UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |||||
For the fiscal year ended: December 31 , 2022
or
| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |||||
For the transition period from to | |||||
Commission File Number 1-01520
(Exact name of registrant as specified in its charter)
| (State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) | |||||||
(Address of principal executive offices) (Zip Code)
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
| Title of each class | Trading Symbol(s) | Name of each exchange on which registered | ||||||||||||
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically 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.
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes ☐ No ☒
The aggregate market value of the voting common equity held by nonaffiliates of the registrant as of June 30, 2022, was $3.3 billion.
As of February 9, 2023, there were 80,677,246 outstanding shares of the Company’s common stock, including unvested common shares, $0.10 par value.
Aerojet Rocketdyne Holdings, Inc.
Annual Report on Form 10-K
For the Year Ended December 31, 2022
Table of Contents
| Item Number | ||||||||
| PART I | ||||||||
| 1 | Business | |||||||
| 1A. | Risk Factors | |||||||
| 1B. | Unresolved Staff Comments | |||||||
| 2 | Properties | |||||||
| 3 | Legal Proceedings | |||||||
| 4 | Mine Safety Disclosures | |||||||
| PART II | ||||||||
| 5 | Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | |||||||
| 6 | Reserved | |||||||
| 7 | Management’s Discussion and Analysis of Financial Condition and Results of Operations | |||||||
| 7A. | Quantitative and Qualitative Disclosures About Market Risk | |||||||
| 8 | Financial Statements and Supplementary Data | |||||||
| 9 | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure | |||||||
| 9A. | Controls and Procedures | |||||||
| 9B. | Other Information | |||||||
| 9C | Disclosure Regarding Foreign Jurisdictions that Prevent Inspections | |||||||
| PART III | ||||||||
| 10 | Directors, Executive Officers and Corporate Governance | |||||||
| 11 | Executive Compensation | |||||||
| 12 | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | |||||||
| 13 | Certain Relationships and Related Transactions, and Director Independence | |||||||
| 14 | Principal Accountant Fees and Services | |||||||
| PART IV | ||||||||
| 15 | Exhibits and Financial Statement Schedules | |||||||
| 16. | Form 10-K Summary | |||||||
| Signatures | ||||||||
Part I
Item 1. Business
Unless otherwise indicated or required by the context, as used in this Annual Report on Form 10-K ("Report"), the terms "we," "our," "us," and the "Company" refer to Aerojet Rocketdyne Holdings, Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States of America ("GAAP").
All statements in this Report other than historical information should be considered "forward-looking statements" as defined by Section 21E of the Private Securities Litigation Reform Act of 1995. These statements present (without limitation) the expectations, beliefs, plans, and objectives of management and future financial performance and assumptions underlying, or judgments concerning, the matters discussed in the statements. The words "believe," "estimate," "anticipate," "project," "expect," "reliable," and similar expressions are intended to identify forward-looking statements. Forward-looking statements involve certain risks, estimates, assumptions, and uncertainties, including with respect to the proposed merger with L3Harris Technologies, Inc. ("L3Harris"), the uncertainties arising from the coronavirus ("COVID-19") pandemic, future sales and activity levels, cash flows, contract performance, the outcome of litigation and contingencies, environmental remediation, availability of capital, and anticipated costs of capital. Important risk factors that could cause actual results or outcomes to differ from those expressed in the forward-looking statements are described in the section "Risk Factors" in Item 1A of this Report. Additional risk factors may be described from time to time in our future filings with the Securities and Exchange Commission ("SEC").
Overview
Our operations are organized into two segments:
Aerospace and Defense — includes the operations of the Company’s wholly-owned subsidiary Aerojet Rocketdyne, Inc. ("Aerojet Rocketdyne"), a leading technology-based designer, developer and manufacturer of aerospace and defense products and systems for the United States ("U.S.") government, including the Department of Defense ("DoD"), the National Aeronautics and Space Administration ("NASA"), and major aerospace and defense prime contractors.
Real Estate — includes the activities of our wholly-owned subsidiary Easton Development Company, LLC ("Easton") related to the re-zoning, entitlement, sale, and leasing of our excess real estate assets. We are currently in the process of seeking zoning changes and other governmental approvals on our excess real estate assets.
L3Harris Merger Agreement
On December 17, 2022, the Company entered into an Agreement and Plan of Merger (the "Merger Agreement"), with L3Harris and Aquila Merger Sub Inc., a Delaware corporation and a wholly-owned subsidiary of L3Harris ("Merger Sub"), pursuant to which, subject to the terms and conditions thereof, Merger Sub will merge with and into the Company (the "Merger") with the Company being the surviving corporation and a wholly-owned subsidiary of L3Harris.
Subject to the terms and conditions set forth in the Merger Agreement, each share of the Company's common stock outstanding as of immediately prior to the effective time of the Merger will be canceled and converted into the right to receive $58.00 in cash, without interest, plus, if the closing occurs after September 17, 2023, $0.0025 for each calendar day elapsed after such date to and including the closing date.
Closing of the Merger is anticipated to occur in 2023, subject to various customary conditions, including our stockholder approval and regulatory clearance under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (the "HSR Act").
Lockheed Martin Corporation ("Lockheed Martin") Terminated Merger Agreement
On December 20, 2020, the Company entered into an Agreement and Plan of Merger (the "Lockheed Terminated Merger Agreement") with Lockheed Martin and Mizar Sub, Inc., a wholly-owned subsidiary of Lockheed Martin, pursuant to which each share of common stock of the Company would have been automatically converted into the right to receive cash in an amount equal to $51.00 per share, adjusted from $56.00 following the payment of a one-time cash dividend of $5.00 per share paid in March 2021, and the Company would have become a wholly-owned subsidiary of Lockheed Martin (the "Terminated Merger").
On January 25, 2022, the Federal Trade Commission ("FTC") filed a complaint against the Company and Lockheed Martin in the FTC’s administrative court and a complaint in U.S. federal court seeking a preliminary injunction to stop the deal pending an administrative trial. On February 13, 2022, Lockheed Martin notified the Company that it had elected to terminate the Lockheed Terminated Merger Agreement. On February 14, 2022, pursuant to the parties’ joint motion, the administrative complaint and the U.S. federal court complaint were dismissed.
Aerospace and Defense
Aerojet Rocketdyne is a world-recognized technology-based engineering and manufacturing company that develops and produces specialized power and propulsion systems, as well as armament systems. We develop and manufacture liquid and solid rocket propulsion, air-breathing hypersonic engines, and electric power and propulsion for space, defense, civil and commercial applications. Principal customers and end users include the DoD (including the U.S. Air Force ("USAF"), U.S. Space Force, U.S. Army, Missile Defense Agency ("MDA"), and U.S. Navy), NASA, The Boeing Company ("Boeing"), Lockheed Martin, Raytheon Technologies Corporation ("Raytheon"), Northrop Grumman Corporation ("Northrop"), and United Launch Alliance ("ULA").
We have demonstrated a legacy of successfully meeting the most challenging missions by producing some of the world’s most technologically advanced propulsion systems to meet our nation's critical needs. We believe we maintain a unique
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competitive position due to our strategic focus on creating and maintaining a broad spectrum of propulsion and energetic products assisted by the growing market demand for our innovative energy management technologies. The highly reliable nature of our revenue comes from the long-term nature of the programs with which we are involved, our attractive contract base and our deep customer relationships. High renewal rates, supported by our market leading technology, provide us with a highly stable business base from which to grow. As of December 31, 2022, our remaining performance obligations, also referred to as backlog, totaled $6.8 billion and our funded backlog, which includes only amounts for which funding has been authorized by a customer and a purchase order has been received, totaled $3.1 billion.
Primary Markets and Programs
The markets and key programs we serve are:
Aerospace. We specialize in the development and production of propulsion and power systems for space applications. Our products include a broad market offering of both electric and chemical propulsion, including liquid propellant engines and solid rocket motors required for launch vehicle and in-space applications supporting defense, civil and commercial missions.
Our key space programs include: (i) RS-25 main and RL10 upper-stage engines that power NASA’s Space Launch System ("SLS"); (ii) RL10 engines that power ULA launch vehicles; (iii) propulsion for the Orion spacecraft and the Starliner Commercial Crew Transportation Capability capsule; (iv) power systems for spacecraft, space stations and rovers; (v) multiple electric and chemical propulsion systems that provide in-space maneuvering capability for spacecraft and satellites; and (vi) chemical propulsion for reaction control systems for launch vehicles.
One of our most exciting accomplishments in 2022 was powering the historic launch of Artemis I; the first launch of NASA’s new mega Moon rocket, the SLS. We provided propulsive elements for the Artemis I mission, as well as high pressure tanks. SLS launched using four shuttle-derived RS-25 main engines on the core stage and one RL10 engine on the upper stage. Artemis I, a three-week mission to cislunar space and back with NASA’s Orion spacecraft, was the first in a series of increasingly complex missions that will enable the return of humans to the Moon and eventually their exploration of Mars.
With the uncrewed Artemis I mission complete, we are beginning preparations with NASA for crewed Artemis flights, and we believe we are positioned to continue supporting the program going forward. We are under contract to build new production RS-25 engines to support Artemis V through IX. The certification process for verifying the new production engine configuration began with an RS-25 confidence test in December 2022. The certification test series will continue throughout 2023.
In addition to the propulsion on NASA’s SLS rocket, we also supply the majority of propulsion aboard the Orion spacecraft and a key component of the Launch Abort System, the jettison motor. In 2022, we received a contract option from Lockheed Martin for the procurement of propulsion systems for the Orion spacecraft that will fly on Artemis missions VI through VIII. This contract option includes delivery of three additional sets of Orion’s service module auxiliary engines and three additional jettison motors. We continue to make progress on the Orion Main Engine contract awarded in 2021.
Aerojet Rocketdyne is also on contract to provide NASA the Advanced Electric Propulsion System for the Power and Propulsion Element ("PPE") of the agency’s Gateway platform. The PPE is intended to ferry crews and cargo between high and low lunar orbit as part of the Artemis program.
Our propulsion and power systems have a long and distinguished flight heritage with the U.S. government and commercial customers. We provide liquid propulsion systems for the first and upper stages of ULA’s Delta IV heavy launch vehicle, as well as the liquid upper-stage propulsion for their Atlas V launch vehicle. ULA’s new Vulcan Centaur launch vehicle is expected to make its inaugural flight in 2023 and we are under contract to supply RL10 upper-stage engines for each Vulcan Centaur mission, as well as reaction control thrusters.
In 2022, ULA awarded Aerojet Rocketdyne to deliver RL10C-X engines for its Vulcan Centaur rocket. The new engines will support ULA as it works to fulfill its commitments under a contract it received from Amazon, as part of the largest commercial launch contract in history, to support the launch of Amazon’s Project Kuiper satellites. The RL10C-X will extend the six-decade flight heritage of the RL10 family of engines by incorporating new upgrades, including a 3D-printed injector and combustion chamber, as well as a lightweight composite nozzle.
In 2022, NASA’s first planetary defense mission, the Double Asteroid Redirection Test ("DART") mission, used our hydrazine thrusters to successfully position the DART spacecraft in order to collide with a small asteroid to change its orbit.
Fission surface power continues to be a growth area for our company. We are on a team (led by Westinghouse of Cranberry Township, Pennsylvania) that was awarded a contract by NASA and the U.S. Department of Energy for a Phase One Nuclear Fission Surface Power contract to provide an initial design concept for a fission surface power system that could be ready to launch to the Moon by the end of the decade.
2022 was a year of firsts and we look forward to continuing to supply power and propulsion systems for NASA’s Artemis program, ULA’s family of rockets, Starliner’s first crewed flight, and a variety of power and in-space propulsion systems in 2023.
Defense. We specialize in the development and production of propulsion systems for defense applications including both solid and liquid propellant based systems, along with air-breathing (ramjet and hypersonic scramjet) systems for missile applications. The majority of these applications are the primary axial propulsion for missile systems. We also develop and manufacture divert and attitude control ("DACs") propulsion (solid propellant and liquid-fueled) systems for missile defense applications. These are complex systems that provide multi-directional and variable thrust levels to steer or control an intercept missile. Additionally, we develop and manufacture post-boost propulsion systems for strategic missiles. These systems provide directional control for ground and sea-based strategic missiles. Using our energetics expertise we also design, develop, and produce warhead/lethality systems for tactical missiles and stored chemical energy propulsion for torpedoes. Our products have
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been successfully fielded on multiple active U.S. and international weapon system platforms. The breadth of our applications includes tactical missiles, missile defense interceptors, hypersonic systems, strategic boosters and post-boost systems and torpedo propulsion for a variety of applications.
During 2022, we continued to expand our strong legacy propulsion franchises on the Standard Missile, Patriot Advanced Capability-3 ("PAC-3"), Terminal High Altitude Area Defense ("THAAD") and Guided Multiple Launch Rocket System ("GMLRS") missile programs. On the THAAD program, we were awarded a multi-year production contract with Lockheed Martin for propulsion elements to include the Liquid Divert and Attitude Control ("LDACs") and Solid Rocket Motor ("SRM") Booster. These franchise programs continue to be globally deployed in support of U.S. and allied armed forces.
In the hypersonic propulsion arena, an advanced Aerojet Rocketdyne scramjet engine powered the successful 2022 flight test of the Hypersonic Air-breathing Weapon Concept ("HAWC"), in a joint effort with Defense Advanced Research Projects Agency ("DARPA"), Air Force Research Laboratory ("AFRL"), and Lockheed Martin. Additionally, in January 2023, a second successful flight test was executed for DARPA by Lockheed Martin and Aerojet Rocketdyne. Significant scramjet performance data was collected on this flight that reached speeds in excess of Mach 5, travelled more than 300 nautical miles and reached altitudes above 60,000 feet. Further, we continued technology maturation and ground testing at in-house and U.S. government facilities on scramjet and ramjet propulsion systems to support emerging U.S. Air Force, Army, and Navy programs.
Our Aerojet Rocketdyne Coleman Aerospace ("Coleman") business continued to expand both its production backlog and technical capability of the medium-range ballistic missile ("MRBM") target program. We were awarded the third lot of production targets that will incorporate advanced propulsion technology. These technologies include a new large SRM (designated eSR-19) that was successfully validated with a static firing at the AFRL.
We opened our Center of Excellence for Undersea Propulsion to support the U.S. Navy's next generation torpedoes at our Coleman site. This facility will be used to produce the innovative undersea propulsion known as Stored Chemical Energy Propulsion ("SCEPS") and the entire torpedo afterbody. Upon completion of the new facility and in support of the MK54 lightweight torpedo proof of manufacturing program, we successfully built and tested a SCEPS lithium boiler that could be used to power the U.S. Navy’s next generation torpedoes. We will also power the U.S. Navy’s new Compact Rapid Attack Weapon ("CRAW") as part of the Raytheon Missiles & Defense team building the next generation torpedo.
A subset of our key defense programs include: (i) Boosters and Solid DACs for the U.S. Navy’s Standard Missile family, (ii) Booster and LDACs for THAAD, (iii) PAC-3, (iv) GMLRS, (v) Stinger, (vi) Javelin, (vii) Patriot GEM-T, (viii) Tactical Tomahawk, (ix) Army Tactical Missile Systems ("ATACMS"), (x) Tube-launched Optically-tracked Wire-guided ("TOW") warhead, (xi) Next Generation Interceptor ("NGI"), and (xii) Ground Based Strategic Deterrent ("GBSD").
Information concerning the percentage of net sales attributable to our significant programs appears in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption "Major Customers."
Competition
The competitive dynamics of our business vary by product type and customer, but we experience many of the same challenges as the broader aerospace and defense industry. The large majority of products we manufacture are highly complex, technically sophisticated and extremely difficult or hazardous to build, which requires rigorous manufacturing systems and highly specialized manufacturing equipment. While historically these factors contributed to substantial barriers to entry, modern design tools and manufacturing techniques (such as additive manufacturing) are enabling new entrants with the funding to enter this industry, leading to increased competition. For example, competitors such as SpaceX and Blue Origin have developed propulsion systems for their satellite and space launch vehicles. These new competitors have signaled their intent to compete primarily on price and are willing to take on substantial risk exposure on development programs with unproven market potential and are, therefore, disrupting existing cost paradigms and manufacturing methodologies. Additionally, Northrop is a longstanding competitor for nearly all of the Company’s propulsion products. For in-space propulsion, customer demand for small satellites is rapidly expanding, and small satellites are increasingly displacing large satellites, which comprise the core end use for the Company’s in-space propulsion products. We see a number of new startups entering into the supply of liquid, chemical, and electric propulsion systems for small launch vehicles and satellites. In missiles and missile defense systems, the U.S. government has utilized its resources to facilitate entry and expansion by propulsion suppliers in order to shore up the U.S. rocket propulsion industrial base. For example, the Naval Surface Warfare Center has partnered with both Nammo Energetics Indian Head ("Nammo") and MBDA Incorporated ("MBDA") to support the development of solid propulsion, and DARPA and AFRL have awarded Small Business Innovation Research contracts to Innoveering, LLC in support of its air-breathing hypersonic propulsion development.
The following table lists significant participants in the propulsion market (in alphabetical order):
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| Parent Company | Propulsion Type | ||||
| ABL Space Systems | Liquid | ||||
| Aerojet Rocketdyne Holdings, Inc. | Solid, liquid, air-breathing, electric, chemical | ||||
| Agile Aerospace | Chemical | ||||
| Amazon Kuiper | Electric | ||||
ArianeGroup | Solid, liquid, electric, chemical | ||||
| Astra (Apollo Fusion) | Electric | ||||
| Avio S.p.A | Solid, liquid | ||||
| Busek Co. Inc. | Electric | ||||
| Blue Origin | Liquid, electric, chemical | ||||
| Bradford | Chemical | ||||
| Exoterra | Electric | ||||
| Fakel | Electric | ||||
| Firefly Aerospace | Liquid | ||||
| Frontier Aerospace | Liquid, chemical | ||||
| General Dynamics | Solid | ||||
| IHI Aerospace | Liquid, electric, chemical | ||||
| Innoveering, LLC | Air-breathing | ||||
| MBDA | Solid | ||||
| Moog Inc. | Liquid, chemical | ||||
| Nammo | Solid, liquid, chemical | ||||
| Northrop | Solid, liquid, air-breathing, electric, chemical | ||||
| Orbion | Electric | ||||
| PhaseFour | Electric | ||||
| Rafael | Electric, chemical | ||||
| Relativity | Liquid | ||||
| Rocket Lab | Liquid | ||||
| Safran | Electric | ||||
| Sierra Nevada Corporation | Liquid, chemical | ||||
| SpaceX | Liquid, electric, chemical | ||||
| Stellar Exploration | Chemical | ||||
| Virgin Orbit | Liquid | ||||
| Voyager Space | Solid | ||||
Industry Overview
Our primary aerospace and defense customers include DoD, NASA, and the prime contractors that supply products to these customers. We rely on U.S. government funding for aerospace and defense and our backlog depends, in large part, on the continued funding by the U.S. government for these programs. With the enactment of the Consolidated Appropriations Act, 2023 ("Public Law 117-328") on December 29, 2022, DoD and NASA are funded for the remainder of government fiscal year 2023. In light of continued Russian actions in Ukraine, Public Law 117-328 also included the Additional Ukraine Supplemental Appropriations Act, 2023, to provide aid, equipment, and munitions to Ukraine. Disruptions to our customer’s facilities or delays in supply chain as a result of global events could delay or decrease expenditures by U.S. government agencies. Such a decrease in DoD and/or NASA expenditures, the elimination or curtailment of a program in which we are or hope to be involved, or changes in payment patterns of our customers as a result of changes in U.S. government outlays, could have a material adverse effect on our operating results, financial condition, and/or cash flows.
Major Customers
Information concerning major customers appears in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption "Major Customers."
Contract Types
Research and development ("R&D") contracts are awarded during the early stages of a program’s development. Production contracts provide for the production and delivery of mature products for operational use. Our contracts are largely categorized as either "fixed-price" (largely used by the U.S. government for production-type contracts) or "cost-
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reimbursable" (largely used by the U.S. government for development-type contracts). During 2022, approximately 55% of our net sales were from fixed-price contracts and 45% from cost-reimbursable contracts.
Fixed-price contracts are typically (i) firm fixed-price, (ii) fixed-price-incentive fee, or (iii) fixed-price level of effort contracts. For firm fixed-price contracts, Aerojet Rocketdyne performs work for a fixed price and realizes all of the profit or loss resulting from variations in costs during contract performance. For fixed-price-incentive fee contracts, Aerojet Rocketdyne receives increased or decreased fees (or profits) based upon actual performance against established targets or other criteria. For fixed-price level of effort contracts, Aerojet Rocketdyne generally receives a structured fixed price per labor hour, dependent upon the customer’s labor hour needs. All fixed-price contracts present the risk of unreimbursed cost overruns potentially resulting in lower than expected contract profit margin and losses. Given broader inflation in the economy, we are monitoring the risk inflation presents to active and future contracts. To date, we have not seen broad-based increases in costs from inflation that are material to our business as a whole; however, if we begin to experience greater than expected supply chain and labor inflation our profits and margins under our contracts, in particular fixed price contracts, could be adversely affected.
Cost-reimbursable contracts are typically (i) cost plus fixed fee, (ii) cost plus incentive fee, or (iii) cost plus award fee contracts. For cost plus fixed fee contracts, Aerojet Rocketdyne typically receives reimbursement of its costs, to the extent the costs are allowable under contractual and regulatory provisions, in addition to receiving a fixed fee. For cost plus incentive fee contracts and cost plus award fee contracts, Aerojet Rocketdyne receives adjustments to the contract fee, within designated limits, based on actual results as compared with contractual targets for factors such as cost, performance, quality, and schedule.
In addition, Other Transaction Agreement ("OTA") contracts are becoming more prevalent in the developmental stages of U.S. government procurements. An OTA is a special vehicle used by federal agencies for obtaining or advancing R&D or prototypes. The U.S. government's procurement regulations and certain procurement statutes do not apply to OTAs, and accordingly, other transaction authority gives agencies the flexibility necessary to develop agreements tailored to a particular transaction. Generally, our sales and backlog figures do not include work we have under contracts obligated by the customer under an OTA as our share of the contract costs are recognized as company-funded R&D.
Government Contracts and Regulations
U.S. government contracts generally are subject to Federal Acquisition Regulations ("FAR"), agency-specific regulations that supplement FAR, such as the DoD’s Defense Federal Acquisition Regulations, and other applicable laws and regulations. These regulations impose a broad range of requirements, many of which are unique to U.S. government contracting, including various procurement, import and export, security, contract pricing and cost, contract termination and adjustments, mandatory disclosure, and audit requirements. Our failure to comply with these regulations and requirements could result in reductions of the value of contracts, contract modifications or termination, inability to bill and collect receivables from customers, and the assessment of penalties and fines that could lead to suspension or debarment from U.S. government contracting or subcontracting. In addition, as a U.S. government contractor, we are subject to routine audits, reviews, and investigations by the Defense Contract Audit Agency ("DCAA"), the Defense Contract Management Agency, and other similar U.S. government agencies. Such reviews include but are not limited to our contract performance, compliance with applicable laws, regulations, and standards as well as the review of the adequacy of our accounting systems, purchasing systems, property management systems, estimating systems, earned value management systems, and material management and accounting systems.
The U.S. government’s ability to unilaterally modify or terminate a contract or to discontinue funding for a particular program at any time could have a material adverse effect on our operating results, financial condition, and/or cash flows. The cancellation of a contract, if terminated for cause, could also subject us to liability for the excess costs incurred by the U.S. government in procuring undelivered items from another source. If terminated for convenience, our recovery of costs would be limited to amounts already incurred or committed (including severance costs for terminated employees), and our profit would be limited based on the work completed prior to termination.
Additional information about the risks relating to government contracts and regulations appears in "Risk Factors" in Item 1A of this Report.
Backlog
Information concerning backlog appears in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption "Backlog."
Seasonality
Aerojet Rocketdyne’s business is not subject to predictable seasonality. Primary factors affecting the timing of our sales include the timing of U.S. government awards, the availability of U.S. government funding, contractual product delivery requirements, and customer acceptances.
Research and Development
We view R&D efforts as critical to maintaining our leadership position in markets in which we compete. Our R&D is primarily supported by customer funding. Our company-funded R&D efforts include expenditures for technical activities that are vital to the development of new products, services, processes or techniques, as well as those expenses for significant improvements to existing products or processes. See Note 1 in the consolidated financial statements in Item 8 of this Report for additional information on R&D expenditures.
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Suppliers and Raw Materials
The national aerospace supply base continues to consolidate due to economic, environmental, and marketplace circumstances beyond our control. The loss of key qualified suppliers of technologies, components, and materials can cause significant disruption to our program performance and cost.
Availability of raw materials and supplies has been generally sufficient. We sometimes are dependent, for a variety of reasons, upon sole-source or qualified suppliers and have, in some instances in the past, experienced difficulties meeting production and delivery obligations because of delays in delivery or reliance on such suppliers. Further, we continue to experience volatility in the price and lead-times of certain commodity metals, electronic components, and constituent chemicals. Finally, as a U.S. government contractor, we are often limited to procuring materials from certain suppliers capable of meeting rigorous customer and government specifications.
Additional information about the risks relating to suppliers and raw materials appears in "Risk Factors" in Item 1A of this Report.
Intellectual Property
Where appropriate, Aerojet Rocketdyne obtains patents in the U.S. and other countries for new and useful processes, machines, manufactures or compositions of matter, or any new and useful improvements thereof relating to its products and services. Our patents are maintained through the statutory limit of time, which is typically 20 years from the date of filing of the patent application, where the claimed invention has value in the markets in which we compete. We rely on trade secret protection for financial, technical and personnel information that provides an economic competitive advantage by virtue of not being known by the relevant public and ordinarily require employees to sign confidentiality agreements as a condition to employment. If properly protected, trade secrets can be maintained in perpetuity. Aerojet Rocketdyne takes reasonable steps to prevent disclosure of its trade secrets in order to maintain protection under applicable state and federal laws. As our products and services typically embody complex systems that include many technologies, we do not believe any single existing patent, license, or trade secret is material to our success.
Real Estate
We own 11,277 acres of land adjacent to U.S. Highway 50 between Rancho Cordova and Folsom, California east of Sacramento ("Sacramento Land"). Acquired in the early 1950s and historically used for our aerospace and defense operations, large portions were used solely to provide safe buffer zones around hazardous operations. Modern changes in propulsion technology coupled with the relocation of our propulsion operations led us to determine large portions of the Sacramento Land were no longer needed for operations. Consequently, our plan has been to re-entitle the Sacramento Land for new uses and explore various opportunities to optimize its value.
The Sacramento Land is made up of 5,203 acres previously used for our aerospace and defense operations, 628 acres available for future entitlement, and 5,446 acres for future development under the brand name "Easton". Easton has 3,904 acres that are fully entitled. The term "entitlement" is generally used to denote the required set of regulatory approvals required to allow land to be zoned for new requested uses. Required regulatory approvals vary with each jurisdiction and each zoning proposal and may include permits, land use master plans, zoning designations, state and federal environmental documentation, and other regulatory approvals unique to the land. The entitlement and development process in California is long and uncertain with approvals required from various authorities, including local jurisdictions, and in select projects, permits required by federal agencies such as the U.S. Army Corps of Engineers and the U.S. Department of Interior, Fish and Wildlife Service, and others prior to construction.
As Easton continues to execute re-entitlement and pre-development activities, we are pursuing a variety of monetization options and are exploring how to maximize value from Easton. Value creation and monetization may include outright land sales and/or joint ventures with real estate developers, residential builders, and/or other third parties. We believe the long-term prospect for the Sacramento region represents an attractive and affordable alternative to the San Francisco Bay Area and other large metropolitan areas of California.
The following table summarizes the Sacramento Land (in acres):
| Environmentally Unrestricted | Environmentally Restricted (1) | Total | Entitled | |||||||||||||||||||||||
| Glenborough and Easton Place | 1,043 | 349 | 1,392 | 1,392 | ||||||||||||||||||||||
| Rio del Oro | 1,818 | 491 | 2,309 | 2,309 | ||||||||||||||||||||||
| Westborough | 1,270 | 272 | 1,542 | — | ||||||||||||||||||||||
| Hillsborough (2) | 51 | 97 | 148 | 148 | ||||||||||||||||||||||
| Office Park and Auto Mall | 47 | 8 | 55 | 55 | ||||||||||||||||||||||
| Total Easton acreage | 4,229 | 1,217 | 5,446 | 3,904 | ||||||||||||||||||||||
| Former operations land (3) | 24 | 5,179 | 5,203 | |||||||||||||||||||||||
| Land available for future entitlement (4) | 386 | 242 | 628 | |||||||||||||||||||||||
| Total Sacramento Land | 4,639 | 6,638 | 11,277 | |||||||||||||||||||||||
_________
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(1) Indicates land subject to restrictions imposed by state and/or federal regulatory agencies because of our historical propulsion system testing and manufacturing activities. We are actively working with the various regulatory agencies to have the restrictions removed as early as practicable, and the solutions to use these lands within Easton have been accounted for in the various land use plans and granted entitlements. See Note 8(b) in the consolidated financial statements in Item 8 of this Report for a discussion of the federal and/or state environmental restrictions affecting portions of the Sacramento Land.
(2) The remaining 148 acres designated in Hillsborough will be transferred, per the completed purchase and sale contract from 2015, when the required environmental remediation work is completed.
(3) In 2019, we completed our manufacturing commitments in our Sacramento, California facility and transitioned the Sacramento site to host our shared services function.
(4) We believe it will be several years before any of this excess Sacramento Land is available for future change in entitlement. Some of this excess land is outside the current Urban Services Boundary established by the County of Sacramento and all of it is far from existing infrastructure, making it uneconomical to pursue entitlement for this land at this time.
Leasing
We currently lease office space to various third parties that generated $2.4 million in revenue in 2022.
Environmental Matters
Our current and former business operations are subject to, and affected by, federal, state, and local environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We continually assess compliance with these regulations, and we believe our current operations are materially in compliance with all applicable environmental laws and regulations.
Under existing U.S. environmental laws, Potentially Responsible Parties ("PRPs"), are jointly and severally liable, and therefore we are potentially liable to the U.S. government or other third parties for the full cost of remediating the contamination at our facilities or former facilities or at third-party sites where we have been designated as a PRP by the Environmental Protection Agency or state environmental agencies. The nature of environmental investigation and cleanup activities requires significant management judgment to determine the timing and amount of any estimated future costs that may be required for remediation measures. Further, environmental standards change from time to time. However, we perform quarterly reviews of these matters and accrue for costs associated with environmental remediation when it becomes probable that a liability has been incurred and the amount of the liability, usually based on proportionate sharing, can be reasonably estimated. These liabilities have not been discounted to their present value as the amounts and timing of cash payments are not fixed or reliably determinable.
On January 12, 1999, we reached a settlement agreement ("Global Settlement") with the U.S. government covering environmental costs associated with our Sacramento site and our former Azusa site. Pursuant to the Global Settlement, we can recover up to 88% of our environmental remediation costs through the establishment of prices for Aerojet Rocketdyne's products and services sold to the U.S. government. Additionally, in conjunction with the sale of the Electronics and Information Systems business in 2001, Aerojet Rocketdyne entered into an agreement with Northrop (the "Northrop Agreement") whereby Aerojet Rocketdyne is reimbursed by Northrop for a portion of environmental expenditures eligible for recovery under the Global Settlement, subject to an annual billing limitation of $6.0 million and a cumulative limitation of $189.7 million.
Operation and maintenance costs associated with environmental compliance and management of contaminated sites are a normal, recurring part of operations. Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowed to be included in our contracts with the U.S. government.
The inclusion of environmental costs in our contracts with the U.S. government impacts our competitive pricing; however, we believe that this impact is mitigated by driving improvements and efficiencies across our operations as well as our ability to deliver innovative and quality products to our customers.
We did not incur material capital expenditures for environmental control facilities in 2022 nor do we anticipate any material capital expenditures in 2023 and 2024. See Management’s Discussion and Analysis in Part II, Item 7 "Environmental Matters" and "Environmental Reserves and Estimated Recoveries " of this Report for additional information.
Additional information on the risks related to environmental matters can be found under "Risk Factors" in Item 1A of this Report, including the material effects on compliance with environmental regulations that may impact our competitive position and operating results.
Human Capital Management
We believe our success depends on the strength of our workforce and our culture of accountability, adaptability, excellence, integrity and teamwork. Our integrated human capital management strategy enables and develops this culture and includes the acquisition, development, and retention of talent, as well as the design of compensation and benefits programs, to deliver on our strategy.
Employees - As of December 31, 2022, 7% of our 5,283 employees were covered by collective bargaining agreements. We believe that our relations with our employees and unions are good.
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Development - We enable our employees to reach their full potential by providing a wide range of career development opportunities, skill development and resources they need to be successful. Our Rocket University learning platform supplements our talent development strategies and enables employees to access instructor-led, in-person and virtual courses, as well as self-directed, web-based courses. Our Talent Management process includes ongoing performance ‘check-ins’ and leader-focused Talent Reviews and Succession Planning, which provide for the formal identification and development of our next generation leaders, and the building of a robust talent pipeline for key roles across the enterprise. We encourage advancement and movement across our organization to fill our open positions with strong and experienced management talent and individual contributors.
Inclusion, Diversity and Engagement ("ID&E") – We believe in the strength of engaged and diverse teams in an inclusive work environment to unleash the potential of our employees. Through the efforts of these diverse and collaborative teams, we seek to be on the cutting edge of technology and exceed customer expectations. We have established a corporate-wide ID&E council and a number of executive-sponsored employee resource groups ("ERG") across the enterprise, where employees can foster connections and develop in a supportive environment. Our ERGs support the acquisition of diverse talent internally and externally. To assess and improve employee engagement, we survey our employees and take actions to address areas of employee concern.
Health and Safety - Safety is one of our core values. We are committed to a safe work environment for our employees as well as being good stewards of the natural environment.
Retention – The labor market has been impacted by the COVID-19 pandemic and other global economic factors, causing more competition among employers, including us, and making it more difficult to find and retain quality employees. We are also periodically subject to our competitors seeking to entice our employees to leave the Company.
Corporate Information
We were incorporated in Ohio in 1915 and reincorporated in the State of Delaware on April 11, 2014. Our principal executive offices are located at 222 N. Pacific Coast Highway, Suite 500, El Segundo, California 90245.
Our Internet website address is www.AerojetRocketdyne.com. We have made available through our Internet website, free of charge, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as soon as reasonably practicable after such materials were electronically filed with, or furnished to, the SEC. We also make available on our Internet website our corporate governance guidelines and the charters for each of the following committees of our Board of Directors: Audit; Corporate Governance & Nominating; and Organization & Compensation. Copies of the Code of Conduct and the Company’s Corporate Governance Guidelines are available on the Company’s Internet website at www.AerojetRocketdyne.com (copies are available in print to any stockholder or other interested person who requests them by writing to Secretary, Aerojet Rocketdyne Holdings, Inc., 222 N. Pacific Coast Highway, Suite 500, El Segundo, California 90245).
Item 1A. Risk Factors
The following discussion describes the material factors, events, and uncertainties that make an investment in us risky, and these risk factors should be considered carefully together with all other information in this Report, including the financial statements and notes thereto. This discussion does not include all risks that we face, and additional risks or uncertainties that are currently not known to us, or that are not currently believed to be material may occur or become material. The occurrence of any of these factors, events, or uncertainties may, in ways we may or may not accurately predict, adversely affect our business, operations, financial condition, and results.
Risks Related to the Merger
Failure to complete the Merger could negatively impact the price of our common stock, as well as our future business and financial results.
On December 17, 2022, we entered into the Merger Agreement, pursuant to which L3Harris will acquire us, as described in Part I, Item 1 of this Report. The Merger Agreement contains a number of conditions that must be satisfied or waived prior to the completion of the Merger, including stockholder approval and regulatory approval. We cannot assure you that all of the conditions to the Merger will be satisfied or waived on a timely basis. If the conditions to the Merger are not satisfied or waived on a timely basis, we may be unable to complete the Merger as quickly as expected or at all.
If the Merger is not completed, our ongoing business may be adversely affected as follows: (i) we may experience negative reactions from the financial markets, including negative impacts on the market price of our common stock; (ii) some of management's attention will have been directed to the Merger instead of being directed to our own operations and the pursuit of other opportunities that could have been beneficial to us; (iii) the manner in which customers, suppliers and other third parties perceive us may be negatively impacted, which in turn could affect our ability to compete for business; (iv) we may experience negative reactions from employees; (v) we will have expended time and resources that could otherwise have been spent on our business; and (vi) we may be required, in certain circumstances, to pay a termination fee of $95.6 million, as provided in the Merger Agreement. In addition, any significant delay in consummating the Merger could have an adverse effect on our operating results and adversely affect our relationships with customers and suppliers and would likely lead to a significant diversion of management and employee attention.
Additionally, in approving the Merger Agreement, the Board of Directors considered a number of factors and potential benefits, including the fact that the merger consideration to be received by holders of common stock represented a significant premium over the unaffected trading price as measured by the closing price on August 15, 2022 (the last full day of unaffected
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trading of the Common Stock). If the Merger is not completed, neither the Company nor the holders of our common stock will realize this benefit of the Merger. Moreover, we would also have nevertheless incurred substantial transaction-related fees and costs and the loss of management time and resources.
Our ability to complete the Merger is subject to certain closing conditions and the receipt of consents and approvals from government entities which may impose conditions that could adversely affect us or cause the Merger to be abandoned.
The Merger Agreement contains certain closing conditions, including, among others, the approval by the holders of a majority of all our outstanding shares to adopt the Merger Agreement and approve the Merger, and the absence of any injunction or similar order issued by any government entity with jurisdiction over any party to the Merger Agreement or law that has the effect of prohibiting the consummation of the Merger or that makes consummation of the Merger illegal. We cannot assure you that the various closing conditions will be satisfied or will not result in the abandonment or delay of the Merger.
In addition, before the Merger may be completed, regulatory approval under the HSR Act, must be obtained. The regulatory review under the HSR Act may impose conditions on the granting of such approval. Such conditions and the process of obtaining regulatory approvals could have the effect of delaying completion of the Merger or of imposing additional costs or limitations on the combined company following the completion of the Merger, and the conditions may result in the failure of a closing condition under the Merger Agreement. The regulatory approvals may not be received at all, may not be received in a timely fashion, or may contain conditions on the completion of the Merger that are unacceptable to L3Harris.
Expenses related to the pending Merger are significant and will adversely affect our operating results.
We have incurred and expect to continue to incur significant expenses in connection with the pending Merger, including legal and investment banking fees. We expect these costs to have an adverse effect on our operating results. If the Merger is not consummated, we may under certain circumstances be required to pay to L3Harris a termination fee of $95.6 million. Our financial position and results of operations would be adversely affected if we were required to pay the termination fee.
We are subject to business uncertainties, litigation risk, and contractual restrictions while the Merger is pending, which could adversely affect our business.
The Merger Agreement requires us to operate in the ordinary course of business and restricts us, without the consent of L3Harris, from taking certain specified actions agreed by the parties to be outside the ordinary course of business until the pending Merger occurs or the Merger Agreement terminates. These restrictions may prevent us from pursuing otherwise attractive business opportunities and making other changes to our business before completion of the Merger or, if the Merger is not completed, termination of the Merger Agreement. One of the conditions to the closing of the Merger is the absence of any injunction or similar order issued by government entity with jurisdiction over any party to the Merger Agreement or law that has the effect of prohibiting the consummation of the Merger or that makes consummation of the Merger illegal. Accordingly, if any of the plaintiffs is successful in obtaining an injunction prohibiting the consummation of the Merger, then such injunction may prevent the Merger from becoming effective, or delay its becoming effective within the expected time frame.
Uncertainties associated with the Merger may cause a loss of management and other key employees and disrupt our business relationships, which could adversely affect our business.
Uncertainty about the effect of the Merger on our employees, customers and suppliers may have an adverse effect on our business. These uncertainties may impair our ability to attract, retain and motivate key personnel until the Merger is completed and for a period of time thereafter. Employee retention may be particularly challenging during the pendency of the Merger. If key employees depart and as we face additional uncertainties relating to the Merger, our business relationships may be subject to disruption as customers, suppliers and other third parties attempt to negotiate changes in existing business relationships or consider entering into business relationships with parties other than the Company. If key employees depart or if our existing business relationships suffer, our results of operations may be adversely affected. The adverse effects of such disruptions could be further exacerbated by any delay in the completion of the Merger.
The Merger Agreement contains provisions that could discourage a potential competing acquirer of us.
The Merger Agreement contains non-solicitation provisions that, subject to limited exceptions, restrict our ability to solicit, initiate, or knowingly encourage or induce competing third-party proposals (or knowingly cooperate in connection with such third party proposals) for the acquisition of our stock or assets. In addition, before our Board of Directors withdraws, qualifies or modifies its recommendation on the Merger or terminates the Merger Agreement to enter into a third-party acquisition proposal, L3Harris generally has an opportunity to offer to modify the terms of the Merger. In some circumstances, upon termination of the Merger Agreement, we will be required to pay a termination fee of $95.6 million.
These provisions could discourage a potential third-party acquirer that might have an interest in acquiring all or a significant portion of us from considering or proposing that acquisition, even if the acquirer was prepared to pay consideration with a higher per share cash or market value than the market value proposed to be received or realized in the Merger, or might otherwise result in a potential third-party acquirer proposing to pay a lower price to our stockholders than they might otherwise have proposed to pay due to the added expense of the termination fee that may become payable in certain circumstances.
If the Merger Agreement is terminated and we decide to seek another business combination, we may not be able to negotiate or consummate a transaction with another party on terms comparable to, or better than, the terms of the Merger Agreement.
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Risks Related to our Business and Industry
Reductions, delays or changes in U.S. government spending, including failure to timely appropriate funding, may reduce, delay or cancel certain programs in which we participate and as a result adversely affect our financial results.
Our primary aerospace and defense customers include the DoD and its agencies, NASA, and the prime contractors that supply products to these customers. We rely on particular levels of U.S. government spending on propulsion systems for defense, space and armament systems for precision tactical weapon systems and munitions applications, and our backlog depends, in a large part, on continued funding by the U.S. government for the programs in which we are involved. These spending levels are not generally correlated with any specific economic cycle, but rather follow the cycle of general public policy and political support for this type of spending, which is unpredictable. Moreover, although our contracts often contemplate that our services will be performed over a period of several years, the U.S. President must propose and Congress must appropriate funds for a given program each government fiscal year and may significantly change, increase, reduce or eliminate, funding for a program. The failure by Congress to approve future budgets on a timely basis could delay procurement of our products and services and cause us to lose future sales. If a prolonged U.S. government shutdown were to occur, it could result in program cancellations, disruptions and/or stop work orders and could limit the U.S. government’s ability to make timely payments, and our ability to perform, on our U.S. government contracts.
In addition, a decrease in the DoD and/or NASA expenditures, the elimination or curtailment of a material program in which we are involved, or changes in payment patterns of our customers as a result of changes in U.S. government spending, could have a material adverse effect on our operating results, financial condition, and/or cash flows.
In addition, U.S. government agency budgets can be negatively impacted by several factors, including, but not limited to, a change in defense spending policy as a result of shifts in political power or otherwise, the U.S. government’s budget deficits, spending priorities, the cost of sustaining the U.S. military presence internationally and possible political pressure to reduce U.S. government military spending, each of which could cause agency budgets to remain unchanged or to decline. A significant decline in U.S. military expenditures could result in a reduction in the amount of our products sold to the various agencies and buying organizations of the U.S. government.
The cancellation or material modification of one or more significant contracts could adversely affect our financial results.
Sales, directly and indirectly, to the U.S. government and its agencies accounted for approximately 95% of our total net sales in 2022. Our contracts typically permit the U.S. government to unilaterally modify or terminate a contract or to discontinue funding for a particular program at any time. The cancellation of a contract, if terminated for cause, could also subject us to liability for the excess costs incurred by the U.S. government in procuring undelivered items from another source. If terminated for convenience under a fixed-price type contract, typically we would be entitled to receive the purchase price for delivered items, reimbursement for allowable costs for work-in-process and an allowance for profit on the contract or adjustment for loss if completion of performance would have resulted in a loss. If terminated for convenience under a cost-reimbursable contract, typically we would be entitled to reimbursement of allowable costs plus a portion of the fee where allowable costs include our cost to terminate agreements with our suppliers and subcontractors. The amount of the fee recovered, if any, is related to the portion of the work accomplished prior to termination and is determined by negotiation.
In addition, we attempt to ensure that adequate funds are available by notifying the customer when its estimated costs, including those associated with a possible termination for convenience, approach levels specified as being allotted to its programs. Funds are typically appropriated on a fiscal year basis and costs of a termination for convenience may exceed the costs of continuing a program in a given fiscal year; however, programs occasionally do not have sufficient funds appropriated to cover the government’s termination liability if the government were to terminate them for convenience.
In addition, termination or suspension of any of our significant commercial contracts could result in the loss of future sales and unreimbursable expenses that could have a material adverse effect on our operating results, financial condition, and/or cash flows. Furthermore, the termination of any such contracts for default could also have a material adverse effect on our reputation and ability to obtain new business in the future.
If our subcontractors or suppliers fail to perform their contractual obligations, our contract performance and our ability to win new contracts may be adversely affected.
We rely on subcontractors to perform a portion of the services we agree to provide our customers, and on suppliers to provide raw materials and component parts for our contract performance. A failure by one or more of our subcontractors or suppliers to satisfactorily provide on a timely basis the agreed-upon services or supplies may affect our ability to perform our contractual obligations. Deficiencies in the performance of our subcontractors and/or suppliers could result in liquidated damages or our customers terminating their contract with us for default. A termination for default could expose us to liability and adversely affect our financial performance and our ability to win new contracts.
Disruptions in the supply of key raw materials, difficulties in the supplier qualification process or increases in prices of raw materials could adversely affect our financial results.
We use a significant quantity of raw materials that are subject to market fluctuations and government regulations. Further, as a U.S. government contractor, we are often required to procure materials from suppliers capable of meeting rigorous customer and government specifications. As market conditions change for these companies, they often discontinue materials with low sales volumes or profit margins. We are often forced to either qualify new materials or pay higher prices to maintain the supply. We may be unable to establish replacement materials and secure customer funding to address specific qualification needs of the
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programs. In addition, due to the rigorous customer and U.S. government specifications, at times, suppliers may experience schedule delays in meeting these requirements. From time to time, our supply chain may experience isolated events and disruptions such as weather, natural disasters and facility impacts which can also cause schedule delays.
We are also impacted, as is the rest of the industry, by fluctuations in the sustained availability, prices and lead-times of raw materials used in production on various fixed-price contracts, particularly on multi-year programs. We continue to experience volatility in the price and lead-times of certain commodity metals, electronic components, and constituent chemicals. Additionally, we may not be able to continue to negotiate with our customers for economic and/or price adjustment clauses tied to obsolete materials and commodity indices to reduce program impact. The DoD also continues to rigorously enforce the provisions of the "Berry Amendment" which imposes a requirement to procure certain strategic materials critical to national security only from U.S. sources. Similarly, European laws and regulations that apply to our business have additional strategic material sourcing requirements. Cost remains a concern as this industry continues to quote "price in effect" at time of shipment terms, increasing the cost risk to our programs.
An emerging challenge to the extended supply chain is U.S. government contracting regulations to comply with stringent cyber security regulations that may influence the cost of material and services on U.S. government contracts. Further, the MDA requirement to pre-approve supplier background screening processes of personnel that will have access to "controlled unclassified information" and separately approve any supplier personnel with dual citizenship has been challenging due to delays at MDA in approving requests which will potentially impact the award of subcontracts while approval is pending. Cyber security requirements from the U.S. government continue to evolve and continue to be a challenge as some small key/critical suppliers may not have the capability or infrastructure to support the requirements.
While the conflict in Ukraine has not caused any direct supply disruption as we do not source material from that region, the increased demand for our products as a result of this or other conflicts could put pressure on the capacity at key suppliers. In some cases we may need to qualify additional sources to meet this demand and/or secure customer funding to address specific qualification needs of the programs.
Prolonged disruptions in the supply of any of our key raw materials, difficulty qualifying new sources of supply, implementing use of replacement materials or new sources of supply, and/or a continuing volatility in the prices of raw materials could have a material adverse effect on our operating results, financial condition, and/or cash flows.
The military conflict between Russia and Ukraine, and the global response to it could exacerbate certain risks we face, and could adversely impact our business, financial condition and results of operations.
On February 24, 2022, the Russian Federation commenced a military invasion of Ukraine. Russia’s invasion of Ukraine and the global response, including the imposition of sanctions by the United States and other countries, has exacerbated, and could continue to exacerbate risks facing our business. Due to the nature of our business and because we protect national security information, we face heightened risk of attack by highly organized adversaries, including nation states and hostile foreign governments such as Russia and its allies. The threats we face range from attacks common to most industries to more advanced and persistent, highly organized adversaries, insider threats and other threat vectors targeting us and other defense and aerospace companies, and may include cyber-attacks, security attacks and other targeted maneuvers affecting our properties and operations, including our mission critical systems. Such attacks may also be targeted at our employees, customers or partners. In the event that one or more of these attacks is directed at us or one of the third-parties we work with (including our suppliers, customers, or partners), our business, financial condition and results of operations could be materially adversely affected. We may be required to expend significant additional resources to investigate and fortify our security systems even if an attack is not successful.
The release, unplanned ignition, explosion, or improper handling of dangerous materials used in our business could disrupt our operations and adversely affect our financial results.
Our business operations involve the handling, production, and disposition of potentially explosive and ignitable energetic materials and other dangerous chemicals, including motors and other materials used in rocket propulsion. The handling, production, transport, and disposition of hazardous materials could result in incidents that temporarily shut down or otherwise disrupt our manufacturing operations and could cause production delays. A release of these chemicals or an unplanned ignition or explosion could result in death or significant injuries to employees and others. Material property damage to us and third parties could also occur. The use of these products in applications by our customers could also result in liability if an explosion, unplanned ignition or fire were to occur. Extensive regulations apply to the handling of explosive and energetic materials, including but not limited to, regulations governing hazardous substances and hazardous waste. The failure to properly store and ultimately dispose of such materials could create significant liability and/or result in regulatory sanctions. Any release, unplanned ignition or explosion could expose us to adverse publicity or liability for damages or cause production delays, any of which could have a material adverse effect on our operating results, financial condition, and/or cash flows.
The real estate market involves significant risk, which could adversely affect our financial results.
Our real estate activities involve significant risks, which could adversely affect our financial results. We are subject to various risks, including the following:
•we may be unable to obtain, or suffer delays in obtaining, necessary re-zoning, land use, building, occupancy, and other required governmental permits and authorizations, which could result in increased costs or our abandonment of these projects;
•we may be unable to complete environmental remediation or to have state and federal environmental restrictions on our property lifted, which could cause a delay or abandonment of these projects;
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•we may be unable to obtain sufficient water sources to service our projects, which may prevent us from executing our plans;
•our real estate activities may require significant expenditures and we may not be able to obtain financing on favorable terms, which may render us unable to proceed with our plans;
•economic and political uncertainties could have an adverse effect on consumer buying habits, construction costs, availability of labor and materials and other factors affecting us and the real estate industry in general;
•our property is subject to federal, state, and local regulations and restrictions that may impose significant limitations on our plans;
•much of our property is raw land that includes the natural habitats of various endangered or protected wildlife species requiring mitigation;
•if our land use plans are approved by the appropriate governmental authorities, we may face lawsuits from those who oppose such plans (such lawsuits and the costs associated with such opposition could be material and have an adverse effect on our ability to sell property or realize income from our projects); and
•the time frame required for approval of our plans means that we may have to wait years for a significant cash return.
Climate change may have a long-term impact on our business.
There are inherent climate-related risks wherever our business is conducted. Global climate change may result in certain natural disasters and adverse weather, such as drought, wildfires, storms, sea-level rise, flooding, heat waves, and cold waves, occurring more frequently or with greater intensity. These disruptions could make it more difficult and costly for us to deliver our products and services, obtain components or other supplies through our supply chain, maintain or resume operations, and perform other critical corporate functions.
Concerns over climate change have resulted in, and are expected to continue to result in, the adoption of legal and regulatory requirements designed to address climate change, as well as legal and regulatory requirements requiring certain climate-related disclosures. Where new laws or regulations are more stringent than current legal or regulatory requirements, we may experience increased compliance costs and other burdens to meet such obligations. Ultimately, the impacts of climate change, whether involving physical risks (such as disruptions resulting from climate-related events or rising sea levels) or transition risks (such as regulatory changes, changes in market dynamics or increased operating costs, including the cost of insurance), are expected to be widespread and unpredictable and could have a material adverse effect on our operating results, financial condition, and/or cash flows.
Risks Related to Our Operations
If we experience cost overruns on our contracts, we would have to absorb the excess costs which could adversely affect our financial results and our ability to win new contracts.
In 2022, approximately 55% of our net sales were from fixed-price contracts, most of which are in mature production mode. Under fixed-price contracts, we agree to perform specified work for a fixed price and realize all of the profit or loss resulting from variations in the costs of performing the contract. As a result, all fixed-price contracts involve the inherent risk of unreimbursed cost overruns. To the extent we incur unanticipated cost overruns on a program or platform subject to a fixed-price contract, our profitability would be adversely affected. Future profitability is subject to risks including the ability of suppliers to deliver components of acceptable quality on schedule and the successful implementation of automated tooling in production processes.
In 2022, approximately 45% of our net sales were from cost reimbursable contracts. Under cost reimbursable contracts, we agree to be reimbursed for allowable costs and paid a fee. When our costs are in excess of the final target cost, fees and our margin may be adversely affected. If our costs exceed authorized contract funding or do not qualify as allowable costs under applicable regulations, those costs are expensed, and we will not be reimbursed for those costs. Cost overruns may adversely affect our financial performance and our ability to win new contracts.
Also, certain costs such as those related to charitable contributions, advertising, interest expense, and public relations are generally not allowable, and therefore not recoverable through U.S. government contracts. Unexpected variances in unallowable costs may adversely affect our financial performance.
Our business and operations could be adversely impacted in the event of a failure of our information technology infrastructure or failure to perform by our third party service providers.
We are dependent on various critical information technologies, including cyber security functions, administered and supported by third party service providers. The use of third party service providers, or disagreements with such providers over the scope and nature of their services, can cause unexpected security vulnerabilities, loss of control and additional costs in the delivery of information services and data storage. Any disruption of our information technology infrastructure may cause operational stoppages, fines, penalties, diminished competitive advantages through reputational damages and increased operational costs. Additionally, we may incur additional costs to comply with our customers', including the U.S. government's, increased cyber security protections and standards in our products.
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Substantially all of our excess real estate, that we are in the process of entitling for new opportunities, is located in Sacramento County, California, making us vulnerable to changes in economic and other conditions in that particular market.
As a result of the geographic concentration of our properties, our long-term real estate performance and the value of our properties will depend upon conditions in the Sacramento region, including:
•the sustainability and growth of industries located in the Sacramento region;
•the financial strength and spending of the State of California;
•local real estate market conditions;
•changes in neighborhood characteristics;
•impacts of natural or people disasters;
•changes in interest rates; and
•real estate tax rates.
If unfavorable economic or other conditions affect the region, our plans and business strategy could be adversely affected.
In order to be successful, we must attract and retain key personnel.
Our business has a continuing need to attract and retain large numbers of skilled personnel, including personnel holding security clearances, to support the growth of the enterprise and to replace individuals who have terminated employment due to retirement or for other reasons. To the extent that the demand for qualified personnel exceeds supply, we could experience higher labor, recruiting, or training costs in order to attract and retain such employees, or could experience difficulties in performing under our contracts if our needs for such employees were unmet. In addition, our inability to appropriately plan for the transfer or replacement of appropriate intellectual capital and skill sets critical to us could result in business disruptions and impair our ability to achieve business objectives. Our business must also attract and retain qualified officers and directors.
A strike or other work stoppage, or our inability to renew collective bargaining agreements on favorable terms, could adversely affect our financial results.
As of December 31, 2022, 7% of our employees were covered by collective bargaining agreements. In the future, if we are unable to negotiate acceptable new agreements with the unions, upon expiration of the existing contracts, we could experience a strike or work stoppage. Even if we are successful in negotiating new agreements, the new agreements could call for higher wages or benefits paid to union members, which would increase our operating costs and could adversely affect our profitability. If our unionized workers were to engage in a strike or other work stoppage, or other non-unionized operations were to become unionized, we could experience a significant disruption of operations at our facilities or higher ongoing labor costs. A strike or other work stoppage in the facilities of any of our major customers or suppliers could also have similar effects on us.
Risks Related to Our Liquidity and Financing
We use estimates when accounting for certain contracts and changes in these estimates may have a significant impact on our financial results.
Our quarterly and annual sales are affected by a variety of factors that may lead to significant variability in our operating results. In our Aerospace and Defense segment, sales earned under long-term contracts are recognized either on a cost basis, when deliveries are made, or when contractually defined performance milestones are achieved. The timing of deliveries or milestones may fluctuate from quarter to quarter. We evaluate the contract value and cost estimates for performance obligations at least quarterly, and more frequently when circumstances change significantly which is described in more detail in Note 1 in the consolidated financial statements in Item 8 of this Report. Changes in estimates and assumptions related to the status of certain long-term contracts which could have a material adverse effect on our operating results, financial condition, and/or cash flows.
Our pension plans are currently underfunded and we expect to be required to make cash contributions in future periods, which would reduce the cash available for our businesses.
As of December 31, 2022, the pension assets, projected benefits obligations, and unfunded pension obligations were $706.9 million, $949.7 million, and $242.8 million, respectively. In 2023, we expect to make cash contributions of approximately $7 million to our tax-qualified defined benefit pension plan. We generally are able to recover contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there are differences between when we contribute to our tax-qualified defined benefit pension plan under pension funding rules and when it is recoverable under Cost Accounting Standards ("CAS").
The funded status of our pension plans may be adversely affected by the investment experience of the plans' assets, by any changes in U.S. law and by changes in the statutory interest rates used by tax-qualified pension plans in the U.S. to calculate funding requirements. Accordingly, if the performance of our plans' assets does not meet our assumptions, if there are changes to the Internal Revenue Service ("IRS") regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded pension plans could be higher than we expect.
Additionally, the level of returns on retirement benefit assets, changes in interest rates, increases in Pension Benefit Guaranty Corporations premiums, changes in regulations, changes in mortality rate assumptions, and other factors affect our financial results. The timing of recognition of retirement benefits expense or income in our financial statements differs from the timing of the required funding under the Pension Protection Act or the amount of funding that can be recorded in our overhead
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rates through our U.S. government contracting business. Significant cash contributions in future periods could materially adversely affect our business, operating results, financial condition, and/or cash flows.
If our operating subsidiaries do not generate sufficient cash flow or if they are not able to pay dividends or otherwise distribute their cash to us, or if we have insufficient funds on hand, we may not be able to service our debt.
All of the operations of our Aerospace and Defense and Real Estate segments are conducted through subsidiaries. Consequently, our cash flow and ability to service our debt obligations will be largely dependent upon the earnings and cash flows of our operating subsidiaries and the distribution of those earnings to us, or upon loans, advances or other payments made by these subsidiaries to us. The ability of our subsidiaries to pay dividends or make other payments or advances to us will depend upon their operating results and cash flows and will be subject to applicable laws and any contractual restrictions contained in the agreements governing their debt, if any.
We have a substantial amount of debt. Our ability to operate is limited by the agreements governing our debt.
We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of December 31, 2022, we had $303.1 million of debt outstanding. Subject to the limits contained in some of the agreements governing our outstanding debt, we may incur additional debt in the future. Our maintenance of higher levels of indebtedness could have adverse consequences including impairing our ability to obtain additional financing in the future.
Our level of debt places significant demands on our cash resources, which could:
•make it more difficult to satisfy our outstanding debt obligations;
•require us to dedicate a substantial portion of our cash for payments related to our debt, reducing the amount of cash flow available for working capital, capital expenditures, entitlement of our real estate assets, contributions to our tax-qualified pension plan, and other general corporate purposes;
•limit our flexibility in planning for, or reacting to, changes in the industries in which we compete;
•place us at a competitive disadvantage with respect to our competitors, some of which have lower debt service obligations and greater financial resources than we do;
•limit our ability to borrow additional funds;
•limit our ability to expand our operations through acquisitions; and
•increase our vulnerability to general adverse economic and industry conditions.
If we are unable to generate sufficient cash flow to service our debt and fund our operating costs, our liquidity may be adversely affected.
We are obligated to comply with financial and other covenants outlined in our debt indentures and agreements that could restrict our operating activities. A failure to comply could result in a default which would, if not waived by the lenders, likely come with substantial cost and accelerate the payment of our debt.
Our debt instruments generally contain various restrictive covenants which include, among others, provisions which may restrict our ability to:
•access the full amount of our revolving credit facility and/or incur additional debt;
•enter into certain leases;
•make certain distributions, investments, and other restricted payments;
•cause our restricted subsidiaries to make payments to us;
•enter into transactions with affiliates;
•create certain liens;
•purchase assets or businesses;
•sell assets and, if sold, retain excess cash flow from these sales; and
•consolidate, merge or sell all or substantially all of our assets.
Our secured debt also contains other customary covenants, including, among others, provisions restricting our ability to pledge assets or create other liens. In addition, certain covenants in our bank facility require that we maintain certain financial ratios.
Based on our existing debt agreements, we were in compliance with our financial and non-financial covenants as of December 31, 2022. Any of the covenants described in this risk factor may restrict our operations and our ability to pursue potentially advantageous business opportunities. Our failure to comply with these covenants could result in an event of default that, if not cured or waived, could result in the acceleration of our amended and restated senior credit facility (the "Senior Credit Facility"). In addition, our failure to pay principal and interest when due is a default under the Senior Credit Facility.
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Risks Related to Our Strategy
Our success and growth depends on our ability to execute long-standing programs and periodically secure new contracts in a competitive environment.
Our sales are primarily derived from long-standing contracts (often sole source) where we are the long-term incumbent. The challenge is to successfully utilize our technical, engineering, manufacturing, and management skills to execute these programs for the customer, to continue to innovate and refine our solutions, and to offer the customer increasing affordability in an era of fiscal restraint. Changes in management or other key personnel can make executing these programs more difficult. If we are unable to successfully execute these long-standing programs, our ability to retain existing customers and attract new customers may be impaired.
In addition, we continue to be subject to intense competition in certain sectors. For example, we face increasing competition from emerging spaceflight companies such as SpaceX and Blue Origin, who have developed liquid fuel propulsion capabilities which are primarily focused on the development of space propulsion systems for heavy lift launch vehicles. For the in-space propulsion market, we also see a number of new startups entering the market in both small chemical propulsion and small electric propulsion systems targeted at the rapidly expanding small satellite market. The U.S. government also has its own manufacturing capabilities in some areas. We may be unable to compete successfully with our competitors and our inability to do so could result in a decrease in sales, profits, and cash flows that we historically have generated from certain contracts. Further, the U.S. government may open to competition programs on which we are currently the sole supplier, which could have a material adverse effect on our operating results, financial condition, and/or cash flows.
We may expand our operations through acquisitions, which may divert management’s attention and expose us to unanticipated liabilities and costs. Also, acquisitions may increase our non-reimbursable costs. We may experience difficulties integrating any acquired operations, and we may incur costs relating to acquisitions that are never consummated.
Our business strategy may lead us to expand our Aerospace and Defense segment through acquisitions. However, our ability to consummate any future acquisitions on terms that are favorable to us may be limited by U.S. government regulations, the number of attractive acquisition targets, internal demands on our resources, and our ability to obtain financing. Our success in integrating newly acquired businesses will depend upon our ability to retain key personnel, avoid diversion of management’s attention from operational matters, implement internal controls, integrate general and administrative services and key information processing systems and, where necessary, re-qualify our customer programs. In addition, future acquisitions could result in the incurrence of additional debt, costs, and/or contingent liabilities. We may also incur costs and divert management attention to acquisitions that are never consummated. Integration of acquired operations may take longer, or be more costly or disruptive to our business, than originally anticipated.
There may be liabilities of the acquired companies that we fail to, or were unable to, discover during our due diligence investigation of each business that we have acquired or may acquire and for which we, as a successor owner, may be responsible. Our efforts to minimize the impact of these types of potential liabilities through indemnities and warranties from sellers in connection with acquisitions may not fully cover the liabilities due to limitations in scope, amount or duration, financial limitations of the indemnitor or warrantor, or other reasons.
Risks Related to Legislation, Regulation, and Compliance
Our Aerospace and Defense segment is subject to procurement and other related laws and regulations inherent in contracting with the U.S. government, and non-compliance could adversely affect our financial results.
In the performance of contracts with the U.S. government, we operate in a highly regulated environment and are routinely audited and reviewed by the U.S. government and its agencies, such as the DCAA. These agencies review performance under our contracts, our cost structure and our compliance with applicable laws, regulations and standards, as well as the adequacy of, and our compliance with, our internal control systems and policies. Systems that are subject to review include, but are not limited to, our accounting systems, purchasing systems, property management systems, estimating systems, earned value management systems, and material management and accounting system. Any costs ultimately found to be unallowable or improperly allocated to a specific contract will not be reimbursed and must be refunded if already reimbursed. If an audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties, sanctions or suspension or debarment from doing business with the U.S. government. Whether or not illegal activities are alleged, the U.S. government also has the ability to decrease or withhold certain payments when it deems systems subject to its review to be inadequate. In addition, we could suffer serious reputational harm if allegations of impropriety were made against us, even if untrue. If such actions were to result in suspension or debarment, this could have a material adverse effect on our business.
These laws and regulations provide for ongoing audits and reviews of incurred costs as well as contract procurement, performance and administration. The U.S. government may, if it deems appropriate, conduct an investigation into possible illegal or unethical activity in connection with these contracts. Investigations of this nature are common in the aerospace and defense industry, and lawsuits may result. In addition, the U.S. government and its principal prime contractors periodically investigate the financial viability of their contractors and subcontractors as part of its risk assessment process associated with the award of new contracts. If the U.S. government or one or more prime contractors were to determine that we were not financially viable, our ability to continue to act as a U.S. government contractor or subcontractor would be impaired.
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Cyber security incidents could disrupt business operations, result in the loss of critical and confidential information, and adversely impact our reputation and results of operations.
We routinely defend against various cyber and other security threats against our defenses to protect the confidentiality, integrity and availability of our information technology infrastructure, supply chain, business or customer information and other threats. We are also subject to similar security threats at customer sites that we operate and manage as a contractual requirement.
The threats we face range from attacks common to most industries to more advanced and persistent, highly organized adversaries, insider threats and other threat vectors targeting us and other defense and aerospace companies; because we protect national security information. In addition, cyber threats are evolving, growing in their frequency and include, but are not limited to, malicious software, destructive malware, attempts to gain unauthorized access to data, disruption or denial of service attacks, and other electronic security breaches that could lead to disruptions in mission critical systems, unauthorized release of confidential, personal or otherwise protected information (ours or that of our employees, customers or partners), and corruption of data, networks or systems. We also could be impacted by cyber threats or other disruptions or vulnerabilities found in products we use or in our partners’ or customers’ systems that are used in connection with our business.
If we are unable to protect sensitive information or the integrity of our systems, our customers or governmental authorities could question the adequacy of our threat mitigation and detection processes and procedures. There can be no assurance that the variety of efforts, procedures and controls we deploy to monitor and minimize the likelihood and impact of adverse cyber security incidents will be sufficient. The costs related to cyber or other security threats or disruptions may not be fully insured or indemnified by other means. The occurrence of any of these events could adversely affect our internal operations, the services we provide to our customers, our future financial results, or our reputation. Such events could also result in the loss of competitive advantages derived from our R&D efforts or other intellectual property, early obsolescence of our products and services, or contractual penalties. Moreover, we may be required to expend significant additional resources to modify our cyber security protective measures, to investigate and remediate vulnerabilities or other exposures or to make required notifications, and we may be subject to litigation and financial losses.
We may experience warranty claims for product failures, schedule delays or other problems with existing or new products and systems.
Many of the products we develop and manufacture are technologically advanced systems that must function under demanding operating conditions. The sophisticated and rigorous design, manufacturing and testing processes and practices we employ do not entirely prevent the risk that we may not be able to successfully launch or manufacture our products on schedule or that our products may not perform as intended.
When our products fail to perform adequately, some of our contracts require us to forfeit a portion of our expected profit, receive reduced payments, provide a replacement product or service or reduce the price of subsequent sales to the same customer. Performance penalties may also be imposed when we fail to meet delivery schedules or other measures of contract performance. We do not generally insure against potential costs resulting from any required remedial actions or costs or loss of sales due to postponement or cancellation of scheduled operations or product deliveries.
Our operations and properties are currently the subject of significant environmental liabilities, and the numerous environmental and other government requirements to which we are subject may become more stringent in the future.
We are subject to federal, state, and local environmental laws and regulations that, among other things, require us to obtain permits to operate and install pollution control equipment and regulate the generation, storage, handling, transportation, treatment, and disposal of hazardous and solid wastes. These requirements may become more stringent in the future. Additional regulations dictate how and to what level we remediate contaminated soils and the level to which we are required to clean contaminated groundwater. These requirements may also become more stringent in the future. We may also be subject to fines and penalties relating to the operation of our existing and formerly owned businesses. We have been and are subject to toxic tort and asbestos lawsuits as well as other third-party lawsuits, due to either our past or present use of hazardous substances or the alleged on-site or off-site contamination of the environment through past or present operations. We may incur material costs in defending these claims and lawsuits and any similar claims and lawsuits that may arise in the future. Contamination at our current and former properties is subject to investigation and remediation requirements under federal, state and local laws and regulations, and the full extent of the required remediation has not yet been determined. Any adverse judgment or cash outlay could have a significant adverse effect on our operating results, financial condition, and/or cash flows.
Given the many uncertainties involved in assessing liability for environmental claims, our established reserves may not be sufficient, which could adversely affect our financial results and cash flows.
As of December 31, 2022, the aggregate range of our estimated future environmental obligations was $290.5 million to $447.1 million and the accrued amount was $290.5 million. In many cases the nature and extent of the required remediation has not yet been determined. Given the many uncertainties involved in assessing liability for environmental claims, our reserves may prove to be insufficient. The reserves are based only on known sites and the known contamination at those sites. It is possible that additional sites needing remediation may be identified or that unknown contamination at previously identified sites may be discovered. It is also possible that the regulatory agencies may change clean-up standards for chemicals of concern such as ammonium perchlorate and trichloroethylene. This could lead to additional expenditures for environmental remediation in the future and, given the uncertainties involved in assessing liability for environmental claims, our reserves may prove to be insufficient.
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Most of our environmental costs are incurred by our Aerospace and Defense segment, and certain of these future costs are allowed to be included in our U.S. government contracts. We currently estimate approximately 12% of our Aerospace and Defense segment environmental costs will not likely be reimbursable.
Our environmental expenses related to non-Aerojet Rocketdyne sites are generally not recoverable and a significant increase in these estimated environmental expenses could have a significant adverse effect on our operating results, financial condition, and/or cash flows.
We face certain significant risk exposures and potential liabilities that may not be adequately covered by insurance.
A significant portion of our business relates to developing and manufacturing propulsion systems for defense and space applications, armament systems for precision tactical weapon systems, and munitions applications. New technologies may be untested or unproven. In addition, we may incur significant liabilities that are unique to our products and services. The amount of our insurance coverage may not be adequate to cover all claims or liabilities, and it is not possible to obtain insurance to protect against all operational risks and liabilities. Accordingly, we may be forced to bear substantial costs resulting from risks and uncertainties of our business, which could have a material adverse effect on our operating results, financial condition, and/or cash flows.
Our Certificate of Incorporation provides that the Court of Chancery of the State of Delaware will be the sole and exclusive forum for certain stockholder litigation matters, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers, employees or stockholders.
Our Certificate of Incorporation provides that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware will be the sole and exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty owed by any director, officer, or employee of the Company to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, or (iv) any action asserting a claim governed by the internal affairs doctrine as that doctrine exists under the law of the State of Delaware. Any person or entity purchasing or otherwise acquiring any interest in shares of our capital stock will be deemed to have notice of, and consented to, the provisions of our Certificate of Incorporation described in the preceding sentence. This exclusive forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that the stockholder finds favorable for disputes with us or our directors, officers, or other employees, which may discourage such lawsuits against us and such persons. Alternatively, if a court were to find these provisions of our Certificate of Incorporation inapplicable to, or unenforceable in respect of, one or more of the specified types of actions or proceedings, we may incur additional costs associated with resolving such matters in other jurisdictions, which could adversely affect our business, financial condition, or results of operations.
This exclusive forum provision would not apply to suits brought to enforce a duty or liability created by the Securities Act of 1933, as amended (the "Securities Act") or the Exchange Act, except that it may apply to such suits if brought derivatively on our behalf. There is, however, uncertainty as to whether a court would enforce such provision in connection with suits to enforce a duty or liability created by the Securities Act or the Exchange Act if brought derivatively on our behalf, and our stockholders will not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder.
General Risk Factors
Our stock price is subject to fluctuations.
The trading price of our common stock has been and may continue to be volatile. Our stock price has fluctuated in response to a number of events and factors, including general economic and financial conditions, regulatory actions, our own quarterly variations in operating results, changes in financial estimates and recommendations by securities analysts, changes in applicable laws or regulations, changes affecting our industry, speculation associated with merger and acquisition activity, and other events impacting our business. The stock market in general has experienced extreme volatility that may be unrelated to the operating performance of a particular company. These broad market and industry fluctuations may adversely affect the price of our common stock, regardless of our operating performance.
Business disruptions could seriously affect us.
Our business may be affected by disruptions including, but not limited to: threats to physical security of our facilities and employees; information technology attacks; natural disasters; political and social unrest; and pandemics or other public health crises. The costs related to these events may not be fully mitigated by insurance or other means. Disruptions could affect our internal operations or services provided to customers, which could have a material adverse effect on our operating results, financial condition, and/or cash flows.
Tax changes could affect our effective tax rate and future profitability
Our effective tax rate for 2022 was 31.7% compared with 24.8% for 2021. Changes in applicable U.S. tax laws and regulations, or their interpretation and application, including the possibility of retroactive effect, could affect our tax expense, operating results, and/or cash flows.
Beginning in 2022, the Tax Cuts and Jobs Act of 2017 eliminates the option to deduct research and experimental expenditures currently and requires taxpayers to amortize such costs incurred in the U.S. over five years. As a result, we expect to make additional income tax payments over the next four years which will have an adverse effect on our operating results, financial condition, and/or cash flows.
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The level of returns on retirement benefit assets, changes in interest rates, changes in legislation, and other factors affect our financial results.
Our earnings are positively or negatively impacted by the amount of expense or income we record for our employee retirement benefit plans. We calculate the expense for the plans based on actuarial valuations. These valuations are based on assumptions that we make relating to financial market and other economic conditions. Changes in key economic indicators result in changes in the assumptions we use. The key assumptions used to estimate retirement benefits expense for the following year are the discount rate and expected long-term rate of return on assets. Our pension expense or income can also be affected by legislation and other government regulatory actions.
Our inability to protect our trade secrets, patents and proprietary rights could adversely affect our businesses’ prospects and competitive positions.
If we are unable to obtain or maintain protections for proprietary technology and inventions through patents and other proprietary rights protections, we may not be able to prevent third parties from using our proprietary rights. In addition, we may incur significant expense in protecting our intellectual property.
We also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive. We have taken measures to protect our trade secrets and know-how, including the use of confidentiality agreements with our employees, consultants and advisors. These agreements may be breached and remedies for a breach may not be sufficient to compensate us for damages incurred. Other parties may independently develop our know-how or otherwise obtain access to our technology.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
Significant operating, manufacturing, research, design, and/or marketing locations are set forth below.
Facilities
Corporate Headquarters
Aerojet Rocketdyne Holdings, Inc.
222 N. Pacific Coast Highway, Suite 500
El Segundo, California 90245
El Segundo, California 90245
| Aerospace and Defense | ||||||||
Operating/Design/Manufacturing Facilities: Camden, Arkansas (owned and leased); Carlstadt, New Jersey*; Chatsworth, California (owned and leased); Hancock County, Mississippi*; Huntsville, Alabama*; Jonesborough, Tennessee**; Orange, Virginia; Orlando, Florida*; Redmond, Washington; West Palm Beach, Florida* | Marketing/Sales Offices: Arlington, Virginia* | |||||||
| Real Estate | ||||||||
| Rancho Cordova, California | ||||||||
_____
* Indicates a leased property.
** Owned and operated by Aerojet Ordnance Tennessee, Inc., a 100% owned subsidiary of Aerojet Rocketdyne.
We believe each of the facilities is suitable and adequate for the business conducted at that facility taking into account current and planned future needs.
Item 3. Legal Proceedings
See Note 8(a) in the consolidated financial statements in Item 8 of this Report for information relating to our legal proceedings.
Item 4. Mine Safety Disclosures
None.
PART II
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
As of February 9, 2023, there were 4,588 holders of record of our common stock. Our common stock is listed on the New York Stock Exchange under the trading symbol "AJRD." On February 9, 2023, the last reported sale price of our common stock on the New York Stock Exchange was $55.73 per share.
On December 19, 2020, our Board of Directors declared the one-time dividend in cash of $5.00 per share (including shares underlying the 2¼% Notes participating on an as-converted basis). On March 24, 2021, the Company paid the dividend to holders of record as of March 10, 2021. At this time, we do not anticipate paying cash dividends in the foreseeable future.
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The table below provides information about shares surrendered to the Company during the three months ended December 31, 2022, to pay employee withholding taxes due upon the vesting of restricted stock.
| Period | Total Number of Shares Purchased | Average Price Paid per Share | Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs | Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased under the Plans or Programs | ||||||||||||||||||||||
| October 1, 2022 through October 31, 2022 | 441 | $ | 47.49 | — | $ | — | ||||||||||||||||||||
| November 1, 2022 through November 30, 2022 | — | — | — | — | ||||||||||||||||||||||
| December 1, 2022 through December 31, 2022 | 20,349 | 54.66 | — | — | ||||||||||||||||||||||
| Total | 20,790 | 54.50 | — | $ | — | |||||||||||||||||||||
Information concerning long-term debt appears in Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption "Liquidity and Capital Resources" and in Part II, Item 8. Financial Statements and Supplementary Data at Note 6 in the consolidated financial statements.
Information concerning securities authorized for issuance under our equity compensation plans appears in Part III, Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters under the caption "Equity Compensation Plan Information."
Stock Performance Graph
The following graph compares the cumulative total stockholder returns, calculated on a dividend reinvested basis, on $100 invested in our common stock in December 2017 with the cumulative total return of (i) the Standard & Poor’s 500 Composite Stock Price Index ("S&P 500 Index"), and (ii) the Standard & Poor’s 500 Aerospace & Defense Index. The stock price performance shown on the graph is not necessarily indicative of future performance.
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Comparison of Cumulative Total Stockholder Return Among
Aerojet Rocketdyne, S&P 500 Index, and the S&P 500 Aerospace & Defense Index,
December 2017 through December 2022
| Company/Index | Base Year 2017 | Year Ended December 31, | ||||||||||||||||||||||||||||||||||||
| 2018 | 2019 | 2020 | 2021 | 2022 | ||||||||||||||||||||||||||||||||||
| Aerojet Rocketdyne Holdings, Inc. | $ | 100.00 | $ | 112.92 | $ | 146.35 | $ | 169.39 | $ | 166.32 | $ | 198.94 | ||||||||||||||||||||||||||
| S&P 500 Index | 100.00 | 95.62 | 125.72 | 148.85 | 191.58 | 156.88 | ||||||||||||||||||||||||||||||||
| S&P 500 Aerospace & Defense | 100.00 | 91.93 | 119.81 | 100.56 | 113.86 | 133.64 | ||||||||||||||||||||||||||||||||
Item 6. Reserved
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Our operations are organized into two segments: (i) Aerospace and Defense and (ii) Real Estate. Refer to “Item 1 Business” for information related to our business segments.
The following discussion should be read in conjunction with the other sections of this Report, including the consolidated financial statements and notes thereto appearing in Item 8 of this Report, the risk factors appearing in Item 1A of this Report, and the disclaimer regarding forward-looking statements appearing at the beginning of Item 1 of this Report. Pursuant to instruction 1 of the instructions to paragraph 303(b) of Regulation S-K, discussion of the results of operations for the fiscal year ended December 31, 2020, has been omitted. Such omitted discussion can be found under Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2021, filed with the SEC on February 18, 2022.
L3Harris Merger Agreement
On December 17, 2022, the Company entered into the Merger Agreement, with L3Harris and Merger Sub. Subject to the terms and conditions set forth in the Merger Agreement, each share of the Company's common stock outstanding as of immediately prior to the effective time of the Merger will be canceled and converted into the right to receive $58.00 in cash, without interest, plus, if the closing occurs after September 17, 2023, $0.0025 for each calendar day elapsed after such date to and including the closing date. Closing of the Merger is anticipated to occur in 2023, subject to various customary conditions, including our stockholder approval and regulatory clearance under the HSR Act.
Lockheed Martin Terminated Merger Agreement
On December 20, 2020, the Company entered into the Lockheed Terminated Merger Agreement with Lockheed Martin and Mizar Sub, Inc., a wholly-owned subsidiary of Lockheed Martin, pursuant to which each share of common stock of the Company would have been automatically converted into the right to receive cash in an amount equal to $51.00 per share, adjusted from $56.00 following the payment of a one-time cash dividend of $5.00 per share paid in March 2021. On January 25, 2022, the FTC
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filed a complaint against the Company and Lockheed Martin in the FTC’s administrative court and a complaint in U.S. federal court seeking a preliminary injunction to stop the deal pending an administrative trial. On February 13, 2022, Lockheed Martin notified the Company that it had elected to terminate the Lockheed Terminated Merger Agreement. On February 14, 2022, pursuant to the parties’ joint motion, the administrative complaint and the U.S. federal court complaint were dismissed.
Overview
A summary of the significant financial highlights for the years ended December 31, 2022 and 2021, which management uses to evaluate our operating performance and financial condition, is presented below.
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| (In millions, except percentage and per share amounts) | |||||||||||
| Net sales | $ | 2,237.6 | $ | 2,188.0 | |||||||
| Net income | 74.0 | 146.6 | |||||||||
| Net income as a percentage of net sales | 3.3 | % | 6.7 | % | |||||||
| Adjusted Net Income (Non-GAAP measure*) | 115.0 | 164.5 | |||||||||
| Adjusted Net Income (Non-GAAP measure*) as a percentage of net sales | 5.1 | % | 7.5 | % | |||||||
| Earnings Per Share ("EPS") - Diluted | 0.90 | 1.78 | |||||||||
| Adjusted EPS (Non-GAAP measure*) | 1.39 | 2.00 | |||||||||
| Adjusted EBITDAP (Non-GAAP measure*) | 238.8 | 298.5 | |||||||||
| Adjusted EBITDAP (Non-GAAP measure*) as a percentage of net sales | 10.7 | % | 13.6 | % | |||||||
| Cash (used in) provided by operating activities | (48.7) | 199.6 | |||||||||
| Free cash flow (Non-GAAP measure*) | (89.4) | 162.3 | |||||||||
* We provide Non-GAAP measures as a supplement to financial results presented in accordance with GAAP. A reconciliation of the Non-GAAP measures to the most directly comparable GAAP measures is presented later in the Management’s Discussion and Analysis under the heading "Use of Non-GAAP Financial Measures."
Our business outlook is affected by both increasing complexity in the global security environment and continuing worldwide economic pressures, including those resulting from the military conflict between Russia and Ukraine. A significant component of our strategy in this environment is to focus on delivering excellent performance to our customers, driving improvements and efficiencies across our operations, and creating value through the enhancement and expansion of our business.
Some of the significant challenges we face are as follows: uncertainty associated with our dependence upon U.S. government programs and contracts, future reductions or changes in U.S. government spending in our markets, environmental matters, capital structure, underfunded pension plan, cyber security and other security threats, and the actions taken by governments.
Major Customers
The principal end user customers of our products and technology are primarily agencies of the U.S. government. Since a majority of our sales are, directly or indirectly, to the U.S. government, funding for the purchase of our products and services generally follows trends in U.S. aerospace and defense spending. However, individual U.S. government agencies, which include the military services, NASA, the Missile Defense Agency, and the prime contractors that serve these agencies, exercise independent purchasing power within "budget top-line" limits. Therefore, sales to the U.S. government are not regarded as sales to one customer, but rather each contracting agency is viewed as a separate customer.
The following table summarizes end user net sales to the U.S. government and its agencies, including net sales to significant customers disclosed below:
| Year Ended December 31, | Percentage of Net Sales | ||||
| 2022 | 95 | % | |||
| 2021 | 96 | ||||
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The following table summarizes net sales by principal end user in 2022:
| MDA | 25 | % | |||
| NASA | 21 | ||||
| U.S. Army | 20 | ||||
| U.S. Air Force | 12 | ||||
| U.S. Navy | 10 | ||||
| Other U.S. government | 7 | ||||
| Total U.S. government customers | 95 | ||||
| Other customers | 5 | ||||
| Total | 100 | % | |||
The following table summarizes the percentages of net sales for significant programs, all of which are included in the U.S. government sales and are comprised of multiple contracts:
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| RS-25 program | 15 | % | 17 | % | |||||||
| Standard Missile program | 12 | 12 | |||||||||
| PAC-3 program | 10 | 10 | |||||||||
The following table summarizes customers that represented more than 10% of net sales, each of which involves sales of several product lines and programs:
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| Lockheed Martin | 32 | % | 32 | % | |||||||
| NASA | 19 | 20 | |||||||||
| Raytheon | 19 | 17 | |||||||||
Industry Update
Information concerning our industry appears in Part I, Item 1. Business under the caption "Industry Overview."
Environmental Matters
Our current and former business operations are subject to, and affected by, federal, state, and local environmental laws and regulations relating to the discharge, treatment, storage, disposal, investigation, and remediation of certain materials, substances, and wastes. Our policy is to conduct our business with due regard for the preservation and protection of the environment. We periodically assess compliance with these regulations and we believe our current operations are materially in compliance with applicable environmental laws and regulations as of December 31, 2022.
In addition to the costs associated with environmental remediation discussed above, we incur expenditures for recurring costs associated with managing hazardous substances or pollutants in ongoing operations which totaled $9.8 million in 2022.
The following table summarizes our recoverable amounts, environmental reserves, and range of liability, as of December 31, 2022:
| Recoverable Amount (1) | Reserve | Estimated Range of Liability | |||||||||||||||
| (In millions) | |||||||||||||||||
| Aerojet Rocketdyne - Sacramento | $ | 196.7 | $ | 223.6 | $223.6 - $357.0 | ||||||||||||
| Aerojet Rocketdyne - Baldwin Park Operable Unit ("BPOU") | 44.7 | 50.8 | 50.8 - 62.6 | ||||||||||||||
| Other Aerojet Rocketdyne sites | 10.8 | 10.8 | 10.8 - 20.9 | ||||||||||||||
| Other sites | 0.9 | 5.3 | 5.3 - 6.6 | ||||||||||||||
| Total | $ | 253.1 | $ | 290.5 | $290.5 - $447.1 | ||||||||||||
_____
(1)Excludes the receivable from Northrop of $34.5 million as of December 31, 2022, related to environmental costs already paid (and therefore not reserved) by us in prior years and reimbursable under our agreement with Northrop.
22
Capital Structure
We have a substantial amount of debt for which we are required to make interest and principal payments. Interest on long-term financing is not a recoverable cost under our U.S. government contracts. As of December 31, 2022, we had $303.1 million of debt outstanding.
Pension Plan
As of the last measurement date at December 31, 2022, the pension assets, projected benefits obligations, and unfunded pension obligations were $706.9 million, $949.7 million, and $242.8 million, respectively. We estimate that 83% of our unfunded pension obligation as of December 31, 2022, is related to our U.S. government contracting business, Aerojet Rocketdyne.
The ARPA that was signed into law on March 11, 2021, provided funding relief to sponsors of defined benefit pension plans. In line with provisions of ARPA, we expect to make cash contributions of approximately $7 million to our tax-qualified defined benefit pension plan in 2023. We generally are able to recover contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there are differences between when we contribute to our tax-qualified defined benefit pension plan under pension funding rules and when it is recoverable under CAS.
Recent macroeconomic and geopolitical developments have continued to cause significant economic uncertainty and volatility in financial markets which could adversely impact the funded status of our tax-qualified defined benefit pension plan. The funded status of our pension plan is also impacted by the investment experience of the plan assets, by any changes in U.S. law, and by changes in the statutory interest rates used by the tax-qualified pension plan in the U.S. to calculate funding requirements. Accordingly, if the performance of our plan assets does not meet our assumptions, if there are changes to the Internal Revenue Service regulations or other applicable law or if other actuarial assumptions are modified, our future contributions to our underfunded pension plan could be higher than we expect.
Cyber Security and Other Security Threats
We routinely defend against various cyber and other security threats against our defenses to protect the confidentiality, integrity and availability of our information technology infrastructure, supply chain, business or customer information and other threats. We are also subject to similar security threats at customer sites that we operate and manage as a contractual requirement.
The threats we face range from attacks common to most industries to more advanced and persistent, highly organized adversaries, insider threats and other threat vectors targeting us and other defense and aerospace companies; because we protect national security information. In addition, cyber threats are evolving, growing in their frequency and include, but are not limited to, malicious software, destructive malware, attempts to gain unauthorized access to data, disruption or denial of service attacks, and other electronic security breaches that could lead to disruptions in mission critical systems, unauthorized release of confidential, personal or otherwise protected information (ours or that of our employees, customers or partners), and corruption of data, networks or systems. We also could be impacted by cyber threats or other disruptions or vulnerabilities found in products we use or in our partners’ or customers’ systems that are used in connection with our business.
Russia’s invasion of Ukraine and the global response to the invasion has exacerbated these cyber and other security threats we face. We continue to assess our information technology systems and are engaged in cooperative efforts with our customers, suppliers, and subcontractors to seek to minimize the impact of cyber threats, other security threats or business disruptions.
COVID-19
Our financial results and operations have not been materially adversely impacted by the COVID-19 pandemic. The CARES Act was enacted on March 27, 2020, in response to the COVID-19 pandemic and the negative impacts that it has had on the global economy and U.S. companies. The CARES Act includes various financial measures to assist companies, including temporary changes to income and non-income-based tax laws. Through these provisions, as of December 31, 2022, we have delayed $10.6 million of payroll tax payments that otherwise would have been paid in 2020 and were paid in January 2023. Additionally, in accordance with the provisions of the CARES Act, we accelerated depreciation on qualified improvement property placed in service after December 31, 2017, for income tax purposes.
Results of Operations
Net Sales
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Net sales | $ | 2,237.6 | $ | 2,188.0 | $ | 49.6 | |||||||||||
Primary reason for change. The increase in net sales was primarily driven by an increase on the NGI program partially offset by lower sales in the RS-25 program. Further, as a result of the 2022 calendar, Aerojet Rocketdyne had 53 weeks of operations in 2022 compared with 52 weeks of operations in 2021. The additional week of operations, which occurred in the fourth quarter of 2022, and accounted for $42.3 million in additional net sales, is included in the discussion above regarding program changes.
23
Cost of Sales (exclusive of items shown separately below)
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions, except percentage amounts) | |||||||||||||||||
Cost of sales (exclusive of items shown separately below) | $ | 1,906.2 | $ | 1,800.1 | $ | 106.1 | |||||||||||
| Percentage of net sales | 85.2 | % | 82.3 | % | |||||||||||||
Primary reason for change. The increase in cost of sales as a percentage of net sales was primarily driven by cost growth from supply chain disruptions and necessary technical and manufacturing changes on a portion of the Standard Missile program and favorable contract performance on the RS-68 program in the prior year.
Selling, General and Administrative Expense ("SG&A")
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions, except percentage amounts) | |||||||||||||||||
| Components of SG&A: | |||||||||||||||||
| SG&A excluding stock-based compensation | $ | 29.9 | $ | 25.3 | $ | 4.6 | |||||||||||
| Stock-based compensation | 26.6 | 20.7 | 5.9 | ||||||||||||||
| SG&A | $ | 56.5 | $ | 46.0 | $ | 10.5 | |||||||||||
| Percentage of net sales | 2.5 | % | 2.1 | % | |||||||||||||
| Percentage of net sales excluding stock-based compensation | 1.3 | % | 1.2 | % | |||||||||||||
Primary reason for change. The increase in SG&A expense was primarily driven by (i) stock-based compensation and (ii) an increase in legal and consulting related costs. For detailed information about stock-based compensation refer to Note 9(e) in the consolidated financial statements in Item 8 of this Report.
Depreciation and Amortization
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Components of depreciation and amortization: | |||||||||||||||||
| Depreciation | $ | 48.1 | $ | 48.8 | $ | (0.7) | |||||||||||
| Amortization | 6.6 | 9.9 | (3.3) | ||||||||||||||
| Accretion | 2.6 | 2.7 | (0.1) | ||||||||||||||
| Depreciation and amortization | $ | 57.3 | $ | 61.4 | $ | (4.1) | |||||||||||
Primary reason for change. The decrease in depreciation and amortization expense was primarily due to the completion of amortization expense for a significant portion of the customer related intangible assets associated with the acquisition of the Rocketdyne Business from United Technologies Corporation in 2013.
Other Expense, Net
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Components of other expense, net: | |||||||||||||||||
| Proxy contest and related litigation costs | $ | 27.8 | $ | — | $ | 27.8 | |||||||||||
| Merger costs | 25.3 | — | 25.3 | ||||||||||||||
| Legal matters | 15.7 | — | 15.7 | ||||||||||||||
| Terminated Merger costs | 2.5 | 18.9 | (16.4) | ||||||||||||||
| Other | 1.0 | 4.6 | (3.6) | ||||||||||||||
| Other expense, net | $ | 72.3 | $ | 23.5 | $ | 48.8 | |||||||||||
Primary reason for change. The increase in other expense, net was primarily due to (i) $27.8 million of costs associated with the proxy contest and associated litigation; (ii) $25.3 million of costs associated with the Merger; and (iii) $15.7 million of costs associated with legal matters. These costs were partially offset by $16.4 million of lower Terminated Merger costs. For detailed information refer to Note 11 in the consolidated financial statements in Item 8 of this Report.
24
Loss on Debt
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Loss on debt | $ | 22.7 | $ | 10.5 | $ | 12.2 | |||||||||||
Primary reason for change. As a result of the irrevocable cash settlement redemption notice issued to holders on July 15, 2022 of our outstanding 2¼% Notes, we were required to separate a derivative from the 2¼% Notes. The irrevocable cash conversion option became a forward sale contract which was not eligible for the “own stock” scope exception allowed under the accounting guidance since it was required to be settled in cash and resulted in a loss on debt of $22.6 million in 2022. Additionally, in 2022, we recorded a loss on debt of $0.1 million related to an amendment to the Senior Credit Facility. For additional information refer to Note 6 in the consolidated financial statements in Item 8 of this Report.
In 2021, we settled $154.1 million of our 2¼% Notes as a result of receiving conversion notices from the noteholders. The principal amount of $154.1 million was settled in cash and the conversion premium was settled in 2.9 million common shares. We incurred a pre-tax charge of $10.5 million in 2021, associated with the settlement of the 2¼% Notes.
Interest Income and other
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Interest income and other | $ | 5.4 | $ | 2.5 | $ | 2.9 | |||||||||||
Primary reason for change. The increase in interest income and other was primarily due to a higher rate of return on our cash and cash equivalents balances.
Interest Expense
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Components of interest expense: | |||||||||||||||||
| Contractual interest and other | $ | 17.1 | $ | 14.2 | $ | 2.9 | |||||||||||
| Amortization of debt discount and deferred financing costs | 1.5 | 5.9 | (4.4) | ||||||||||||||
| Interest expense | $ | 18.6 | $ | 20.1 | $ | (1.5) | |||||||||||
Primary reason for change.The decrease in interest expense was primarily due to the adoption of the new accounting standard that eliminated the amortization of the debt discount effective January 1, 2022 and the settlement of the 2¼% Notes partially offset by higher interest rates on borrowings under our Senior Credit Facility.
Income Tax Provision
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| (In millions) | |||||||||||
| Income tax provision | $ | 34.3 | $ | 48.4 | |||||||
In 2022, our effective tax rate was 31.7%. Our effective tax rate differed from the 21% statutory federal income tax rate primarily due to state income taxes and certain other expenditures which are permanently not deductible for tax purposes, partially offset by R&D credits.
As of December 31, 2022, the liability for uncertain income tax positions was $151.3 million. Due to the uncertainty regarding the timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid.
In 2021, our effective tax rate was 24.8%. Our effective tax rate differed from the 21% statutory federal income tax rate primarily due to state income taxes, uncertain tax positions, and certain expenditures which are permanently not deductible for tax purposes, offset by R&D credits, excess tax benefits related to our stock-based compensation and deductible premiums paid upon the redemption of a portion of our convertible debt.
On August 16, 2022, the "Inflation Reduction Act" was signed into law in the U.S. We evaluated the impact and the Inflation Reduction Act does not have a material impact on our financial results.
25
Retirement Benefits Expense
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Components of retirement benefits expense: | |||||||||||||||||
| Interest cost on benefits obligation | $ | 36.1 | $ | 34.0 | $ | 2.1 | |||||||||||
| Assumed return on assets | (62.8) | (61.4) | (1.4) | ||||||||||||||
| Amortization of prior service costs | 0.1 | 0.1 | — | ||||||||||||||
| Amortization of net losses | 27.7 | 61.2 | (33.5) | ||||||||||||||
| Retirement benefits expense | $ | 1.1 | $ | 33.9 | $ | (32.8) | |||||||||||
Primary reason for change. The decrease in retirement benefits expense was primarily due to lower amortization of net actuarial losses as a result of an increase in the discount rate used to calculate the benefits obligation at December 31, 2021.
In 2023, we expect to record a benefit of approximately $10 million associated with our retirement benefit plans. Additionally, we estimate the CAS recoverable amounts related to the retirement benefit plans to be approximately $32 million in 2023. See "Critical Accounting Policies and Estimates - Retirement Benefit Plans" for more information about our accounting practices with respect to retirement benefits.
Operating Segment Information
We evaluate our operating segments based on several factors, of which the primary financial measure is segment performance. Segment performance represents net sales less applicable costs, expenses and provisions for unusual items relating to the segment. Excluded from segment performance are: corporate income and expenses, interest expense, interest income, income taxes, and unusual items not related to the segment. We believe that segment performance provides information useful to investors in understanding our operational performance.
Aerospace and Defense Segment
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions, except percentage amounts) | |||||||||||||||||
| Net sales | $ | 2,235.2 | $ | 2,179.3 | $ | 55.9 | |||||||||||
| Segment performance | 252.9 | 285.9 | (33.0) | ||||||||||||||
| Segment margin | 11.3 | % | 13.1 | % | |||||||||||||
Primary reason for change. The increase in net sales was primarily driven by an increase on the NGI program partially offset by lower sales in the RS-25 program. Further, as a result of the 2022 calendar, Aerojet Rocketdyne had 53 weeks of operations in 2022 compared with 52 weeks of operations in 2021. The additional week of operations, which occurred in the fourth quarter of 2022, and accounted for $42.3 million in additional net sales, is included in the discussion above regarding program changes.
The decrease in segment margin was primarily driven by (i) cost growth from supply chain disruptions and necessary technical and manufacturing changes on a portion of the Standard Missile program; (ii) favorable contract performance on the RS-68 program in the prior year; and (iii) legal settlements in the current year. These factors were partially offset by lower retirement benefits expense.
Our contracts are largely categorized as either "fixed-price" (largely used by the U.S. government for production-type contracts) or "cost-reimbursable" (largely used by the U.S. government for development-type contracts). Fixed-price contracts present the risk of unreimbursed cost overruns, potentially resulting in lower than expected contract profits and margins. This risk is generally lower for cost-reimbursable contracts which, as a result, generally have a lower margin. The following table summarizes the percentages of net sales by contract type:
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| Fixed-price | 55 | % | 57 | % | |||||||
| Cost-reimbursable | 45 | 43 | |||||||||
During 2022, we had $33.8 million of net unfavorable changes in contract estimates on operating results before income taxes compared with net favorable changes of $31.2 million during 2021.
26
Real Estate Segment
| Year Ended December 31, | |||||||||||||||||
| 2022 | 2021 | Change | |||||||||||||||
| (In millions) | |||||||||||||||||
| Net sales | $ | 2.4 | $ | 8.7 | $ | (6.3) | |||||||||||
| Segment performance | (1.0) | 2.9 | (3.9) | ||||||||||||||
Primary reason for change. During 2022, net sales and segment performance consisted primarily of rental property operations. During 2021, we recognized net sales of $6.2 million associated with an industrial land sale which resulted in a pre-tax gain of $2.3 million.
Backlog
As of December 31, 2022, our total remaining performance obligations, also referred to as backlog, totaled $6.8 billion. We expect to recognize approximately 33%, or $2.3 billion, of the remaining performance obligations as sales over the next twelve months, an additional 27% the following twelve months, and 40% thereafter. The following table summarizes backlog:
| As of December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| (In billions) | |||||||||||
| Funded backlog | $ | 3.1 | $ | 3.1 | |||||||
| Unfunded backlog | 3.7 | 3.7 | |||||||||
| Total backlog | $ | 6.8 | $ | 6.8 | |||||||
Total backlog includes both funded backlog (unfilled orders for which funding is authorized, appropriated and contractually obligated by the customer) and unfunded backlog (firm orders for which funding has not been appropriated). Indefinite delivery and quantity contracts and unexercised options are not reported in total backlog. Backlog is subject to funding delays or program restructurings/cancellations which are beyond our control.
Use of Non-GAAP Financial Measures
Adjusted EBITDAP, Adjusted Net Income, and Adjusted EPS
We provide the Non-GAAP financial measures of our performance called Adjusted EBITDAP, Adjusted Net Income, and Adjusted EPS. We use these metrics to measure our operating and total Company performance. We believe that for management and investors to effectively compare core performance from period to period, the metrics should exclude items that are not indicative of, or are unrelated to, results from our ongoing business operations such as retirement benefits (pension and postretirement benefits), significant non-cash expenses, the impacts of financing decisions on earnings, and items incurred outside the ordinary, ongoing and customary course of our business. Accordingly, we define Adjusted EBITDAP as GAAP net income adjusted to exclude interest expense, interest income, income taxes, depreciation and amortization, retirement benefits net of amounts that are recoverable under our U.S. government contracts, and unusual items which we do not believe are reflective of such ordinary, ongoing and customary activities. Adjusted Net Income and Adjusted EPS exclude retirement benefits net of amounts that are recoverable under our U.S. government contracts and unusual items which we do not believe are reflective of such ordinary, ongoing and customary activities. Adjusted Net Income and Adjusted EPS do not represent, and should not be considered an alternative to, net income or diluted EPS as determined in accordance with GAAP.
27
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| (In millions, except per share and percentage amounts) | |||||||||||
| Net income | $ | 74.0 | $ | 146.6 | |||||||
| Interest expense | 18.6 | 20.1 | |||||||||
| Interest income | (5.4) | (2.5) | |||||||||
| Income tax provision | 34.3 | 48.4 | |||||||||
| Depreciation and amortization | 57.3 | 61.4 | |||||||||
| GAAP retirement benefits expense | 1.1 | 33.9 | |||||||||
| CAS recoverable retirement benefits expense | (35.1) | (38.8) | |||||||||
| Unusual items (1) | 94.0 | 29.4 | |||||||||
| Adjusted EBITDAP | $ | 238.8 | $ | 298.5 | |||||||
| Net income as a percentage of net sales | 3.3 | % | 6.7 | % | |||||||
| Adjusted EBITDAP as a percentage of net sales | 10.7 | % | 13.6 | % | |||||||
| Net income | $ | 74.0 | $ | 146.6 | |||||||
| GAAP retirement benefits expense | 1.1 | 33.9 | |||||||||
| CAS recoverable retirement benefits expense | (35.1) | (38.8) | |||||||||
| Unusual items | 94.0 | 29.4 | |||||||||
| Income tax impact of adjustments (2) | (19.0) | (6.6) | |||||||||
| Adjusted Net Income | $ | 115.0 | $ | 164.5 | |||||||
| Diluted EPS | $ | 0.90 | $ | 1.78 | |||||||
| Adjustments | 0.49 | 0.22 | |||||||||
| Adjusted EPS | $ | 1.39 | $ | 2.00 | |||||||
| Diluted weighted average shares, as reported and as adjusted | 83.3 | 81.7 | |||||||||
________
(1) See Note 11 in the consolidated financial statements in Item 8 of this Report for additional information.
(2) The income tax impact is calculated using the federal and state statutory rates in the corresponding year.
Free Cash Flow
We also provide the Non-GAAP financial measure of Free Cash Flow. Free Cash Flow is defined as cash flow from operating activities less capital expenditures. Free Cash Flow should not be considered in isolation as a measure of residual cash flow available for discretionary purposes or as an alternative to cash flows from operations presented in accordance with GAAP. We use Free Cash Flow, both in presenting our results to stakeholders and the investment community, and in our internal evaluation and management of the business. Management believes that this financial measure is useful to investors because it provides supplemental information to assist them in viewing the business using the same tools that management uses to evaluate progress in achieving our goals. The following table summarizes Free Cash Flow:
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| (In millions) | |||||||||||
| Net cash (used in) provided by operating activities | $ | (48.7) | $ | 199.6 | |||||||
| Capital expenditures | (40.7) | (37.3) | |||||||||
| Free Cash Flow | $ | (89.4) | $ | 162.3 | |||||||
Because our method for calculating these Non-GAAP measures may differ from other companies’ methods, the Non-GAAP measures presented above may not be comparable to similarly titled measures reported by other companies. These measures are not recognized in accordance with GAAP, and we do not intend for this information to be considered in isolation or as a substitute for GAAP measures.
28
Liquidity and Capital Resources
We believe that our existing cash and cash equivalents and availability under the Senior Credit Facility coupled with cash generated from our future operations will provide sufficient funds to meet our operating plan for the next twelve months. As of December 31, 2022, we had $322.1 million of cash and cash equivalents as well as $621.1 million of available borrowings under our Senior Credit Facility. However, there are a number of factors that could positively or negatively impact our liquidity position, including:
•failure to complete the Merger;
•reductions, delays or changes in U.S. government spending;
•cost overruns on the Company's contracts that require the Company to absorb excess costs;
•issuance or repurchase of debt or equity securities;
•potential funding of pension liabilities either voluntarily or as required by law or regulation;
•compliance with covenants and other terms and conditions related to our financing arrangements;
•environmental claims related to the Company's current and former businesses and operations;
•reductions in the amount recoverable from environmental claims;
•changes or clarifications to current tax law; and
•risks and uncertainties detailed in Item 1A of this Report.
Cash and Cash Equivalents and Short Term Investments
Our cash and cash equivalents and marketable securities consist of cash, time deposits, money market funds, and investment grade corporate debt securities. Our investment policy and strategy are focused on preservation of capital and supporting our liquidity requirements. Changes in U.S. interest rates affect the interest earned on our cash and cash equivalents and marketable securities, and the market value of those securities. Our strategy is focused on the preservation of capital and supporting our liquidity requirements that meet high credit quality standards, as specified in our investment policy approved by the Audit Committee of our Board of Directors.
We continually evaluate opportunities to sell additional equity or debt securities, obtain credit facilities, obtain finance and operating lease arrangements, enter into financing obligations, repurchase common stock, pay dividends, or repurchase, refinance, or otherwise restructure our debt for strategic reasons or to further strengthen our financial position.
As of December 31, 2022, our combined balance of cash and cash equivalents and restricted cash decreased by $378.2 million to $325.2 million from a balance of $703.4 million as of December 31, 2021.
The cash used in operating activities in 2022 of $48.7 million was primarily due to (i) an increase in accounts receivable and unbilled receivables due to the timing of sales and billings and (ii) income tax payments.
The cash used in investing activities in 2022 of $42.4 million was primarily related to $40.7 million of cash used for capital expenditures and $1.7 million of net investments in marketable securities.
Cash used in financing activities in 2022 was $287.1 million primarily resulting from (i) debt payments and conversion settlements of $263.8 million (ii) $18.9 million of net cash used by our equity plans; (iii) $1.7 million of costs incurred associated with the Senior Credit Facility amendment; and (iv) $2.7 million of dividend payments.
