-volume technology manufacturing center, we do not have immediate access to other manufacturing facilities and, as a result, our business, results of operations and financial condition would be materially adversely affected. To support our long-term business goals for our satellite earth station product line, in September 2020, we signed a 15-year lease for a 146,000 square foot facility in Chandler, Arizona. This facility is located less than 10 miles from our existing facility located in Tempe, Arizona, and we anticipate that that we will fully relocated by February 2021. If we are unable to have a smooth transition to our new facility, production and deliveries of our products may be impacted and may incur unexpected costs.