PMT 402 Defense Contractor Finance August 12, 2004 Jack Cash

Discussion Topics Government—Industry Relationship Defense Industry Consolidation Aerospace Defense Profitability New DOD Focus on Profit New DOD Emphasis on Cash Flow Senior DOD Management Concerns Current Issues

PM'S CHALLENGE STRIKING THE RIGHT BALANCE PRODUCT PERFORMANCE INVESTMENT FINANCING PROFIT PERFORMANCE COST SCHEDULE SUPPORTABILITY GOVERNMENT PROGRAM INDUSTRY REQUIREMENT CONTRACT TYPE TERMS AND CONDITIONS AWARD AND ADMINISTRATION

Recent Acquisition Activity “Bolt On” Lockheed Martin –Titan $2.4B (Just Cancelled) General Dynamics –Veridian $1.5B –Alvis $561M (BAE Countered) General Electric –Invision $900M CACI –AMS Defense $400M

Industry Profitability Ratios - How profitable is a company relative to sales, total assets, and stockholder’s equity? INCOME STATEMENT BALANCE SHEET AS OF 12/31/200X FOR YEAR END 12/31/200X ASSETS LIAB & STK EQUITY Sales $Cash $Accrued Expenses $ Return on Sales: Net Income Cost of Goods Sold -$Marketable Securities+$Accounts Payable+$ Sales Gross Profit=$Accounts Receivable+$Advances from Cust.+$ Return on Assets: S, G&A -$Finished Goods+$Line of Credit+$ Net Income Total Assets EBIT=$Work in Progress+$Current Portion of LTD+$ Interest Expense -$Raw Materials+$ Total Current Liab.=$ Return on Equity: Net Income EBT=$Govt. Contracts (net)+$Term Bank Loan $ Stockholder's Equity Income Taxes -$ Total Current Assets=$ Total Long Term Debt=$ Net Income=$Land $Common Stock $ Plant & Equip. (net)+$Paid in Surplus+$ Total Fixed Assets=$Retained Earnings+$ Other Assets $ Tot Stockholders' Eq=$ Total Assets=$ = Total Liab & Stk Eq=$

Interrelationship of Profitability Measures Dupont Formula Extended Dupont Formula Return on Assets Financial Leverage** Return on Stockholder's Equity X= Net Income Total Assets Debt + Stockholder’s Equity Stockholder's Equity Net Income Stockholder's Equity ( ( ( ( ( ( Return on Sales* Total Asset Turnover Return on Assets X= Net Income Sales Sales Total Assets Net Income Total Assets ( ( ( ( ( ( *Return on Sales is also called Net Profit Margin *** This financial leverage ratio is sometimes called the equity multiplier

Profit Limitations by Law Cost Plus Fixed Fee (CPFF) contracts –For R&D, limited to 15% –For other, limited to 10% All other types of contracts –Use a “structured approach” to determine the profit objective … hence, the Weighted Guidelines Methodology

Government vs Industry View of Profit Government Perspective Defense Contractor Perspective Total Allowable Cost $9,000,000 15% $1,350,000 Price $10,350,000 Sales $10,350,000 Total Allowable Cost ($9,000,000) Unallowable 3% of Sales ($310,500) Earnings Before Taxes $1,039,500 Income 35% ($363,825) Net Income $675,675 Return on Sales 6.53%

Shift in DOD Profit Focus Purpose is to reduce facilities investment as a factor in establishing profit objectives on negotiated contracts The goal is to reorient profit incentives from facilities investment to reward technical innovation and cost reduction efforts

DOD Negotiation Method Where do I Get this info from? Pre- negotiation objective ABC Co. PROPOSAL

DoD Negotiation Method Values selected from applicable profit range. 55% X 11% = 6.05% 45% X 5% = 2.25% 8.30% The Performance Risk Factor is based on two criteria. Each criteria is assigned a weight with the result being the composite factor for Performance Risk

DoD Negotiation Method RECOGNIZES RISK ASSOCIATED WITH VARIOUS CONTRACT TYPES (FFP VS. CPFF ETC.) PROFIT RANGE VARIES BY CONTRACT TYPE

DoD Negotiation Method RECOGNIZES CONTRACTOR FINANCING ON FIXED PRICE CONTRACTS. This calc. Is based on 20% financing under an 80% Progress Payment: $58,064,871 x 20% = $11,612,974 Based on DFARS table Current T-Rate

DoD Negotiation Method The amount employed uses FCCOM dist. %’s found in the Contractor’s proposal applied to the total capital investment. Total capital investment is calculated by dividing FCCOM by the T – Rate. Total Capital Investment = ($823,430 / 5.5%) = $14,971,455 Dist.Calc. $ Land 3.3%$ 494,058 Buildings49.5%$ 7,410,870 Equipment47.2%$ 7,066,527 FCCOM Employed 100.0% $14,971,455 Evaluate based on the below DFARS defined range: Profit Range Land N/A Buildings N/A Equipment 10-25%

DOD Negotiation Method 0% - 4% To Reward Contractor’s Cost Reduction Efforts

DOD Negotiation Method PROFIT + FCCOM: $11,610,874 DIVIDED BY COST : $58,064,871 RETURN ON COST %: 20.0%

Change Specifics Technology Risk Factor: Introduced a new technical risk factor range (7-11%) under “Performance Risk”.Introduced a new technical risk factor range (7-11%) under “Performance Risk”. New range applies to technical risk factor only; not applicable to management/cost control factor.New range applies to technical risk factor only; not applicable to management/cost control factor.

Technology Risk Factor - Criteria for Use: Does not apply to efforts that have a technical report as the primary deliverable. This includes:Does not apply to efforts that have a technical report as the primary deliverable. This includes: - Studies- Analyses- Demonstrations Applicable to only the most innovative efforts.Applicable to only the most innovative efforts. Applies to new technology that:Applies to new technology that: –fundamentally changes existing product/system characteristics. –increases technical performance, improves reliability, or reduces cost.

Technology Risk Factor Candidates: Possible Candidates Include:Possible Candidates Include: –Engineering Change Proposals (ECP’s) –Value Engineering Change Proposals (VECP’s) –Test Programs –Support Equipment –R&D Efforts –New Manufacturing Technologies

Change Specifics Change Specifics l Cost Efficiency Factors: - These are special factors -- various incentives for Contractors to reduce cost. - Increase to profit by up to 4% of total cost base (less FCOM). - Contractor must demonstrate cost reduction efforts that benefit the pending contract and provide supporting data. - Contracting Officer has maximum flexibility in determining the best way to evaluate the benefit the cost reduction efforts will have on the pending contract. Encourage contractors to submit their own existing information to support analysis of cost efficiency Encourage contractors to submit their own existing information to support analysis of cost efficiency

Change Specifics Change Specifics l Cost Efficiency Factor Evaluation Criteria Includes : 1)The Contractor’s participation in Single Process Initiative improvements; (or) 2)Actual cost reductions achieved on prior contracts; (or) 3)Reduction or elimination of excess or idle facilities; (or) 4)Contractor’s cost reduction initiatives (e.g., competition advocacy programs, technical insertion programs, obsolete parts control programs, spare parts pricing reform, value engineering, the use of metrics to drive down key costs); (or) 5)The Contractor’s adoption of process improvements to reduce costs; (or) 6)Subcontractor cost reduction efforts; (or) 7)Contractor’s effective incorporation of commercial items and processes; (or) 8)Contractor’s investment in new facilities to improve productivity.

Profit Summary DOD uses profit to encourage and reward contractor behaviorDOD uses profit to encourage and reward contractor behavior –Must provide earnings commensurate with risk, investment and technology employed Significant profit changesSignificant profit changes –Addition of new technology incentive range –Adds G&A to cost base (includes IR&D) –Decreases facilities capital profit –Adds cost efficiency factor

Cash Flow versus Profit 0 0 PROGRAM LIFE CYCLE DOLLARS Cumulative Net Income Cumulative Net Cash Flow

Advantages of Performance Based Payments Enhanced technical and schedule focus Broadening contractor participation Reinforcing role of program managers and integrated team members Increasing contractor cash flow Linking payment to performance

Effective January 2004 DOD authorizes provisional award fees under CPAF contracts No more frequently than monthly Based on successful prior evaluation periods Limitations –Initial fee period, 50% of fee available –Subsequently, 80% x prior evaluation score x fee available for current period

Couple of Senior DOD Mgmt Concerns Capping of overhead rates Independent research and development

Other Current Issues Restructuring costs Share in savings Contract close out Executive compensation