Senior Credit Facility
The Senior Credit Facility matures on September 20, 2025, and consists of (i) a $650.0 million revolving line of credit (the "Revolver") and (ii) a $269.1 million Term Loan. The Term Loan and any borrowings under the Revolver bear interest at the Secured Overnight Financing Rate ("SOFR") plus a SOFR adjustment of 10 basis points for all terms and an applicable margin ranging from 175 to 250 basis points based on our leverage ratio measured at the end of each quarter. In addition to interest, we must pay certain fees including (i) letter of credit fees ranging from 175 to 250 basis points per annum on the amount of issued but undrawn letters of credit and alternative currency rate loans and (ii) commitment fees ranging from 30 to 45 basis points per annum on the unused portion of the Revolver. The Term Loan amortized at a rate of 5.0% per annum as of December 31, 2022. The Company was in compliance with its financial and non-financial covenants as of December 31, 2022.
29
Contractual Obligations
We have contractual obligations and commitments in the form of debt obligations, operating leases, certain other liabilities, and other commitments. The following table summarizes our contractual obligations as of December 31, 2022:
| Payments due by period | |||||||||||||||||||||||||||||
| Total | Less than 1 year | 1-3 years | 3-5 years | After 5 years | |||||||||||||||||||||||||
| (In millions) | |||||||||||||||||||||||||||||
| Senior debt | $ | 262.3 | $ | 13.5 | $ | 248.8 | $ | — | $ | — | |||||||||||||||||||
| Interest on senior debt (1) | 41.7 | 15.9 | 25.8 | — | — | ||||||||||||||||||||||||
| Finance lease obligations (2) | 65.0 | 3.7 | 7.6 | 7.8 | 45.9 | ||||||||||||||||||||||||
| Operating lease obligations | 65.1 | 11.8 | 17.4 | 15.3 | 20.6 | ||||||||||||||||||||||||
| Postretirement medical and life insurance benefits (3) | 14.9 | 2.4 | 4.0 | 3.2 | 5.3 | ||||||||||||||||||||||||
| Purchase obligations (4) | 1,353.8 | 845.9 | 470.1 | 37.8 | — | ||||||||||||||||||||||||
| Conditional asset retirement obligations (5) | 57.4 | 19.0 | 1.5 | 3.4 | 33.5 | ||||||||||||||||||||||||
| Total | $ | 1,860.2 | $ | 912.2 | $ | 775.2 | $ | 67.5 | $ | 105.3 | |||||||||||||||||||
________
(1) Interest on variable senior debt calculated based on the interest rate at December 31, 2022.
(2) We have an additional finance lease that has not yet commenced amounting to $22.9 million. This finance lease is expected to commence in 2023 with an expected lease term of 15 years.
(3) The payments presented above are expected payments for the next 10 years. The payments for postretirement medical and life insurance benefits reflect the estimated benefit payments of the plans using the provisions currently in effect. The obligation related to postretirement medical and life insurance benefits is actuarially determined on an annual basis. A substantial portion of these amounts are recoverable through our contracts with the U.S. government.
(4) Purchase obligations represent open purchase orders and other commitments to suppliers, subcontractors, and other outsourcing partners for equipment, materials, and supplies in the normal course of business. These amounts are based on volumes consistent with anticipated requirements to fulfill purchase orders or contracts for product deliveries received, or expected to be received, from customers. A substantial portion of these amounts are recoverable through our contracts with the U.S. government.
(5) The conditional asset retirement obligations presented are related to our Aerospace and Defense segment and are allowable costs under our contracts with the U.S. government.
We expect to make cash contributions of approximately $7 million to our tax-qualified defined benefit pension plan in 2023. We generally are able to recover contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there can be differences between when we contribute to our tax-qualified defined benefit pension plan under pension funding rules and recover it under CAS.
As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, as is defined in rules promulgated by the SEC, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. See Note 8(d) in the consolidated financial statements in Item 8 of this Report for information relating to our off-balance sheet risk.
Critical Accounting Policies and Estimates
Our Consolidated Financial Statements have been prepared with GAAP, which require management to make judgments, estimates and assumptions that affect the reported amounts of assets and liabilities, net revenue and expenses, and the disclosure of contingent assets and liabilities. Our estimates are based on historical experience and assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. We believe that the accounting estimates employed and the resulting balances are reasonable; however, actual results may differ from these estimates and such differences may be material. We believe the following critical accounting policies are affected by significant estimates, assumptions or judgments used in the preparation of our Consolidated Financial Statements.
The areas most affected by our accounting policies and estimates are revenue recognition, retirement benefit plans, environmental remediation costs and recoveries, and income taxes. Except for income taxes, which are not allocated to our operating segments, these areas affect the financial results of our business segments.
Revenue Recognition
In our Aerospace and Defense segment, the majority of our revenue is earned from long-term contracts to design, develop, and manufacture aerospace and defense products, and provide related services, for our customers, including the U.S. government, major aerospace and defense prime contractors, and the commercial sector. Each customer contract defines our distinct performance obligations and the associated transaction price for each obligation. A contract may contain one or multiple performance obligations. In certain circumstances, multiple contracts with a customer are required to be combined in determining the distinct performance obligation. For contracts with multiple performance obligations, we allocate the contracted transaction price to each performance obligation based upon the relative standalone selling price, which represents the price at which we
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would sell the promised good or service separately to the customer. We determine the standalone selling price based upon the facts and circumstances of each obligated good or service. The majority of our contracts have no observable standalone selling price since the associated products and services are customized to customer specifications. As such, the standalone selling price generally reflects our forecast of the total cost to satisfy the performance obligation plus an appropriate profit margin.
Contract modifications are routine in the performance of our long-term contracts. Contracts are often modified to account for changes in contract specifications or requirements. In most instances, contract modifications are for goods or services that are not distinct, and, therefore, are accounted for as part of the existing contract.
We recognize revenue as each performance obligation is satisfied. The majority of our aerospace and defense performance obligations are satisfied over time either as the service is provided, or as control transfers to the customer. Transfer of control is evidenced by our contractual right to payment for work performed to date plus a reasonable profit on contracts with highly customized products that we have no alternative use for. We measure progress on substantially all our performance obligations using the cost-to-cost method, which we believe best depicts the transfer of control of goods and services to the customer. Under the cost-to-cost method, we record revenues based upon costs incurred to date relative to the total estimated cost at completion. Contract costs include labor, material, overhead, and general and administrative expenses, as appropriate.
Recognition of revenue and profit on long-term contracts requires the use of assumptions and estimates related to the total contract value, the total cost at completion, and the measurement of progress towards completion for each performance obligation. Due to the nature of the programs, developing the estimated total contract value and total cost at completion for each performance obligation requires the use of significant judgment.
The contract value of long-term contracts may include variable consideration, such as incentives, awards, or penalties. The value of variable consideration is generally determined by contracted performance metrics, which may include targets for cost, performance, quality, and schedule. We include variable consideration in the transaction price for the respective performance obligation at either estimated value, or most likely amount to be earned, based upon our assessment of expected performance. We record these amounts only to the extent it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved.
We evaluate the contract value and cost estimates for performance obligations at least quarterly and more frequently when circumstances significantly change. Factors considered in estimating the work to be completed include, but are not limited to: labor productivity, the nature and technical complexity of the work to be performed, availability and cost volatility of materials, subcontractor and vendor performance, warranty costs, volume assumptions, anticipated labor agreements, inflationary trends, schedule and performance delays, availability of funding from the customer, and the recoverability of costs incurred outside the original contract included in any estimates to complete. When our estimate of total costs to be incurred to satisfy a performance obligation exceeds the expected revenue, we recognize the loss immediately. When we determine that a change in estimates has an impact on the associated profit of a performance obligation, we record the cumulative positive or negative adjustment to the statement of operations. Changes in estimates and assumptions related to the status of certain long-term contracts may have a material effect on our operating results. The following table summarizes the impact of the changes in significant contract accounting estimates on our Aerospace and Defense segment operating results:
| Year Ended December 31, | |||||||||||
| 2022 | 2021 | ||||||||||
| (In millions, except per share amounts) | |||||||||||
| Net (unfavorable) favorable effect of the changes in contract estimates on net sales | $ | (21.4) | $ | 34.8 | |||||||
| (Unfavorable) favorable effect of the changes in contract estimates on income before income taxes | (33.8) | 31.2 | |||||||||
| (Unfavorable) favorable effect of the changes in contract estimates on net income | (23.1) | 23.5 | |||||||||
| (Unfavorable) favorable effect of the changes in contract estimates on basic and diluted EPS | (0.29) | 0.29 | |||||||||
See Note 1 in the consolidated financial statements in Item 8 of this Report for additional information.
Retirement Benefit Plans
We discontinued future benefit accruals for our defined benefit pension plans in 2009. We provide medical and life insurance benefits to certain eligible retired employees, with varied coverage by employee group. Annual charges are made for the cost of the plans, including interest costs on benefits obligations, and net amortization and deferrals, increased or reduced by the return on assets. We also sponsor a defined contribution 401(k) plan and participation in the plan is available to all employees.
Retirement benefits are a significant cost of doing business and represent obligations that will be ultimately settled far in the future and therefore are subject to estimates. We generally are able to recover cash contributions related to our tax-qualified defined benefit pension plan as allowable costs on our U.S. government contracts, but there is a lag between when we contribute cash to our tax-qualified defined benefit pension plan under pension funding rules and recover it under our U.S. government contracts. Our pension and medical and life insurance benefits obligations and related costs are calculated using actuarial concepts in accordance with GAAP. We are required to make assumptions regarding such variables as the expected long-term rate of return on assets and the discount rate applied to determine the retirement benefits obligations and expense (income) for the year.
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The following table presents the assumptions to determine the benefits obligations:
Pension Benefits | Medical and Life Insurance Benefits | ||||||||||||||||||||||
| As of December 31, | As of December 31, | ||||||||||||||||||||||
2022 | 2021 | 2022 | 2021 | ||||||||||||||||||||
| Discount rate | 5.56 | % | 2.90 | % | 5.66 | % | 2.77 | % | |||||||||||||||
The following table presents the assumptions to determine the retirement benefits expense (income):
| Pension Benefits | Medical and Life Insurance Benefits | ||||||||||||||||||||||
| Year Ended December 31, | Year Ended December 31, | ||||||||||||||||||||||
| 2022 | 2021 | 2022 | 2021 | ||||||||||||||||||||
| Discount rate | 2.90 | % | 2.52 | % | 2.77 | % | 2.28 | % | |||||||||||||||
| Expected long-term rate of return on assets | 7.00 | % | 7.00 | % | * | * | |||||||||||||||||
____
* Not applicable as our medical and life insurance benefits are unfunded.
The discount rate represents the current market interest rate used to determine the present value of future cash flows currently expected to be required to settle pension obligations. Based on market conditions, discount rates can experience significant variability. Changes in discount rates can significantly change the liability and, accordingly, the funded status of the pension plan. The assumed discount rate represents the market rate available for investments in high-quality fixed income instruments with maturities matched to the expected benefit payments for pension and medical and life insurance benefit plans.
The expected long-term rate of return on assets represents the rate of earnings expected in the funds invested, and funds to be invested, to provide for anticipated benefit payments to plan participants. We evaluated the historical investment performance, current and expected asset allocation, and, with input from our external advisors, developed best estimates of future investment performance.
Market conditions and interest rates significantly affect assets and liabilities of our pension plans. Pension accounting permits market gains and losses to be deferred and recognized over a period of years. This "smoothing" results in the creation of other accumulated income or loss which will be amortized to pension costs in future years. The accounting method we utilize recognizes one-fifth of the unamortized gains and losses in the market-related value of pension assets and all other gains and losses including changes in the discount rate used to calculate the benefits obligation each year. Investment gains or losses for this purpose are the difference between the expected return and the actual return on the market-related value of assets which smoothes asset values over three years. Although the smoothing period mitigates some volatility in the calculation of annual pension costs, future pension costs are impacted by changes in the market value of assets and changes in interest rates.
The following table summarizes the effects of a one-percentage-point change in key assumptions on the projected benefits obligations as of December 31, 2022, and on retirement benefits expense for 2022:
Pension Benefits and Medical and Life Insurance Benefits Discount Rate | Expected Long-term Rate of Return | Assumed Healthcare Cost Trend Rate | |||||||||||||||||||||||||||
Net Periodic Benefit Expense | Projected Benefit Obligation | Net Periodic Pension Benefit Expense | Net Periodic Medical and Life Insurance Benefit Expense | Accumulated Benefit Obligation | |||||||||||||||||||||||||
| (In millions) | |||||||||||||||||||||||||||||
| 1% decrease | $16.5 | $80.7 | $9.0 | $— | $(0.1) | ||||||||||||||||||||||||
| 1% increase | $(14.2) | $(69.7) | $(9.0) | $— | $0.1 | ||||||||||||||||||||||||
Environmental Reserves and Estimated Recoveries
We accrue for costs associated with the remediation of environmental contamination when it becomes probable that a liability has been incurred, and when our costs can be reasonably estimated. In most cases, only a range of reasonably probable costs can be estimated. In establishing the reserves, the most probable estimated amount is used when determinable, and the minimum amount is used when no single amount in the range is more probable. Environmental reserves include the costs of completing remedial investigation and feasibility studies, remedial and corrective actions, regulatory oversight costs, the cost of operation and maintenance of the remedial action plan, and employee compensation costs for employees who are expected to devote a significant amount of time to remediation efforts. Calculation of environmental reserves is based on the evaluation of currently available information with respect to each individual environmental site and considers factors such as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. Such estimates are based on the expected costs of investigation and remediation and the likelihood that other potentially responsible parties will be able to fulfill their commitments at sites where we may be jointly or severally liable.
The following table summarizes our environmental reserve activity in 2022 (in millions):
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| Balance at January 1, 2022 | $ | 296.4 | |||
| Additions | 33.8 | ||||
| Expenditures | (39.7) | ||||
| Balance at December 31, 2022 | $ | 290.5 | |||
The $33.8 million of environmental reserve additions in 2022 was primarily due to the following items: (i) $13.9 million of remediation related to operable treatment units; (ii) $13.0 million of additional operations and maintenance for treatment facilities; (iii) $3.9 million of additional costs at inactive Rancho Cordova Test Sites; and (iv) $3.0 million related to other environmental clean-up matters.
At the time a liability is recorded for future environmental costs, we record an asset for estimated future recoveries that are estimable and probable. Some of our environmental costs are eligible for future recovery in the pricing of our products and services to the U.S. government and under existing third party agreements. We consider the recovery probable based on the Global Settlement, U.S. government contracting regulations, and our long history of receiving reimbursement for such costs.
The following table summarizes the activity in the current and non-current recoverable amounts from the U.S. government and Northrop in 2022 (in millions):
| Balance at January 1, 2022 | $ | 298.9 | |||
| Additions | 29.6 | ||||
| Reimbursements | (34.9) | ||||
| Other adjustments | (6.0) | ||||
| Balance at December 31, 2022 | $ | 287.6 | |||
The activity for recoveries is commensurate with the activity associated with the environmental reserve activity.
The expenses associated with adjustments to the environmental reserves are recorded as a component of other expense, net in the consolidated statements of operations. Expenses associated with adjustments to the environmental reserves incurred throughout 2022 totaled $4.1 million.
Income Taxes
We file a consolidated U.S. federal income tax return for the Company and our 100% owned consolidated subsidiaries. The deferred tax assets and/or liabilities are determined by multiplying the differences between the financial reporting and tax reporting bases for assets and liabilities by the enacted tax rates expected to be in effect when such differences are recovered or settled. The effect on deferred taxes of a change in tax rates is recognized in the period of the enactment date of the change.
The carrying value of our deferred tax assets is dependent upon our ability to generate sufficient taxable income in the future. A valuation allowance is required when it is more likely than not that all or a portion of a deferred tax asset will not be realized. A review of all available positive and negative evidence is considered, including our past and future performance, the market environment in which we operate, the utilization of tax attributes in the past, the length of carryback and carryforward periods, and evaluation of potential tax planning strategies.
We believe that certain positions may be challenged by taxing authorities. