(Consisting of 19,999,999 Shares Offered by PAE Incorporated and
62,707,533 Shares Offered by the Selling Holders)
6,666,666 Warrants to Purchase Class A Common Stock
This prospectus supplement (this “Supplement”) supplements the prospectus, dated April 23, 2020 (the “Prospectus”), which forms a part of our Registration Statement on Form S-1 (Registration No. 333-236468) (the “Registration Statement”). The Prospectus and this Supplement relate to
the issuance by us of up to: (i) 6,666,666 shares of our Class A Common Stock, par value $0.0001 per share (“Class A Common Stock”), issuable upon the exercise of 6,666,666 warrants issued in a private placement in connection with our initial public offering, at an exercise price of $11.50 per share of Class A Common Stock (the “Private Placement Warrants”), and (ii) 13,333,333 shares of our Class A Common Stock issuable upon the exercise of 13,333,333 warrants issued in connection with our initial public offering, at an exercise price of $11.50 per share of Class A Common Stock (the “Public Warrants” and, together with the Private Placement Warrants, the “Warrants”). The Prospectus and this Supplement also relate to the resale from time to time by the selling holders (the “Selling
Holders”) named in the Prospectus of up to 6,666,666 Private Placement Warrants and 62,707,533 shares of our Class A Common Stock.
This Supplement is being filed to update, amend, and supplement the information included in the Prospectus with the information contained in our quarterly report on Form 10-Q, filed on August 6, 2020 (the “Quarterly Report”) with the Securities and Exchange Commission (the “SEC”). Accordingly, we have attached the Quarterly Report to the end of this Supplement.
The Prospectus provides you with a general description of the securities and the general manner in which we and the Selling Holders may offer or sell the securities. More specific terms of any securities
that we and the Selling Holders may offer or sell may be provided in a subsequent prospectus supplement that describes, among other things, the specific amounts and prices of the securities being offered and the terms of the offering. Such subsequent prospectus supplement may also add, update or change information contained in the Prospectus or this Supplement.
We will not receive any proceeds from the sale of shares of Class A Common Stock or Private Placement Warrants by the Selling Holders or of shares of Class A Common Stock by us pursuant to the Prospectus and this Supplement, except with respect to amounts received by us upon exercise of the Warrants. However, we will pay the expenses, other than any underwriting discounts and commissions, associated with the sale of securities pursuant to the Prospectus and this Supplement.
Our registration
of the securities covered by the Prospectus and this Supplement does not mean that either we or the Selling Holders will issue, offer or sell, as applicable, any of the securities. The Selling Holders may offer and sell the securities covered by the Prospectus and this Supplement in a number of different ways and at varying prices. We provide more information in the Prospectus in the section entitled “Plan of Distribution.”
1
You should read the Prospectus, this Supplement and any subsequent prospectus supplement or amendment carefully before you invest in our securities. This Supplement should be read in conjunction with the Prospectus. This Supplement updates, amends, and supplements the information included or incorporated
by reference in the Prospectus. If there is any inconsistency between the information in the Prospectus and this Supplement, you should rely on the information in this Supplement.
Our Class A Common Stock and Warrants are traded on the Nasdaq Stock Market under the symbols “PAE” and “PAEWW,” respectively. On August 5, 2020, the last reported sales price of the Class A Common Stock was $8.67 per share and the last reported sales price of the Warrants was $2.26 per warrant.
We are an “emerging growth company,” as that term is defined under the federal securities laws and, as such, are subject to certain reduced public company reporting requirements.
Investing
in our securities involves risks. See “Risk Factors” beginning on page 5 of the Prospectus and any risks and uncertainties described under similar headings in this Supplement and any amendments or supplements to the Prospectus.
Neither the SEC nor any state securities commission has approved or disapproved of the securities or determined if the Prospectus or this Supplement is truthful or complete. Any representation to the contrary is a criminal offense.
The date of this prospectus supplement is August 6, 2020.
2
UNITED
STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
__________________________
FORM 10-Q
__________________________
(Mark One)
☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
(Registrant’s telephone number, including area code)
__________________________
Securities
registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbols
Name of each exchange on which registered
Class A Common Stock
PAE
Nasdaq Stock Market
Warrants
PAEWW
Nasdaq
Stock Market
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
☒
Non-accelerated filer
☐
Smaller reporting company
☐
Emerging
growth 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 is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒
This Quarterly Report on Form 10-Q (the “Form 10-Q”) contains our condensed consolidated financial statements for the three-month and six-month periods ended June 28, 2020.
We were originally incorporated in Delaware on October 23, 2017 under the name “Gores Holdings III, Inc.” as a special purpose acquisition company formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, or other similar business combination with one or more target businesses. On September 11, 2018, we consummated our initial public offering (the “IPO”), following which our shares began trading on the Nasdaq
Stock Market (“Nasdaq”).
On February 10, 2020 (the “Closing Date”), we consummated the previously announced business combination (the “Business Combination”) pursuant to that certain Agreement and Plan of Merger, dated November 1, 2019, by and among Gores Holdings III, Inc. (“Gores III”), EAP Merger Sub, Inc. (“First Merger Sub”), EAP Merger Sub II, LLC (“Second Merger Sub”), Shay Holding Corporation (“Shay”), and Platinum Equity Advisors, LLC (in its capacity as the Stockholder Representative, the “Stockholder Representative”) (the “Merger Agreement”), as more fully described in the
Company’s Form 8-K filed with the Securities and Exchange Commission on February 14, 2020, and the amendment thereto filed on March 11, 2020. In connection with the closing of the Business Combination (the “Closing”), we acquired 100% of the stock of Shay (as it existed immediately prior to the Second Merger, as such term is defined in the Merger Agreement) and its subsidiaries, changed our name from “Gores Holdings III, Inc.” to “PAE Incorporated”, and changed the trading symbols of our Class A Common Stock and warrants on Nasdaq from “GRSH” and “GRSHW,” to “PAE” and “PAEWW,” respectively.
For accounting purposes, the Business Combination is treated
as a reverse acquisition and recapitalization, in which Shay is considered the accounting acquirer (and legal acquiree) and Gores III is considered the accounting acquiree (and legal acquirer). Additionally, unless otherwise stated or the context indicates otherwise, with respect to the financial information contained in this Form 10-Q, including in “Part I, Item 1. Financial Statements” and the notes thereto and in “Part I, Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the financial information relating to the three-month and six-month periods ended June 30, 2019 are those of Shay and its subsidiaries, and for the three-month and six-month periods ended June 28, 2020, the financial information includes the financial
information of Shay and its subsidiaries for the period prior to the Closing and the financial information of PAE Incorporated and its subsidiaries for the period subsequent to the Closing. See Note 1 – “Description of Business” and Note 6 – “Business Combinations and Acquisitions” of the Notes to the condensed consolidated financial statements for additional information.
Unless the context indicates otherwise, the terms “PAE,” the “Company,”“we,”“us,” and “our” refer to PAE Incorporated and its consolidated subsidiaries taken as a whole.
Preferred stock, $0.0001 par value per share, 1,000,000 shares authorized;
no shares issued and outstanding
—
—
Common stock, $0.0001 par value per share: 210,000,000 shares authorized; 92,040,654 and 21,127,823 shares issued and outstanding as of June 28, 2020 and December 31, 2019, respectively
9
2
Additional
paid-in capital
245,815
101,743
Accumulated deficit
(134,293)
(145,371)
Accumulated other comprehensive loss
(628)
(134)
Total
PAE Incorporated stockholders' equity
110,903
(43,760)
Noncontrolling interests
34,430
31,851
Total liabilities and stockholders’ equity
$
1,411,032
$
1,371,299
See
accompanying notes to condensed consolidated financial statements
3
PAE Incorporated
Condensed Consolidated Statements of Stockholders’ Equity (Unaudited)
Adjustments to reconcile
net income (loss) to net cash provided by operating activities:
Depreciation of property and equipment
5,072
6,301
Amortization of intangible assets
16,094
16,853
Amortization of debt issuance cost
7,821
4,082
Stock-based
compensation
3,700
—
Net undistributed income from unconsolidated ventures
(1,739)
(2,184)
Deferred income taxes, net
(13,295)
(372)
Other
non-cash activities, net
404
3,324
Changes in operating assets and liabilities, net:
Accounts receivable, net
9,607
28,396
Accounts payable
(17,547)
11,278
Accrued
expenses
6,358
(5,166)
Customer advances and billings in excess of costs
19,282
26,297
Salaries, benefits and payroll taxes
4,310
9,845
Inventories,
net
2,415
(2,051)
Prepaid expenses and other current assets
(3,256)
(545)
Other current and noncurrent liabilities
(5,101)
(9,580)
Investments
1,701
1,769
Other
noncurrent assets
11,600
(9,951)
Accrued taxes
(3,847)
(4,601)
Net cash provided by operating activities
55,588
71,923
Investing
activities
Expenditures for property and equipment
(1,597)
(5,633)
Other investing activities, net
37
2,042
Net cash used in investing activities
(1,560)
(3,591)
Financing
activities
Net contributions from noncontrolling interests
1,950
5,400
Borrowings on long-term debt
60,468
69,319
Repayments on long-term debt
(204,464)
(136,821)
Payments
of debt issuance costs
(964)
—
Recapitalization from merger with Gores III
605,713
—
Payment of underwriting and transaction costs
(27,267)
—
Distribution
to selling stockholders
(419,548)
—
Other financing activities, net
(292)
(742)
Net cash provided by (used in) financing activities
15,596
(62,844)
Effect
of exchange rate changes on cash and cash equivalents
810
(1,205)
Net increase in cash and cash equivalents
70,434
4,283
Cash and cash equivalents at beginning of period
68,035
50,954
Cash
and cash equivalents at end of period
$
138,469
$
55,237
Supplemental cash flow information
Cash paid for interest
$
23,278
$
39,538
Cash
paid for taxes
$
2,796
$
4,897
Supplemental non-cash financing activities
Working capital adjustment payable to Shay Stockholders
$
20,169
$
—
See
accompanying notes to condensed consolidated financial statements
6
PAE Incorporated
Notes to Condensed Consolidated Financial Statements (Unaudited)
1. Description of Business
PAE Incorporated, formerly known as Gores Holdings III, Inc. (“Gores III”), was originally incorporated in Delaware on October 23, 2017 as
a special purpose acquisition company formed for the purpose of effecting a merger, capital stock exchange, asset acquisition, stock purchase, reorganization, or other similar business combination with one or more target businesses. On September 11, 2018, Gores III consummated its initial public offering (the “IPO”), following which our shares began trading on the Nasdaq Stock Market (“Nasdaq”). Unless the context otherwise indicates, references herein to the “Company" or “PAE” refer to PAE Incorporated and its consolidated subsidiaries.
On February 10, 2020 (the “Closing Date”), the
Company completed the previously announced business combination (the “Business Combination”) in which Shay Holding Corporation (“Shay”) was acquired by Gores III. The transaction was completed in a multi-step process pursuant to which Shay ultimately merged with and into a wholly-owned subsidiary of Gores III, with the Gores III subsidiary continuing as the surviving company. As a result of the Business Combination, each share of common stock of Shay was cancelled and converted into the right to receive a portion of the consideration payable in connection with the transaction and Gores III acquired Shay (as it existed immediately prior to the Second Merger, as such term is defined in the Merger Agreement) and its subsidiaries. Additionally, the stockholders of Shay as of immediately prior to the transaction hold a portion of the common stock of the
Company.
For accounting purposes, the Business Combination is treated as a reverse acquisition and recapitalization, in which Shay is considered the accounting acquirer (and legal acquiree) and Gores III is considered the accounting acquiree (and legal acquirer).
Accordingly, as of the Closing Date, Shay’s historical results of operations replaced Gores III’s historical results of operations for periods prior to the Business Combination and the results of operations of both companies are included in the accompanying condensed consolidated financial statements for periods following the Closing Date. See Note 6 - “Business Combinations and Acquisitions” for additional information.
PAE provides a wide variety of integrated
support solutions, including defense and military readiness, diplomacy, intelligence support, business process outsourcing, counter-terrorism solutions, peacekeeping, development, host nation capacity building, aircraft and ground equipment maintenance and logistics, and operations and maintenance of facilities and infrastructure. Customers include agencies of the U.S. Government, such as the Department of Defense (“DoD”) and Department of State (“DoS”), the National Aeronautics and Space Administration (“NASA”), Department of Homeland Security, intelligence community agencies and other civilian agencies, as well as allied foreign governments and international organizations such as the United Nations.
The Company’s operations are organized into the following two reportable segments:
•Global
Mission Services (“GMS”): GMS provides infrastructure and logistics management, international logistics and stabilization support, and aircraft and vehicle readiness and sustainment support. The segment focuses on customer relationships with DoD, DoS, NASA, United Nations, and other government agencies for work both in the United States and outside of the United States.
7
•National Security Solutions (“NSS”): NSS provides counter-threat
solutions, business process outsourcing, adjudication support services and full life cycle support for complex legal matters. NSS focuses on customer relationships in the areas of intelligence, defense and security, and with civilian agencies.
The Company separately presents the costs associated with certain corporate functions as “Corporate”, which primarily include costs that are not reimbursed by the Company’s U.S. Government customers.
2. Significant Accounting Principles and Policies
Basis of Presentation
The
accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. In management’s opinion, all adjustments, consisting of only normal recurring adjustments, considered necessary for a fair presentation have been included. The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full fiscal year. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto for the year ended December 31, 2019, which are
filed as Exhibit 99.3 to the Company’s Form 8-K/A filed with the SEC on March 11, 2020.
The Company closes its books and records on the last Sunday of the calendar quarter to align its financial closing with its business processes,and therefore the closing of books and records for the second quarter was on June 28, 2020 and June 30, 2019, respectively. The condensed consolidated financial statements and disclosures included herein are labeled based on that convention. This practice only affects interim periods, as the
Company’s fiscal year ends on December 31.
The condensed consolidated financial statements include the accounts of PAE Incorporated and subsidiaries and ventures in which the Company owns more than 50% or otherwise controls. All intercompany amounts have been eliminated in consolidation.
Use of Estimates
These consolidated financial statements are prepared in conformity with U.S. GAAP, which requires the use of estimates and assumptions, including assumptions to determine the fair value of acquired assets and liabilities, recoverability of long-lived
assets, goodwill, valuation allowances on deferred taxes, inputs used in stock based compensation and anticipated contract costs and revenues utilized in the earnings recognition process, which affect the reported amounts in the consolidated financial statements and accompanying notes. Due to the size and nature of many of the Company’s programs, the estimation of total revenues and cost at completion is subject to a wide range of variables, including assumptions for schedule and technical issues. Actual results may differ from management’s estimates.
8
Update
to Significant Accounting Policies
There have been no material changes to the Company’s significant accounting policies described in the Company’s Form 8-K/A filed with the SEC on March 11, 2020, other than Accounts Receivable, net and Net Income (Loss) Per Share as described below.
Accounts Receivable, net
Amounts billed and due from customers are recorded as billed receivables within accounts receivable, net on the condensed consolidated balance sheets. Generally, customer accounts are due within 30 to
45 days of billings. The Company recognizes an allowance for credit losses based on historical experience, current conditions and reasonable and supportable forecasts. The Company assesses its overall allowance for credit losses at least on a quarterly basis. Prior to the implementation of the allowance for credit losses the Company recorded adjustments to an allowance for doubtful accounts when collectability was uncertain.
Net Income (Loss) Per Share
Basic net income (loss) per common share is determined by dividing the net income (loss) allocable to stockholders by the weighted
average number of common shares outstanding during the periods presented. Diluted income (loss) per share is computed by dividing the net income (loss) allocable to common stockholders by the weighted average number of shares of common stock and common stock equivalents outstanding for the period.
Fair Value of Financial Instruments
Fair value is the price that would be received to sell an asset or paid to transfer a liability in the principal or most advantageous market in an orderly transaction between marketplace participants at the measurement date. The valuation techniques the Company utilized to measure the fair value of financial instruments are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent
sources, while unobservable inputs reflect internal market assumptions.
These two types of inputs create the following fair value hierarchy:
Level 1 – Quoted prices for identical instruments in active markets.
Level 2 – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3 – Significant inputs to the valuation model are unobservable.
The carrying
amounts of cash and cash equivalents, accounts receivable, accounts payable, and amounts included in other current assets and current liabilities that meet the definition of a financial instrument approximate fair value because of the short-term nature of these amounts.
The carrying value of the Company’s outstanding debt obligations approximates its fair value. The fair value of long-term debt is calculated using Level 2 inputs, based on interest rates available for debt with terms and maturities similar to the Company’s existing debt arrangements.
9
3.
Recent Accounting Pronouncements
Accounting Pronouncements Adopted
In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses for financial instruments, which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost, replacing the existing incurred loss impairment model. The new standard is effective for reporting periods beginning after December 15, 2019, with early adoption permitted. The Company adopted this guidance effective January 1, 2020 under the modified retrospective method and such adoption
did not have a material impact on the Company’s financial statements.
In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Topic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement that is a Service Contract, which requires the tracking and recognition of costs that will be capitalized as an asset and amortized over the assets useful life. The new standard is effective for reporting periods beginning after December 15, 2019, with early adoption permitted. The Company adopted this guidance effective January
1, 2020 prospectively and the standard did not have a material impact on the Company’s financial statements.
4. Revenues
Disaggregated Revenues
Disaggregated revenues by customer type were as follows (in thousands):
The Company’s remaining performance obligations balance represents the expected revenue to be recognized for the satisfaction of remaining performance obligations on existing contracts. This balance excludes unexercised contract option years and task orders that may be issued underneath an indefinite delivery, indefinite quantity contract. The remaining performance obligations balance as of June 28, 2020 and December 31, 2019 was $1,260.0 million
and $1,640.0 million, respectively.
The Company expects to recognize approximately 95.2% and 4.8% of the remaining performance obligations balance as revenue over the next year and thereafter, respectively.
Contract assets consist of unbilled receivables which represent rights to
payment for work or services completed but not billed as of the reporting date. Contract assets are recorded as unbilled receivables within accounts receivable, net on the condensed consolidated balance sheets.
Contract liabilities are advances and milestone payments from customers on certain contracts that exceed revenue earned to date. Contract liabilities are recorded as customer advances and billings in excess of costs on the condensed consolidated balance sheets.
Contract
assets and contract liabilities consisted of the following as of the dates presented (in thousands):
The increase in contract
assets of $2.0 million during the six-month period ended June 28, 2020 was primarily due to the timing of billings, partially offset by revenue recognized related to the satisfaction of performance obligations.
The increase in contract liabilities of $19.3 million during the six-month period ended June 28, 2020 was primarily due to the timing of advance payments from customers partially offset by revenue recognized during the period.
During the three-month and six-month periods ended June 28, 2020, the Company recognized $1.1 million and $33.4 million, respectively,
relating to amounts that were included in the beginning balance of contract liabilities. During the three-month and six-month periods ended June 30, 2019, the Company recognized $4.5 million and $16.6 million, respectively, relating to amounts that were included in the beginning balance of contract liabilities.
13
6.
Business Combinations and Acquisitions
As described in Note 1- “Description of Business”, the Business Combination was consummated on February 10, 2020. For financial accounting and reporting purposes under U.S. GAAP, the Business Combination was accounted for as a reverse acquisition and recapitalization, with no goodwill or other intangible asset recorded. Under this method of accounting, Gores III (“legal acquirer”) is treated as the acquired entity and Shay (legal acquiree) is deemed to have issued common stock for the net assets and equity of Gores III consisting of mainly cash, accompanied by simultaneous equity recapitalization of Shay (“Recapitalization”). The net assets of Gores III are stated at historical cost, and accordingly the equity and net assets of Shay have not been adjusted to fair value. Consequently, the consolidated assets, liabilities
and results of operations of Shay are the historical financial statements of PAE Incorporated and the Gores III assets, liabilities and results of operations are consolidated with the assets, liabilities and results of operations of Shay beginning on the Closing Date. Shares and earnings per share information prior to the Business Combination have been retroactively restated to reflect the exchange ratio established in the Recapitalization.
Other than professional fees paid to consummate the transaction, the Business Combination primarily involved the exchange of cash and equity between Gores III, Shay and the stockholders of the respective companies. The aggregate proceeds paid to the Shay Stockholders on the Closing Date was approximately $424.2 million. The remainder of the consideration paid to the Shay Stockholders consisted
of 21,127,823 newly issued shares of Class A Common Stock of PAE Incorporated, par value $0.0001 per share (“Class A Common Stock”).
In addition to the foregoing consideration paid on the Closing Date, former stockholders of Shay are entitled to receive additional Earn-Out Shares from PAE of up to an aggregate of 4,000,000 shares of Class A Common Stock if the price of Class A Common Stock trading on the Nasdaq exceeds certain thresholds during the five-year period following the completion of the Business Combination. See Note 11 - “Stockholders’ Equity - Earn-Out Agreement” for additional information.
The Company also has certain warrants issued by Gores III that remain outstanding
after the Business Combination. See Note 11 - “Stockholders’ Equity - Warrants” for further information about the warrants.
In connection with the Business Combination, the Company recorded $20.9 million, net of tax as a reduction to additional paid in capital related to the transaction costs. These costs were directly attributable to the Recapitalization.
During the second quarter, pursuant to the post-closing adjustment provisions contained in the Merger Agreement, the Company determined that a post-closing adjustment payment was due to the Shay Stockholders. As a result of such determination, the
Company recorded a $20.2 million liability and an adjustment to additional paid-in capital in the Company’s condensed consolidated balance sheets as of June 28, 2020.
14
7. Accounts Receivable,
net
The components of Accounts receivable, net consisted of the following as of the dates presented (in thousands):
As
of June 28, 2020 approximately 91.7% of the Company’s accounts receivable are with the U.S. government.
8. Goodwill and Intangible Assets, net
Goodwill
Based on management’s assessment of goodwill, there was no impairment or change for the three-month and six-month periods ended June 28, 2020.
The Company considered the implications of COVID-19 as it relates to goodwill
and indefinite-lived assets fair value. COVID-19 has had a marginally unfavorable impact on the Company’s results of operations for the three-month and six-month periods ended June 28, 2020. Since the Company’s primary customers are departments and agencies within the U.S. Government, it has not historically had significant issues collecting its receivables and management does not foresee issues collecting receivables in the foreseeable future. In addition, the Company’s contract awards typically extend to at least five years, including options, and it has a strong history
of being awarded a majority of these contract options. Management does not anticipate that the pandemic will have a materially adverse impact on such options. The Company’s liquidity position has not been materially impacted, and management continues to believe that the Company has adequate liquidity to fund its operations and meet its debt service obligations for the foreseeable future. Based on management’s assessment there has been no impact to goodwill and indefinite-lived assets fair value due to the implications of COVID-19.
15
Intangible
Assets, net
The components of intangible assets, net consisted of the following as of the dates presented (in thousands):
As
of the six-month period ended June 28, 2020, customer relationships and trade name intangibles had weighted average remaining useful lives of 7.2 and 5.5 years, respectively. As of the year-ended December 31, 2019, customer relationships and trade name had weighted average remaining useful lives of 7.9 and 6.0 years, respectively.
During the three-month and six-month periods ended June 28, 2020 amortization expense was approximately $8.0 million and $16.1 million, respectively. During the three-month and six-month periods ended June 30, 2019, amortization expense was approximately $8.2 million and $16.9 million, respectively.
16
Estimated
amortization expense in future years is expected to be:
The Company has entered into ventures and investments that allow it to participate in projects in areas where it is advantageous or required by law to partner with a local organization.
The Company is the majority shareholder and primary beneficiary of PAE (New Zealand) Limited, ATOM Training Limited, PAE-Perini LLC, Syncom Space Services LLC, PAE-SGT Partners LLC, and accordingly, these entities are consolidated. As the primary beneficiary, the Company has a risk and obligation to absorb any losses significant to the VIE and the power, through voting
rights or similar rights, to direct the activities that could impact economic performance of the VIE. The use of the assets of the VIEs to settle the Company’s obligations is subject to the approval of the managing body of each VIE.
The cash flows generated by these VIEs are included within the Company’s condensed consolidated statements of cash flows. The condensed consolidated balance sheets include the following amounts from these consolidated VIEs as of the dates presented (in thousands):
Total debt, net of discount and debt issuance costs
612,797
749,937
Less current maturities of long-term debt
(22,969)
(22,007)
Total
long-term debt, net of current
$
589,828
$
727,930
Credit Agreements
The Company’s borrowing arrangement provides for current borrowings up to $499.3 million under a first lien term loan credit agreement, dated October 26, 2016, as amended (the “First Term Loan”), $128.8 million under a second lien term loan credit agreement, dated October 26, 2016,
as amended (the “Second Term Loan”), and $150.0 million under a revolving credit facility dated October 26, 2016, as amended (the “Revolving Credit Facility,” and together with the First Term Loan and the Second Term Loan, the “Credit Agreements”). Principal and interest are due quarterly on the First Term Loan and interest only is due quarterly on the Second Term Loan. The maturity date of the First Term Loan is October 20, 2022. For the Second Term Loan the maturity date is October 20, 2023. For the Company’s Revolving Credit Facility the maturity date is October 20, 2021.
In connection with the Business Combination,
Shay was required to amend its existing credit facilities and reduce its outstanding indebtedness under its credit facilities such that the total indebtedness under the facilities, minus cash on hand at the consummation of the transaction would not be greater than $572.1 million. Immediately after the closing of the transaction the
18
outstanding balance on the Second Term Loan was reduced by approximately $136.5 million to a principal balance of $128.8 million.
The Credit
Agreements require the Company to comply with specified financial covenants under certain circumstances, including the maintenance of certain leverage ratios.
The Credit Agreements also contain various non-financial covenants, including affirmative covenants with respect to reporting requirements and maintenance of business activities, and negative covenants that, among other things, may limit or impose restrictions on the Company’s ability to alter the character of the business, consolidate, merge, or sell assets, incur liens or additional indebtedness, make investments, and undertake certain additional actions.
As
of June 28, 2020 and December 31, 2019, the available borrowing capacity under the Revolving Credit Facility was approximately $83.5 million and $121.8 million, respectively.
Interest Rates on Credit Agreements
The interest rate per annum applicable to amounts borrowed under the First Term Loan is equal to either the Base Rate (as defined below) or the LIBO Rate (as defined below), in either case, plus (i) 4.5% in the case of the Base Rate loans and (ii) 5.5% in the case of LIBO Rate loans.
The interest rate per annum applicable to amounts borrowed under the Second Term Loan is equal to either the Base Rate or the LIBO Rate, in either case, plus (i) 8.5% in the case of the Base Rate loans and (ii) 9.5% in the case of LIBO Rate loans.
The
“Base Rate” is defined as a fluctuating rate per annum equal to the highest of (a) the Federal Funds Rate plus one half of one percent, (b) the rate of interest in effect for such day as publicly announced from time to time by Bank of America (“BofA”) as its “prime rate,” and (c) the LIBO Rate for a LIBO Rate loan with a one month Interest Period commencing on such day plus 1.0%. The “prime rate” is a rate set by BofA based upon various factors including BofA’s costs and desired return, general economic conditions and other factors, and is used as a reference point for pricing some loans, which may be priced at, above, or below such announced rate. The
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LIBO
Rate is defined as the rate per annum equal to the London Interbank Offered Rate or a comparable or successor rate, whichever rate is approved by the Administrative Agent (as that term is defined in the Credit Agreements).
The interest rate per annum applicable to the Revolving Credit Facility is equal to either a Base Rate or a LIBO Rate plus (i) a range of 0.8% to 1.3% in the case of Base Rate loans and (ii) a range of 1.8% to 2.3% in the case of LIBO Rate loans, each based on average availability as of the first day of each quarter.
As of June 28, 2020 and December 31, 2019, the applicable interest rate on the amounts borrowed under the First Term Loan was 6.5% and 7.4%, respectively. As of June 28, 2020 and December
31, 2019, the applicable interest rate on amounts borrowed under the Second Term Loan was 10.5% and 11.4%, respectively.
As of June 28, 2020 and December 31, 2019, the applicable interest rate on amounts borrowed under the Revolving Credit Facility was 4.0% and 5.8%, respectively.
In addition, the interest rate on our term loan borrowings and revolving loan borrowings is based on the London Interbank Offered Rate (“LIBOR” or “LIBO Rate”). LIBOR is the subject of recent national, international, and other regulatory guidance and proposals for reform. In July 2017, the Chief Executive of the U.K. Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that the FCA will no longer persuade or compel banks
to submit rates for the calculation of the LIBOR benchmark after 2021. This announcement indicates that the continuation of LIBOR on the current basis cannot and will not be guaranteed after 2021, and it appears likely that LIBOR will be discontinued or modified by 2021. The consequences of the discontinuance of the LIBOR benchmark cannot be entirely predicted but could include an increase in the cost of our variable rate indebtedness.
Letters of Credit
The Company had 11 outstanding letters of credit for program and insurance requirements totaling approximately $21.2 million as of both June 28, 2020 and December 31, 2019.
11.
Stockholders’ Equity
Authorized and Outstanding Stock
In connection with the Business Combination, the Company made changes to its capital stock. The Company’s amended and restated certificate of incorporation authorizes the issuance of 211,000,000 shares of capital stock, par value of $0.0001 per share, consisting of (a) 210,000,000 shares of Class A common stock, and (b) 1,000,000 shares of preferred stock.
As a result of the Business Combination, the shares issued to Shay Stockholders are reflected as if they were issued and outstanding as of the
earliest reported period to reflect the new capital structure.
Warrants
As of June 28, 2020, there were warrants outstanding to acquire 19,999,985 shares of our Class A Common Stock including: (i) 13,333,319 warrants sold as part of the public units issued in our
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IPO on September 11, 2018 (the “Public Warrants”), and (ii)
6,666,666 warrants issued or transferred to our former sponsor in a private placement on the IPO closing date (the “Private Placement Warrants” and, together with the Public Warrants, the “Warrants”). The Company currently has an effective registration statement on Form S-1 relating to the issuance by the Company of up to (i) 13,333,333 shares of its Class A Common Stock issuable upon the exercise of the outstanding Public Warrants, and (ii) 6,666,666 shares of its Class A Common Stock issuable upon exercise of the Private Placement Warrants.
Each whole Warrant entitles the registered holder to purchase one share of Class A Common Stock at a price of $11.50 per share. The Warrants became exercisable on March
11, 2020, thirty days following the completion of the Business Combination, and expire five years after that date, or upon redemption or liquidation. The Company may redeem outstanding Public Warrants and, unless held by the former sponsor or its permitted transferees, the Private Placement Warrants at a price of $0.01 per Warrant, provided the last reported sales price of the Company’s Class A Common Stock equals or exceeds $18.00 per share for any 20 trading days within a 30-trading-day period ending on the third business day before the Company gives proper notice of such redemption to the warrant holders.
The Private Placement Warrants are identical to the Public
Warrants except that, so long as they are held by the former sponsor or its permitted transferees: (i) they will not be redeemable by the Company; (ii) they may be exercised by the holders on a cashless basis; and (iii) they are subject to registration rights.
Any transactions related to the Warrants are recorded within the stockholders’ equity section of the Company’s condensed consolidated financial statements. However, the issuance of shares pursuant to the exercise of these warrants is contingent upon the share price reaching $11.50. Therefore, share activity related to such warrants will not be recorded until such time as the contingency has been met.
Earn-Out Agreement
In
connection with the Business Combination, stockholders of Shay immediately prior to the transaction (which stockholders consisted of certain affiliates of Platinum Equity, LLC and members of PAE management (the “Shay Stockholders”)) will be entitled to receive up to an aggregate of 4,000,000 additional shares of Class A Common Stock (the “Earn-Out Shares”) if at any time during the five-year period following the Closing Date (the “Earn-Out Period”) the volume weighted average closing sale price of one share of Class A Common Stock on the Nasdaq (or the exchange which shares of Class A Common Stock are then listed) for a period of at least 10 days out of 20 consecutive trading days (the “Common Share Price”) exceeds certain thresholds, described below.
The thresholds (each a “Triggering Event”) causing the Earn-Out Shares to be issued by the
Company to the Shay Stockholders is any such event occurs within the Earn-Out period are: (i) a one-time issuance of 1,000,000 shares if the Common Share Price is greater than $13.00; (ii) a one-time issuance of 1,000,000 shares if the Common Share Price is greater than $15.50; (iii) a one-time issuance of 1,000,000 shares if the Common Share Price is greater than $18.00; and (iv) a one-time issuance of 1,000,000 shares if the Common Share Price is greater than $20.50.
Further, if during the Earn-Out Period there is a change in control (as defined in the Merger Agreement) that results in the holders of Class A Common Stock receiving a per share price in
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respect
of their Class A Common Stock that is equal to or greater than the applicable Common Share Price required in connection with any Triggering Event (an “Acceleration Event”), then any such Triggering Event that has not previously occurred will be deemed to have occurred, and the Company must issue Earn-Out Shares accordingly.
If no Triggering Event is achieved within the Earn-Out Period, the Company will not be required to issue the Earn-Out Shares. No Triggering Event was achieved during the three-month and six-month periods ended June 28, 2020.
Any transactions related to Earn-Out Shares are recorded within the stockholders’ equity section of the
Company’s condensed consolidated financial statements. Earn-Out Shares will be recognized as stock dividends and recorded at fair value as an increase in accumulated deficit (or reduction of retained earnings) and as an increase in Common Stock and Additional Paid-in Capital when they are effectively declared by virtue of a Triggering Event being achieved.
12. Stock-Based Compensation
2016 Participation Plan
On May 23, 2016, the Company adopted the Pacific Architects and Engineers Incorporated 2016 Participation Plan (the “2016 Participation
Plan”). The purpose of the 2016 Participation Plan was to provide incentive compensation to key employees by granting performance units (“Units”). The Units were valued on the date of grant by the compensation committee of the pre-Business Combination company. Participants in the Plan were entitled to receive compensation for their Units in the event a qualifying event occurs. In connection with the Business Combination, which was a qualifying event, the 2016 Participation Plan was terminated effective immediately prior to the Closing Date and, in exchange for a release of claims relating to the plan, plan participants received payments totaling approximately $17.4 million. The $17.4 million was paid out during the three-month ended March 29, 2020, and was recorded as compensation expense.
2020 Incentive Plan
Prior to
the closing of the Business Combination, the Gores III Board of Directors and stockholders approved the PAE Incorporated 2020 Equity Incentive Plan (the “2020 Incentive Plan”). The 2020 Incentive Plan provides for the grant of stock options, stock appreciation rights, restricted units (RSUs) and other stock or cash-based awards.
Restricted Stock Units
During the three-month period ended June 28, 2020, the Company issued 2,141,273 RSUs to certain employees out of the shares approved for issuance under the 2020 Incentive Plan. In addition, the Company issued 35,875 RSUs to its three independent directors in connection with their annual compensation as directors.
RSUs cliff vest in accordance with their respective service period or grade vest on an anniversary date, subject to the terms of the grant agreements and the 2020 Incentive Plan.
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The Company recognized $3.5 million in share-based compensation costs related to RSUs during the three-month and six-month periods ended June 28, 2020. Forfeitures are recognized in compensation costs when those occur.
Activity
related to RSUs during the six-months ended June 28, 2020 is as follows:
The Company issued 330,303 performance-based restricted stock units (“PSUs”) to certain employees out of the shares approved for issuance under the 2020 Incentive Plan. These PSUs earn out over a 3-year performance period, subject to the terms of the grant agreements and the 2020 Incentive Plan. The vesting of PSUs is contingent on the achievement of performance goals stated in the agreement,
such as revenue growth, weighted at 50%, and EBITDA margin, weighted at 50%. Compensation costs are recognized when the performance conditions are satisfied or likely to be satisfied. The Company recognized $0.2 million in PSUs compensation costs during the three-month and six-month periods ended June 28, 2020. Forfeitures are recognized in compensation costs when those occur.
Activity related to PSUs during the six months ended June 28, 2020 is as follows:
Basic net income (loss) per common share is determined by dividing the net income (loss) attributed to stockholders by weighted average number of common shares outstanding during period presented. Diluted income (loss) per share is determined by adjusting the weighted
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average
number of shares of common stock and common stock equivalents outstanding for the dilutive effect of common stock equivalents for the periods presented.
The following table sets forth the computation of basic and diluted loss per share attributable to the Company’s common stockholders for the periods presented (in thousands, except shares and per share amounts):
The
Company has not included the effect of 19,999,985 shares of Common Stock issuable upon the exercise of Warrants in the calculation of diluted net income (loss) per share for the three-month and six-month periods ended June 28, 2020. Warrants are excluded when the exercise price exceeds the average market value of the Company’s common stock price during the applicable period.
The Company has not included the effect of 4,000,000 Earn-Out Shares in the calculation of basic and diluted net (loss) income per share for the three-month and six-month periods ended June 28, 2020. The condition for the issuance of these shares is based on weighted average closing
sale price of the Company’s Class A Common Stock and such condition had not been met as of June 28, 2020.
Unvested RSUs and PSUs will not impact the calculation of basic earnings per share (“EPS”) until vested, in which case they would be included in the total weighted average numbers of shares. All potential dilutive securities, which include unvested RSUs, are included in the diluted EPS calculation. Unvested PSUs are included in the calculation of diluted EPS to the extent that the performance criteria have been achieved.
14. Leases
At June
28, 2020, the Company had right-of-use (“ROU”) assets, net of $154.4 million and lease liabilities of $157.4 million recorded on the condensed consolidated balance sheet.
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The Company rents certain facilities and equipment under operating leases. The Company’s total lease cost is recorded
primarily within selling, general and administrative expenses on the condensed consolidated statements of operations. Rents which are directly chargeable to a project are charged to cost of revenues.
During the three-month and six-month periods ended June 28, 2020, the Company recognized operating lease costs of approximately $14.3 million and $28.4 million, respectively.
The Company’s future minimum operating lease payments for noncancelable operating leases were as follows (in thousands):
The
weighted-average remaining lease term and the weighted-average discount rate for the Company’s operating leases were approximately 6.95 years and 7.3%, respectively, at June 28, 2020.
The Company made cash payments of approximately $10.6 million and $21.2 million for operating leases for the three-month and six-month periods ended June 28, 2020, which are included in cash flows from operating activities in the condensed consolidated statement of cash flows.
15. Legal Proceedings, Commitments, and
Contingencies
The Company is a party to, or has property subject to, litigation and other proceedings. Management believes the probability is remote that the outcome of the matters will have a material adverse effect on its operations as a whole, notwithstanding that the unfavorable resolution of any matter may have a material effect on net earnings in a future period. The Company cannot predict the outcome of legal proceedings and loss or range of loss contingencies with certainty.
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16.
Segment Reporting
The Company's operations and reportable segments are organized around the nature of the services and products provided to customers. The Company defines its reportable segments based on the way the chief operating decision maker (“CODM”), currently its President and Chief Executive Officer, manages the operations of the Company for purposes of allocating resources and assessing performance.
The GMS operating segment provides support to the U.S. Government and its partners within and outside the United States providing sustainment, training and readiness support
and advancing foreign policy objectives. The NSS operating segment provides a wide-ranging portfolio of offerings that support all facets of national security, including intelligence, homeland security and civil government missions.
While the CODM uses a variety of different measures to evaluate the Company’s segments, the primary measures used to evaluate segment performance are revenues and operating income. As a result, interest expense, net and provision for income taxes as recorded on the condensed consolidated statements of operations are not allocated to the Company’s operating segments.
The following table shows information
by reportable segment for the periods presented (in thousands):
Under U.S. Government cost accounting standards, indirect costs including depreciation expense are collected in numerous indirect cost pools, which are then
collectively allocated to the Company’s reportable segments based on a representative causal or beneficial relationship
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of the costs in the pool to the costs in the base. While depreciation expense is a component of the allocated costs, the allocation process precludes depreciation expense from being specifically identified by the Company’s individual reportable segments. For this
reason, depreciation expense by reportable segment is not presented separately above.
Asset information by segment is not a key measure of performance used by the CODM and therefore segment assets are not presented.
Less than 10% of the Company’s revenues and tangible long-lived assets are generated by or owned by entities outside of the United States. Therefore, additional segment financial information by geographic location is not presented.
17. Related-Party Transactions
Tax Overpayment/Underpayment Amount
In
connection with the Business Combination, the Shay Stockholders are entitled to a payment of the net cash savings in U.S. federal, state and local income tax that the post-closing company actually realizes (or is deemed to realize in certain circumstances) in periods after the Closing Date. The liability for this estimated payment and the corresponding charge to equity of $4.7 million are reflected in the Company’s consolidated balance sheets as of June 28, 2020.
Advisory Services
During the six-month period ended June 28, 2020 and twelve month ended December 31, 2019,
the Company recognized management fees, transaction and advisory fees, and expenses of approximately $15.8 million and $5.1 million, respectively. As a result of the Business Combination $15.0 million was grouped with other similar transactional expenses and recorded as a reduction to the recapitalized equity and $0.8 million was recorded in selling, general and administrative expenses. The amount of $5.1 million was recorded in selling, general and administrative expenses for the period ended December 31, 2019.
These expenses were for services rendered by one or more affiliates of Platinum Equity, LLC.
18.
Income Taxes
The Company’s provision for income tax expense (benefits) were approximately $3.8 million, and $(5.0) million and its effective income tax rates were 18.3% and (70.4)% for the three-month and six-month periods ended June 28 2020, respectively. The Company’s provision for income tax expense (benefits) were approximately $1.2 million and $(2.0) million and its effective income tax rates were 25.4% and 52.9% for the three-month and six-month periods ended June 30, 2019 respectively.
The provision for income taxes for the period ended June 28, 2020 differed from
the U.S. federal statutory rate computed by applying the U.S. federal statutory rate to income or loss before income taxes primarily due to the benefit of Foreign Derived Intangible Income (“FDII’), increased prior year interest expense deduction under the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”), nontaxable income and settlement of foreign taxes offset by disallowed compensation deduction under Section 162(m) and disallowed transaction costs. The provision for income taxes for the period ended June 30, 2019 differed from the U.S. federal statutory rate computed by applying the U.S. federal statutory rate to income or loss before
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income
taxes primarily due to a disallowed interest deduction, non-deductible settlement paid to the U.S. Government, non-deductible goodwill and the effect of foreign operations offset by a benefit from foreign derived intangible income.
On March 27, 2020, President Trump signed into U.S. federal law the CARES Act, which is aimed at providing emergency assistance and health care for individuals, families, and businesses affected by the COVID-19 pandemic and generally supporting the U.S. economy. The CARES Act, among other things, includes provisions relating to refundable payroll tax credits, deferment of employer side social security payments, net operating loss carry-back periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified
improvement property.
In particular, under the CARES Act, for taxable years beginning in 2019 and 2020, the base for interest deductibility is increased from 30% to 50% of EBITDA. As of June 28, 2020, the Company estimated that the tax benefit on increased 2019 interest expense deduction related to the CARES Act is approximately $3.6 million. The Company is expecting to defer $35.0 million of employer share Social Security tax under the CARES Act that will be paid equally by December 31, 2021 and 2022. We are in the process of analyzing the different aspects of the
CARES Act to determine whether any other specific provision may impact the Company.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations
(“MD&A”) is designed to provide a reader of our financial statements with a narrative from the perspective of management on the Company’s financial condition, results of operations, liquidity and certain other factors that may affect future results. The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the MD&A and the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2019, which was filed with the Securities and Exchange Commission (the “SEC”) on March
11, 2020, the Company’s Current Report on Form 8-K/A filed with the SEC on March 11, 2020, the Form 424B3 prospectus filed with the SEC on April 23, 2020, and the unaudited condensed consolidated financial statements and related notes contained in this Quarterly Report on Form 10-Q. Unless otherwise noted, the MD&A compares the three-month and six-month periods ended June 28, 2020 to the three-month and six-month periods ended June 30, 2019.
This Quarterly Report on Form 10-Q of PAE contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities
and Exchange Act of 1934, as amended (the “Exchange Act’). These forward-looking statements include information concerning the Company’s plans, objectives, goals, strategies, future events, future revenues, performance, capital expenditures, financing needs and other information that is not historical information. Many of these statements appear, in particular, in the MD&A. When used in this Quarterly Report on Form 10-Q, the words “anticipates,”“assumes,”“believes,”“estimates,”“expects,”“intends,”“may,”“plans,”“projects,”“seeks,”“should,” and variations of such words or similar expressions, or the negatives thereof, are intended to identify forward-looking statements. All forward-looking statements, including, without limitation, those based on the
Company’s examination of historical operating trends, are based upon the Company’s current expectations and various assumptions. The Company believes there is a reasonable basis for its expectations and assumptions, but there can be no assurance that the Company will realize its expectations or that the Company’s assumptions will prove correct.
There are a number of risks and uncertainties that could cause the Company’s actual results to differ materially from the forward-looking statements contained
in this Quarterly Report. Important factors that could cause the Company’s actual results to differ materially from those expressed as forward-looking statements are set forth in the Company’s 2019 Annual Report on Form 10-K in Part I, Item 1A under the heading Risk Factors, the Company’s Current Report on Form 8-K/A filed on March 11, 2020 under the heading Risk Factors, and the Company’s Form 424B3 prospectus filed on April 23, 2020 under the heading Risk Factors. Such risks, uncertainties and other important factors include,
among others, risks related to:
•a loss of contracts with the U.S. federal government or its agencies or other state, local or foreign governments or agencies, including as a result of a reduction in government spending;
•service failures or failures to properly manage projects;
•issues that damage our professional reputation;
•disruptions in or changes to prices of our supply chain, including from difficulties in the supplier qualification process;
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•failures
on the part of our subcontractors or joint venture partners to perform their contractual obligations;
•failures to maintain strong relationships with other contractors;
•the impact of a negative audit or other investigation;
•failure to comply with numerous laws and regulations regarding procurement, anti-bribery and organizational conflicts of interest;
•inability to comply with the laws and other security requirements governing access to classified information;
•inability to share information from classified contracts with investors;
•the
impact of implementing various data privacy and cybersecurity laws;
•costs and liabilities arising under various environmental laws and regulations;
•various claims, litigation and other disputes that could be resolved against PAE;
•delays, contract terminations or cancellations caused by competitors’ protests of major contract awards received by us;
•risks from operating internationally;
•disruptions caused by natural or environmental disasters, terrorist
activities or other events outside our control;
•disruptions caused by social unrest, including related protests or disturbances;
•the impact of public health crises, such as COVID-19;
•issues arising from cybersecurity threats or intellectual property infringement claims;
•the loss of members of senior management;
•the inability to attract, train or retain employees with the requisite skills, experience and security clearances;
•the impact of the expiration of our collective bargaining agreements; and
•other
risks and uncertainties described in this Form 10-Q, including under the section entitled “Risk Factors,” and described in our other filings with the SEC.
There may be other factors that may cause the Company’s actual results to differ materially from those expressed in these forward-looking statements. Except as may be required by law, the Company undertakes no obligation to publicly update or revise forward-looking statements that may be made to reflect events or circumstances after the date made or to reflect the occurrence of unanticipated events.
Stockholders of the Company should read the following discussion and
analysis of our financial condition and results of operations together with the condensed consolidated financial statements and related notes that are included elsewhere in this Quarterly Report on Form 10-Q.
This MD&A generally discusses 2020 and 2019 items and year-over-year comparisons between 2020 and 2019. As used in this MD&A, unless the context indicates otherwise, the financial information relating to the three-month and six-month periods ended June 30, 2019, are those of Shay Holdings and its subsidiaries, and the financial information and data for the three-month and six-month periods ended June 28, 2020 includes the financial information and data of Shay Holdings and its subsidiaries
for the period prior to the Closing and the financial information and data of PAE Incorporated for the period subsequent to the Closing. See Note 1 – “Description of Business” and Note 6 – “Business Combinations and Acquisitions” for additional information.
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We are subject to the informational requirements of the Exchange Act, and we file or furnish reports, proxy statements and other information with the SEC. Such reports and other information we file with the SEC are available free of charge at https://investors.pae.com/financials-and-filings/sec-filings as soon as practicable
after such reports are available on the SEC’s website at www.sec.gov. The SEC’s website contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. We periodically provide other information for investors on our corporate website, www.pae.com, and our investor relations website, https://investors.pae.com.
This includes press releases and other information about financial performance, information on corporate governance and details related to our annual meeting of stockholders. We intend to use our website as a means of disclosing material non-public information and for complying with our disclosure obligations under Regulation FD. Accordingly, investors should monitor our website, in addition to following the Company's press releases, SEC filings and public conference
calls and webcasts. The information contained on the websites referenced in this Quarterly Report on Form 10-Q is not incorporated by reference into this filing. Further, our references to website URLs are intended to be inactive textual references only.
Business Overview
PAE is a leading, highly diversified, global company that provides a broad range of operational solutions and outsourced services to meet the critical, enduring needs of the U.S. government,
other allied governments, international organizations and companies. PAE merges technology with advanced business practices to deliver faster, smarter and more efficient managed services. Whether clients require high-profile support to operate the largest U.S. embassies around the world or need technical solutions for programs that monitor bioterrorism agents, PAE delivers for its customers. PAE leverages its scale, 65 years of experience and talented global workforce of approximately 20,000 to provide the essential services PAE’s clients need to tackle some of the world’s toughest challenges.
Basis of Presentation
PAE provides a wide variety integrated support solutions, including defense and military readiness, diplomacy, intelligence support, business process
outsourcing, counter-terrorism solutions, peacekeeping, development, host nation capacity building, aircraft and ground equipment maintenance and logistics, and operations and maintenance of facilities and infrastructure. Customers include agencies of the U.S. Government, such as the Department of Defense (“DoD”) and Department of State (“DoS”), the National Aeronautics and Space Administration (“NASA”), Department of Homeland Security, intelligence community agencies and other civilian agencies, as well as allied foreign governments and international organizations such as the United Nations.
PAE’s operations are organized into two reportable segments, Global Mission Services (“GMS”) and National Security Solutions (“NSS”).
•The GMS segment generates revenues through contracts
under which PAE provides customers with logistics and stability operations, force readiness and infrastructure management.
•The NSS segment generates revenues through contracts under which PAE provides customers with counter-threat solutions, intelligence solutions and information optimization.
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Segment performance is based on consolidated revenues and consolidated operating income. For additional information regarding PAE’s reportable segments, refer to Note 16 - “Segment Reporting” of the notes to PAE’s condensed consolidated financial statements.
Factors
Affecting PAE’s Operating Results
Business Combinations and Acquisitions
Business Combination
Merger Consideration
As described in Note 1 - “Description of Business” and Note 6 - “Business Combinations and Acquisitions” of the notes to the condensed consolidated financial statements, the Company completed the Business Combination on February 10, 2020. Pursuant to the terms of the Merger Agreement, the aggregate merger consideration paid for the Business Combination was approximately $1,427.0 million. The consideration paid to the Shay Stockholders consisted of a combination of cash and stock consideration.
The aggregate cash consideration paid to the Shay Stockholders at the Closing was approximately $424.2 million, consisting of (a) approximately $408.0 million of cash available to Gores III from its trust account, after giving effect to income and franchise taxes payable in respect of interest income earned in the trust account and redemptions that were elected by Gores III’s public stockholders, plus (b) all of Gores III’s other cash and cash equivalents, plus (c) gross proceeds of approximately $220.0 million from a private placement offering conducted by Gores III in which investors purchased an aggregate of 23,913,044 shares of Class A Common Stock for $9.20 per share, less (d) certain transaction fees and expenses, including the payment of deferred underwriting commissions agreed to at the time of Gores III’s initial public offering, less (e) certain payments to participants in the 2016 Participation Plan, less (f) approximately $136.5 million used to repay a portion
of the indebtedness of Shay immediately prior to the Closing, less (g) approximately $33.8 million of transaction fees and expenses of Shay. The remainder of the consideration paid to the Shay Stockholders consisted of 21,127,823 newly issued shares of Class A Common Stock.
In addition to the foregoing consideration paid on the Closing Date, Shay Stockholders will be entitled to receive additional Earn-Out Shares of up to an aggregate of four million shares of Class A Common Stock, if the price of Class A Common Stock trading on the Nasdaq exceeds certain thresholds during the five-year period following the completion of the Business Combination or if there is an Acceleration Event. See Note 11 - “Stockholders’ Equity - Earn-Out Agreement” of the notes to the condensed consolidated financial statements for additional information.
During the second quarter, pursuant to the
post-closing adjustment provisions contained in the Merger Agreement, the Company determined that a post-closing adjustment payment was due to the Shay Stockholders. As a result of such determination, the Company recorded a $20.2 million liability and an adjustment to additional paid-in capital in the Company’s condensed consolidated balance sheets as of June 28, 2020.
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Incentive Plan
For
a discussion on the 2020 Incentive Plan refer to Note 12 - “Stock-Based Compensation” of the notes to the condensed consolidated financial statements.
Debt
In connection with the Business Combination, Shay was required to amend its existing credit facilities and reduce its outstanding indebtedness under its credit facilities such that the total indebtedness under the facilities, minus cash on hand at the consummation of the transaction would not be greater than $572.1 million. Immediately after the closing of the transaction the outstanding balance on the Second Term Loan was reduced by approximately $136.5 million to a principal balance of $128.8 million.
Financial and Other Highlights
From
December 31, 2019 to June 28, 2020, PAE’s overall contract backlog decreased by 1.4% from $6,351.8 million to $6,265.6 million, of which $1,240.6 million was funded. Backlog is an operational measure representing PAE’s estimate of the amount of revenue that it expects to realize over the remaining life of awarded contracts and task orders; the funded backlog refers to the value on contracts for which funding is appropriated less revenues previously recognized on these contracts. Unfunded backlog represents the
estimated future revenues to be earned from negotiated contracts for which funding has not been appropriated or authorized, and unexercised priced contract options. The total backlog consists of remaining performance obligations plus unexercised options. PAE believes backlog is a useful metric for investors because it is an important measure of business development performance and revenue growth. This metric is used by management to conduct and evaluate its business during its regular review of operating results for the periods presented. See Note 4 - “Revenues" of the notes to the condensed consolidated financial statements for more information.
The estimated value of PAE’s total backlog was as follows (in thousands):
As of June 28, 2020, PAE had a contract
base of more than 469 active contracts and task orders. PAE served as the prime contractor on approximately 96.3% of its contracts. The DoD and DoS are PAE’s largest customers and accounted for 37.4% and 18.4% of its revenue during the six-month period ended June 28, 2020, respectively and 36.3% and 24.7% of its revenue during the six-month period ended June 30, 2019, respectively. International Logistics and Stabilization, Infrastructure and Logistics, Readiness and Sustainment, and Business Process Solutions were PAE’s largest contributors by service area, representing 32.8%, 28.9%, 14.9%, and 11.6% of its revenue, respectively during the six-month period ended June
28, 2020. International Logistics and Stabilization, Infrastructure and Logistics, Readiness and Sustainment, and Business Process Solutions were PAE’s largest contributors by service area, representing 34.9%, 25.1%, 15.3%, and 15.2% of its revenue, respectively during the six-month period ended June 30, 2019.
PAE’s long-tenured contracts have created a recurring base business with its top revenue-generating contracts having a weighted average contract length of greater than 7.72 years, as of June 28, 2020. We believe that revenue from these long-running
contracts will continue to be secure as PAE’s contracts are predominately funded from stable portions of the U.S. Government budget with little dependence on wartime or emergency overseas contingency operations funding.
Trends and Factors Affecting PAE’s Future Performance
External Factors
PAE’s business primarily focuses on providing services to the U.S. Government and allied nations and organizations; PAE’s performance is inherently linked to governmental missions and goals. We have concentrated our business efforts on those missions
and goals that are enduring and that have limited exposure to abrupt policy changes. For example, PAE has supported U.S. embassies since the 1970s. We are also trusted by our customers to support them on major policy initiatives that require immediate response to solve an acute crisis. Examples of this work include our rapid establishment and operation of Ebola treatment units in Liberia in 2015 and our work this year on behalf of the state of Georgia in converting a convention center to a COVID-19 treatment center in less than one week.
Over most of the last two decades, the U.S. Government has increased its reliance on the private sector for a wide range of professional and support services. This increased use of outsourcing by the U.S. Government has been driven by a variety of factors, including lean-government initiatives launched in the 1990s, surges in demand during times of national crisis, the increased complexity
of missions conducted by the U.S. military and the DoS, increased focus of the U.S. military on war-fighting efforts and loss of skills within the government caused by workforce reductions and retirements.
Although the size of future U.S. Government department and agency budgets remains subject to change, current indications are that overall U.S. Government spending will remain consistent with current spending levels. PAE believes the following industry trends will result in continued strong demand in the target markets for the types of services it provides:
34
•the continued transformation of military forces, leading to increased outsourcing of non-combat functions, including life-cycle asset management functions
ranging from organizational to depot level maintenance;
•an increased level of coordination between the DoS and DoD on key national security initiatives and foreign policies;
•increased maintenance, overhaul and upgrade needs to support aging military platforms; and
•the on-going evolution of international relations that may require enhanced or new policy initiatives.
Current Economic Conditions
PAE believes that its industry and customer base are less likely to be affected by many of the factors generally affecting business and consumer spending. PAE’s contract
awards typically extend to five years, including options, and it has a strong history of being awarded a majority of these contract options. Additionally, since PAE’s primary customers are departments and agencies within the U.S. Government, it has not historically had significant issues collecting its receivables. However, PAE cannot be certain that the economic environment, government debt levels, or other factors will not adversely impact its business, financial condition or results of operations in the future. The government has taken several financial precautions and measures to combat the current financial market conditions, including in response to the COVID-19 pandemic.
Impact of COVID-19
We continue to work with our stakeholders (including customers, employees, suppliers and local
communities) to address this global pandemic. Specifically, we are working closely with our customers, including those within the U.S. Government, to permit continued contract performance and to mitigate the impact of the current COVID-19 pandemic on our operations and personnel. We continue to review our contractual provisions, hold discussions with customers regarding the pandemic’s potential impact on contract operations, and take actions to reduce the impact of COVID-19 on our business, workforce, supply chain, revenues, and results of operations. We are continuing to monitor the impact of the pandemic and other related uncertainties on financial markets, which has caused us to delay undertaking certain actions in support of our strategic plans. In response to COVID-19, we have taken
a number of steps to ensure the protection of employees and customers, as well as to mitigate any operational and financials impacts. In particular, we are:
•Implementing enhanced health and safety protocols, including at customer sites, in order to protect our employees and customers and to maintain continuity of operations;
•Monitoring on a daily basis the COVID-19 status of employees and independent contractors;
•Reviewing on a daily basis the impact of COVID-19 on programs, facilities and contracts with customers;
•Reducing overhead costs by among other things delaying planned hiring and by cancelling
travel that is not directly related to program requirements;
35
•Developing contingency and business continuity plans in case COVID-19 disruptions increase or key personnel become incapacitated;
•Identifying new business opportunities related to COVID-19, including expanded service offerings for existing customers;
•Entering into contract modifications and advance agreements where applicable to permit recovery of costs relating to COVID-19; and
•Engaging in frequent
and ongoing dialogue and contract negotiations with customers to either:
◦Permit PAE employees to continue to work safely (including remotely); or,
◦Permit PAE to be reimbursed the costs of paid leave for employees who are unable to work (as provided by Section 3610 of the Coronavirus Aid, Relief and Economic Security Act (“CARES Act”).
COVID-19 has had a marginally unfavorable impact on the Company’s results of operations for the three-month and six-month periods ended June 28, 2020. Although our operations have been
disrupted by the COVID-19 pandemic, the impact has been mitigated due to the nature of our business. In particular, our U.S. Government customers have taken steps to ensure the continuance of many of the services provided by us and other contractors, including, but not limited to, designating certain PAE contracts as essential for continued performance and authorizing remote work for contractor personnel that cannot access worksites. In addition, the impact may be further mitigated by Section 3610 of the CARES Act, which allows U.S. government agencies to reimburse contractors such as us at the minimum applicable contract billing rate for costs of certain paid leave for employees who cannot access work sites or telework through September 30,
2020. However, some U.S. Government customers have suspended or reduced work under certain of our contracts.
COVID-19 related costs for us and our subcontractors could be significant, and we are seeking reimbursement of such costs under our U.S. Government contracts through a combination of contract actions and reimbursement of costs under Section 3610 of the CARES Act. Reimbursement of any costs under Section 3610 is not expected to include profit or fee. Costs for employees whose jobs cannot be performed remotely may not be fully recoverable under our contracts. We also
have no assurance that Congress will appropriate funds to cover the reimbursement of contractors authorized by the CARES Act.
Management expects that the impact of COVID-19 will be marginally unfavorable on our full year results based on information known to us at this time. Since our primary customers are departments and agencies within the U.S. Government, we have not historically had significant issues collecting our receivables and do not foresee issues collecting our receivables in the foreseeable future. In addition, our contract awards typically extend to at least five years, including options, and we have a strong history of being awarded a majority of these contract options; we do not anticipate that the pandemic will have a materially
adverse impact on such awards.
Our liquidity position has not been materially impacted, and we continue to believe that we have adequate liquidity to fund our operations and meet our debt service obligations for the foreseeable future. However, we cannot predict the impact of the COVID-19 pandemic, and the longer the duration of the event and the more widespread in geographic locations where we and our suppliers operate, the more likely it is that it could have an adverse impact on our financial condition, results of operations, and/or cash flows in the future.
36
Inflation and Pricing
Most of PAE’s contracts
provide for estimates of future labor costs to be escalated for any option periods, while the non-labor costs in its contracts are normally considered reimbursable at cost. PAE’s property and equipment consists principally of computer systems equipment, machinery and transportation equipment, leasehold improvements, and furniture and fixtures. PAE does not expect the overall impact of inflation on replacement costs of its property and equipment to be material to its future results of operations or financial condition.
Primary Components of Operating Results
Revenues
The majority of PAE’s revenues
are generated from contracts with the U.S. Government and its agencies. PAE enters into a variety of contract types, including fixed price, cost reimbursable, and time and materials contracts.
Cost of revenues
Cost of revenues includes costs related to labor, material, subcontract labor and other costs that are allowable and allocable to contracts under federal procurement standards.
Selling, general and administrative expenses
Selling,
general and administrative expenses primarily consist of (i) fringe benefits related to the contract costs; (ii) salaries and wages plus associated fringe benefits and occupancy costs related to executive and senior management, business development, bid and proposal, contracts administration, finance and accounting, human resources, recruiting, information systems support, legal and corporate governance; and (iii) unallowable costs under applicable procurement standards that are not allocable to contracts for billing purposes. Unallowable costs do not generate revenue but are necessary for business operations.
37
Results
of Operations
Comparison of Results for the Three Months Ended June 28, 2020 (unaudited) and June 30, 2019 (unaudited) (in thousands):
Three
Months Ended
Percent
June 28,
June 30,
Dollar
Change
2020
2019
Change
%
Revenues
$
643,303
$
695,607
$
(52,304)
(7.5)
Cost
of revenues
496,678
540,772
(44,094)
(8.2)
Selling, general and administrative expenses
105,451
126,438
(20,987)
(16.6)
Amortization
of intangible assets
8,047
8,196
(149)
(1.8)
Total operating expenses
610,176
675,406
(65,230)
(9.7)
Program
profit (loss)
33,127
20,201
12,926
64.0
Other income, net
1,168
5,958
(4,790)
(80.4)
Operating
income
34,295
26,159
8,136
31.1
Interest expense, net
(13,757)
(21,617)
7,860
(36.4)
Income
before income taxes
20,538
4,542
15,996
352.2
Expense from income taxes
3,752
1,153
2,599
225.4
Net
income
16,786
3,389
13,397
395.3
Noncontrolling interest in earnings of ventures
765
715
50
7.0
Net
income attributed to PAE Incorporated
$
16,021
$
2,674
$
13,347
499.1
Revenues
Revenues for the three-month period ended June 28, 2020, decreased by approximately $52.3 million, or 7.5%, from the comparable
period in 2019. The decrease was attributable to a $58.5 million impact from COVID-19, of which approximately $40.4 million was non-labor, and $18.1 million was labor, which was partially offset by a $6.2 million net increase in contract volume and new business programs. The GMS and NSS segment revenues decreased by approximately $18.2 million and $34.1 million, respectively.
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Cost of revenues
Cost of revenues for the three-month period ended June 28, 2020, decreased by approximately $44.1 million, or 8.2%, from the comparable period in 2019. The decrease in cost of revenues was primarily driven
by lower revenue volume offset by lower non-labor volumes.
Selling, general and administrative expenses
Selling, general and administrative expense for the three-month period ended June 28, 2020, decreased by approximately $21.0 million, or 16.6%, from the comparable period in 2019. The decrease in selling, general and administrative expenses was primarily driven by lower indirect expenses, and the sale of substantially all the assets of PAE ISR LLC in 2019.
Amortization of intangible assets
Amortization of intangible assets for the three-month period ended June 28, 2020, decreased by approximately $0.1 million, or 1.8%, from the comparable period in 2019. The reduction was associated with amortizing
certain customer relationships, development technologies, and trade names.
Other income, net
Other income, net for the three-month period ended June 28, 2020, decreased by approximately $4.8 million, from the comparable period in 2019. The decrease is primarily due to a one-time contract reserve write-off in 2019.
Operating income
Operating income for the three-month period ended June 28, 2020, increased by approximately $8.1 million, from the comparable period in 2019. The increase resulted from lower selling, general, and administrative expenses, and increased volume on higher
margin programs, partially offset by lower revenue volume.
Interest expense, net
Interest expense, net for the three-month period ended June 28, 2020, decreased by approximately $7.9 million, or 36.4%, from the comparable period in 2019. This decrease was driven by the reduction of debt year over year.
Net income
Net income attributed to PAE for the three-month period ended June 28, 2020 was $16.0 million compared with a net income attributed to PAE of approximately $2.7 million in the comparable period in 2019. The increase in net income for the three-month period ended June 28, 2020, was primarily driven by factors impacting operating income and lower
interest expenses, which was driven by a reduction in debt year over year.
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Comparison of Results for the Six Months Ended June 28, 2020 (unaudited) and June 30, 2019 (unaudited) (in thousands):
Six
Months Ended
Percent
June 28,
June 30,
Dollar
Change
2020
2019
Change
%
Revenues
$
1,260,556
$
1,369,091
$
(108,535)
(7.9)
Cost
of revenues
961,886
1,057,931
(96,045)
(9.1)
Selling, general and administrative expenses
242,777
261,474
(18,697)
(7.2)
Amortization
of intangible assets
16,094
16,853
(759)
(4.5)
Total operating expenses
1,220,757
1,336,258
(115,501)
(8.6)
Program
profit (loss)
39,799
32,833
6,966
21.2
Other income, net
1,954
7,678
(5,724)
(74.6)
Operating
income
41,753
40,511
1,242
3.1
Interest expense, net
(34,705)
(44,277)
9,572
(21.6)
Income
(loss) before income taxes
7,048
(3,766)
10,814
(287.1)
Benefit from income taxes
(4,961)
(1,994)
(2,967)
148.8
Net
income (loss)
12,009
(1,772)
13,781
(777.7)
Noncontrolling interest in earnings of ventures
931
1,274
(343)
(26.9)
Net
income (loss) income attributed to PAE Incorporated
$
11,078
$
(3,046)
$
14,124
(463.7)
Revenues
Revenues for the six-month period ended June 28, 2020, decreased by approximately $108.5 million, or 7.9%, from the comparable period in 2019.
The decrease was attributable to a $72.0 million impact from COVID-19, of which approximately $49.7 million was non-labor, and $22.3 million was labor, and by a $36.5 million net decrease in contract volume and new business programs. The GMS and NSS segment revenues decreased by approximately $65.2 million and $43.3 million, respectively.
Cost of revenues
Cost of revenues for the six-month period ended June 28, 2020, decreased by approximately $96.0 million, or 9.1%, from the comparable period in 2019. This decrease in cost of revenues was attributable to lower revenue volume offset by lower non-labor volumes.
40
Selling,
general and administrative expenses
Selling, general and administrative expense for the six-month period ended June 28, 2020, decreased by approximately $18.7 million, or 7.2%, from the comparable period in 2019. This decrease in selling, general and administrative expenses was primarily driven by lower revenue volume.
Amortization of intangible assets
Amortization of intangible assets for the six-month period ended June 28, 2020, decreased by approximately $0.8 million, or 4.5%, from the comparable period in 2019. The reduction was associated with amortizing certain customer relationships, development technologies, and trade names.
Other income, net
Other
income, net for the six-month period ended June 28, 2020, decreased by approximately $5.7 million, from the comparable period in 2019. This decrease was driven by a one-time contract reserve write-off in 2019.
Operating income
Operating income for the six-month period ended June 28, 2020, increased by approximately $1.2 million, from the comparable period in 2019. The increase was driven by increased volume on higher margin programs, partially offset by lower revenue volume and lower other operating income in 2020.
Interest expense, net
Interest expense, net for the six-month period ended June
28, 2020, decreased by approximately $9.6 million, or 21.6%, from the comparable period in 2019. This decrease was primarily driven by reduction of debt year over year.
Net income (loss)
Net income attributed to PAE for the six-month period ended June 28, 2020 was $11.1 million compared with a net loss attributed to PAE of approximately $3.0 million in the comparable period in 2019. The increase in net income for the six-month period ended June 28, 2020, was primarily driven by the decrease in interest expense and provision for income taxes, as well as by the factors impacting operating income.
41
PAE’s
Segments
Comparison of Results by Segments for the Three Months Ended June 28, 2020 (Unaudited), and June 30, 2019 (Unaudited) (in thousands):
Revenues for the three-month period ended June 28, 2020, decreased by $18.2 million, or 3.5%, from the comparable period in 2019. The decrease was attributable to a $40.7 million impact from COVID-19, of which approximately $29.7 million was
non-labor and $11.0 million was labor, partially offset by $22.5 million net increase in contract volume and new business programs.
Operating income
Operating income for the three-month period ended June 28, 2020 increased by $6.3 million from the comparable period in 2019. This improvement was primarily the result of increased volume on higher margin programs partially offset by lower revenue volume.
42
National
Security Solutions Segment Results
Revenues
Revenues for the three-month period ended June 28, 2020 decreased by $34.1 million, or 20.1%, from the comparable period in 2019. This decrease was attributable to a $17.8 million impact from COVID-19, of which approximately $11.0 million was non-labor, and $6.8 million was labor, and by a $16.3 million net decrease from small business re-compete losses, net of new business wins .
Operating income
Operating income for the three-month period ended June 28, 2020 increased by $3.8 million from the comparable period in 2019. The increase was primarily driven by lower selling, general, and administrative expenses, and increased volume on higher margin programs, partially
offset by lower revenue volume.
Comparison of Results by Segments for the Six Months Ended June 28, 2020 (Unaudited), and June 30, 2019 (Unaudited) (in thousands):
Revenues for the six-month period ended June 28, 2020, decreased by $65.2 million, or 6.3%, from the comparable period in 2019. The decrease was attributable to a $52.9 million impact from COVID-19, of which approximately $38.6 million was non-labor,
and $14.3 million was labor, and by a $12.3 million net decrease in contract volume and new business programs.
43
Operating income
Operating income for the six-month period ended June 28, 2020 decreased by $6.9 million from the comparable period in 2019. This decrease was primarily from lower revenue volume and increases in selling, general and administrative expenses.
National Security Solutions Segment Results
Revenues
Revenues
for the six-month period ended June 28, 2020 decreased by $43.3 million, or 12.8%, from the comparable period in 2019. This decrease was attributable to a $19.1 million impact from COVID-19, of which approximately $11.8 million was non-labor, and $7.3 million was labor, and by a $24.2 million net decrease in contract volume and new business programs.
Operating income
Operating income for the six-month period ended June 28, 2020 increased by $8.9 million from the comparable period in 2019. The increase was primarily driven by lower selling, general, and administrative expenses, partially offset by lower revenue volume.
Liquidity
and Capital Resources
As of June 28, 2020, PAE had cash and cash equivalents totaling $138.5 million and the Company had no outstanding borrowings on its asset-based revolving loan credit facility.
As of December 31, 2019, PAE had cash and cash equivalents totaling $68.0 million and the Company had no outstanding borrowings on its asset-based revolving loan credit facility.
PAE’s primary sources of liquidity are cash flow from operations and borrowings under its credit facility to provide
capital necessary for financing working capital requirements, capital expenditures and making selective strategic acquisitions.
PAE expects the combination of its current cash, cash flow from operations, and the available borrowing capacity under its Revolving Credit Facility to be sufficient to continue to meet its normal working capital requirements, capital expenditures and other cash requirements. However, significant increases or decreases in revenues, accounts receivable, accounts payable, and merger and acquisition activity can affect PAE’s liquidity. PAE’s accounts receivable and accounts payable levels can be affected by changes in the level of contract work it performs, by the timing of large materials purchases, and subcontractor efforts used in its contracts.
Government funding delays can cause delays in PAE’s ability to invoice for revenues earned, presenting a potential negative impact on liquidity.
In connection with the Business Combination, Shay was required to amend its existing credit facilities and reduce its outstanding indebtedness under its credit facilities such that the total indebtedness under the facilities, minus cash on hand at the consummation of the transaction would not be greater than $572.1 million. Immediately after the closing of the transaction the outstanding balance on the Second Term Loan was reduced by approximately $136.5 million to a principal balance of $128.8 million.
44
See Note 10 - “Debt” of the notes to the
condensed consolidated financial statements for further information on the terms and availability of PAE’s credit facilities.
Cash Flows Analysis
Comparison of Results for the Three Months Ended June 28, 2020 (Unaudited), and June 30, 2019 (Unaudited) (in thousands):
Three
Months Ended
June 28,
June 30,
Dollar
2020
2019
Change
Net cash provided by operating activities
44,675
32,560
$
12,115
Net
cash (used in) provided by investing activities
(1,156)
23
(1,179)
Net cash used in financing activities
(5,938)
(19,144)
13,206
Effect of exchange
rate changes on cash and cash equivalents
1,098
(747)
1,845
Net increase in cash and cash equivalents
$
38,679
$
12,692
$
25,987
Net
cash provided by operating activities
Net cash provided by operating activities for the quarter of $44.7 million, increased by $12.1 million over the prior year period, primarily as a result of an increase in accounts payable and accrued salaries, offset by reduced cash collections.
Net cash (used in) provided by investing activities
Cash used in investing activities for the three-month period ended June 28, 2020 increased from the comparable period in 2019, primarily driven by lower proceeds from sale of assets and property and equipment.
Net cash used in financing activities
Cash used in financing activities for the three-month period ended June 28, 2020
was $(5.9) million, a decrease of $13.2 million from the comparable period in 2019. The decrease was primarily driven by lower long-term debt borrowings.
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Comparison of Results for the Six Months Ended June 28, 2020 (Unaudited), and June 30, 2019 (Unaudited) (in thousands):
Six
Months Ended
June 28,
June 30,
Dollar
2020
2019
Change
Net cash provided by operating activities
$
55,588
$
71,923
$
(16,335)
Net
cash used in investing activities
(1,560)
(3,591)
2,031
Net cash provided by (used in) financing activities
15,596
(62,844)
78,440
Effect of exchange
rate changes on cash and cash equivalents
810
(1,205)
2,015
Net increase in cash and cash equivalents
$
70,434
$
4,283
$
66,151
Net
cash provided by operating activities
Net cash provided by operating activities for the six-month period ended June 28, 2020 decreased by $16.3 million primarily as a result of an increase in accounts payable and accrued salaries, offset by reduced cash collections.
Net cash used in investing activities
Cash used in investing activities for the six-month period ended June 28, 2020 improved by $2.0 million from the comparable period in 2019, primarily driven by lower expenditures for property and equipment.
Net cash provided by (used in) financing activities
Cash provided by financing activities for the six-month period ended June
28, 2020 was $15.6 million, an increase of $78.4 million from the comparable period in 2019. The increase was primarily driven by the Recapitalization, partially offset by prepayment of the Second Lien Term Loan event from previous quarter.
46
Financing
Long-term debt consisted of the following as of the dates presented (in thousands):
Total
debt, net of discount and debt issuance costs
612,797
749,937
Less current maturities of long-term debt
(22,969)
(22,007)
Total long-term debt, net of current
$
589,828
$
727,930
The
Company’s borrowing arrangement provides for borrowings up to $499.3 million under a first lien term loan credit agreement, dated October 26, 2016, as amended (the “First Term Loan”), $128.8 million under a second lien term loan credit agreement, dated October 26, 2016, as amended (the “Second Term Loan”), and $150.0 million under a revolving credit facility dated October 26, 2016, as amended (the “Revolving Credit Facility,” and together with the First Term Loan and the Second Term Loan, the “Credit Agreements”). Principal and interest are due quarterly on the First Term Loan and interest is due quarterly on the Second Term Loan. The maturity date of the First Term Loan is October 20, 2022. For the Second Term Loan the maturity date is October
20, 2023. For the Company’s Revolving Credit Facility the maturity date is October 20, 2021.
In connection with the Business Combination, Shay was required to amend its existing credit facilities and reduce its outstanding indebtedness under its credit facilities such that the total indebtedness under the facilities, minus cash on hand at the consummation of the transaction would not be greater than $572.1 million. Immediately after the closing of the transaction the outstanding balance on the Second Term Loan was reduced by approximately $136.5 million to a principal balance of $128.8 million.
The Credit Agreements require the
Company to comply with specified financial covenants under certain circumstances, including the maintenance of certain leverage ratios.
The Credit Agreements also contain various non-financial covenants, including affirmative covenants with respect to reporting requirements and maintenance of business activities, and negative covenants that, among other things, may limit or impose restrictions on the Company’s ability to alter the character of the business, consolidate, merge, or sell assets, incur liens or additional indebtedness, make investments, and undertake certain additional actions.
PAE was in compliance with the financial covenants under the Credit Agreements as of June 28, 2020. See Note 10 - “Debt” of the notes to the condensed
consolidated financial statements.
47
Off-Balance Sheet Arrangements
PAE has outstanding performance guarantees and cross-indemnity agreements in connection with certain aspects of its business. PAE also has letters of credit outstanding principally related to performance guarantees on contracts and surety bonds outstanding principally related to performance and subcontractor payment bonds as described in Note 10 - “Debt" of the notes to the condensed consolidated financial statements.
PAE has entered into various arrangements to provide program management, construction management and operations and maintenance services. The ownership percentage of these ventures is typically representative of the work to be performed or the amount of risk assumed by each venture partner. Some of these ventures are considered variable interest entities. PAE has consolidated all ventures over which it has control. For all others, PAE’s portion of the earnings are recorded in equity in earnings of ventures. See Note 9 - “Consolidated Variable Interest Entities" of the notes to the condensed consolidated financial statements.
PAE does not believe that it has any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition,
revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that would be material to investors.
Recently Issued Accounting Pronouncements
For a description of recently announced accounting standards, including the expected dates of adoption and estimated effects, if any, on PAE’s condensed consolidated financial statements, see Note 3 - “Recent Accounting Pronouncements" of the notes to the condensed consolidated financial statements.
Critical Accounting Policies
PAE’s MD&A is based upon its consolidated financial
statements, which are prepared in conformity with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements in accordance with GAAP requires the use of estimates and assumptions which affect the reported amounts in the consolidated financial statements. Due to the size and nature of many of PAE’s programs, the estimation of total revenues and cost at completion is subject to a wide range of variables, including assumptions for schedule and technical issues. Actual results may differ from PAE’s management’s estimates.
PAE has identified the following Significant Accounting Principles and Policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on its results of operations
or financial condition.
•Revenue Recognition
•Goodwill and Indefinite-Lived Intangibles
•Income Taxes
48
Revenue Recognition
The majority of PAE’s revenues are generated from contracts with the U.S. Government and its agencies. PAE enters into a variety of contract
types, including fixed price, cost reimbursable, and time and materials contracts.
PAE accounts for a contract when it has been approved by all parties in the arrangement, the rights of the parties and payment terms are identified, and collectability of consideration is probable. At contract inception, PAE identifies distinct goods or services promised in the contract, referred to as performance obligations, and then determines the transaction price for the contract.
PAE’s contracts contain promises to provide distinct goods or services to its customers. These represent separate performance obligations and units of account. PAE’s management evaluates whether a single contract should be accounted for as more than one performance obligation or whether two or more contracts should be combined and accounted for as one single arrangement at the outset of the contract. Most of PAE’s contracts consist of providing
a complex set of interrelated goods and services that together provide a single deliverable or solution to the customer, and accordingly are accounted for as a single performance obligation. PAE also may engage with a customer on a contract where multiple distinct goods or services may be provided. In such circumstance, multiple performance obligations exist, and PAE would allocate the contract’s transaction price to the individual performance obligations based on estimated relative standalone selling price. The primary method used to estimate standalone selling price is the expected cost plus a margin approach, under which PAE forecasts expected costs of satisfying a performance obligation and then adds an appropriate margin for that distinct good or service promised.
Revenue
is recognized when, or as, the performance obligation is satisfied. For substantially all of PAE’s contracts, PAE satisfies its performance obligations over time as its customer simultaneously receives and consumes benefits. Revenue is recognized over time when there is a continuous transfer of control to the customer.
For U.S. Government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the U.S. Government to unilaterally terminate the contract for convenience, pay for
costs incurred plus a reasonable profit and take control of any work in process. When control is transferred over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. Based on the nature of the products and services provided in the contract, PAE uses judgment to determine if an input measure or output measure best depicts the transfer of control over time.
For service type contracts, performance obligations are typically satisfied as services are rendered and PAE uses a contract cost-based input method to measure progress. Contract
costs include labor, material and allocable indirect expenses. Revenue is recognized proportionally as contract costs are incurred plus estimated fees. If a contract does not meet the criteria for recognizing revenue over time, revenue is recognized at the point in time when control of the good or service is transferred to the customer. Control is considered to have transferred when PAE has a right to payment and the customer has legal title.
PAE reviews the progress and execution of performance obligations under the estimate at completion process. As part of this process, PAE reviews information including, but not limited
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to,
key contract terms and conditions, program schedule, progress towards completion, identified risks and opportunities and the related changes in estimates of revenues and costs. The risks and opportunities include judgments about the ability and cost to achieve the contract milestones and other technical contract requirements. PAE must make assumptions and estimates regarding labor productivity and availability, the complexity of the work to be performed, the availability of materials, the length of time to complete the performance obligation, execution by subcontractors, the availability and timing of funding from customers and overhead cost rates, among other variables. A significant change in one
or more of these estimates could affect the profitability of PAE’s contracts.
Goodwill and Indefinite-Lived Intangibles
PAE evaluates goodwill for potential impairment annually on the first day of the fourth quarter or if an event occurs or circumstances change that indicate that the fair value of a reportable segment may have fallen below its carrying value. The evaluation includes a qualitative assessment to determine if it is more likely than not that fair value of a reportable segment is less than its carrying amount. If, as result of the qualitative assessment, it is more likely than not that the fair value of a reportable segment is less than its carrying amount, PAE compares the fair value of each of the reportable segments using
a discounted cash flow methodology, or other fair value measures as considered appropriate in the circumstances, to its net book value, including goodwill. If the net book value exceeds the fair value, PAE will measure impairment by comparing the derived fair value of goodwill to its carrying value, and any impairment is recorded in the current period.
During the fourth quarter of 2019, PAE performed the annual qualitative impairment test for both of its reportable segments and noted that no impairment existed. There were no events or circumstances during the three-month and six-month periods ended June 28, 2020 indicating that the carrying amount of goodwill was impaired. The Company has considered the implications of COVID-19 as they relate to the
carrying value of goodwill and indefinite-lived assets. COVID-19 has had a marginally unfavorable impact on the Company’s results of operations for the three-month and six-month periods ended June 28, 2020. Management expects that such impact will similarly be marginally unfavorable to the Company’s full year results. Since our primary customers are departments and agencies within the U.S. Government, we have not historically had significant issues collecting our receivables and do not foresee issues collecting our receivables in the foreseeable future. In addition, our contract awards typically extend to at least five years, including options, and we have
a strong history of being awarded a majority of these contract options; we do not anticipate that the COVID-19 pandemic will have a materially adverse impact on such options. Our liquidity position has not been materially impacted, and we continue to believe that we have adequate liquidity to fund our operations and meet our debt service obligations for the foreseeable future. However, we cannot predict the impact of the COVID-19 pandemic, and the longer the duration of the event and the more widespread in geographic locations where we and our suppliers operate, the more likely it is that it could have an adverse impact on our financial condition, results of operations, and/or cash flows in the future.
Income Taxes
Income taxes are
accounted for using the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of assets and liabilities, and their respective tax bases, and operating loss and tax credit carry forwards. PAE accounts for
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tax contingencies in accordance with ASC 740-10- 25, Income Taxes – Recognition (Topic 740). Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized
in income in the period that includes the enactment date. Estimates of the realizability of deferred tax assets are based on the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies. PAE’s effective tax rate will be higher due to establishment of valuation allowance on the disallowed interest expense. Any interest or penalties incurred in connection with income taxes are recorded as part of income tax expense for financial reporting purposes.
Item 3. Quantitative and Qualitative Disclosures About Market Risks
There have not been any material changes to the Company’s market risk
since December 31, 2019. For additional information, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in Exhibit 99.2 of the Company’s Current Report on Form 8-K/A filed with the SEC on March 11, 2020.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in company reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
As required by Rules 13a-15 and 15d-15 under the Exchange Act, our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of June 28, 2020. Based upon their evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e)
and 15d-15(e) under the Exchange Act) were effective.
Internal Control over Financial Reporting
During the most recently completed fiscal quarter, the Company continued to make changes to certain internal controls to reflect the operations of PAE acquired as a result of the Business Combination.
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Part
II. Other Information
Item 1. Legal Proceedings
PAE is involved in various legal proceedings, government audits, investigations, claims and disputes that arise in the normal course of business, including those related to employment matters, contractual relationships and other business matters. These legal proceedings seek various remedies, including claims for monetary damages in varying or unspecified amounts. In addition, awards of government contracts may be protested at the U.S. Government Accountability Office or the U.S. Court of Federal Claims; and conversely, PAE may from time to time protest awards made to other companies.
Although
the outcome of any such matter is inherently uncertain and may be materially adverse, based on current information, PAE does not expect any of the currently ongoing audits, reviews, investigations, or litigation to have a material adverse effect on its financial condition or operating results. Its view of the matters not specifically disclosed could change in future periods as events unfold.
Item 1A. Risk Factors
For a discussion of risk factors that could significantly and negatively affect our business, financial condition, results of operations, cash flows and prospects, see the disclosure under the heading "Risk Factors" in our prospectus on Form 424B3, filed with the SEC on April 23, 2020, File No. 333-236468
(the “Prospectus”). There have been no material changes from the risk factors set forth in the Prospectus, other than the additional risk factor provided below, which is an update to the risk factor included in Part II, item 1A of our Quarterly Report on Form 10-Q for the quarter ended March 29, 2020. .
We face various risks related to public health crises, such as the coronavirus (“COVID-19”), that could disrupt PAE’s business and result in loss of revenue or higher expenses.
Our operations face risks related to public health crises, such as the global outbreak of COVID-19 and other pandemics and epidemics. The COVID-19 virus has spread to over 100 countries, including the United States, and the World Health Organization has classified the COVID-19 outbreak as a pandemic. The ability of our personnel to work effectively
and travel and the continued adequacy of our supply chains have been adversely impacted by the pandemic and responses thereto, such as the travel restrictions resulting from the COVID-19 virus. Additionally, as a result of COVID-19, we have experienced, and expect that we will experience in the future, delays, or partial reductions or full suspensions of contract work, which have caused and could result in further decreases of revenue and may have a material adverse impact on our business. We have experienced increased medical, housing, facility cleaning, and other costs due to quarantine requirements imposed by various jurisdictions and exposure of our personnel to pandemics such as the COVID-19 virus. In addition, we are permitting employees to telework who can meet our customer commitments remotely, and many of our employees are teleworking. Due to COVID-19, we are uncertain
when and how many teleworking employees will return to work in person. We have not previously experienced so
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many employees working remotely for such an extended period of time, so the long-term effects on our operations are unknown. Moreover, we may be subject to additional cybersecurity risks as a result of a significant portion of our workforce working remotely. In addition, the resulting volatility in the global capital markets could, among other things, restrict our access to capital and/or increase our cost of capital. At this time, we cannot predict the impact of the COVID-19 pandemic or the duration of time that the pandemic and its impacts will last, but it could have a material adverse effect on our business, financial position, results of operations and/or cash flows.
See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Current Economic Conditions – Impact of COVID-19” for additional discussion of management’s assessment of the COVID-19 pandemic.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Form of Amended and Restated Restricted Stock Unit Grant Notice and Restricted Stock Unit Agreement for Directors under the PAE Incorporated 2020 Equity Incentive
Plan
31.1
Certification by the Chief Executive Officer of the Company Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification by the Chief Financial Officer of the Company Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification
by the Chief Executive Officer of the Company Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification by the Chief Financial Officer of the Company Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101)
*Management contract or compensatory plan or arrangement
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SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
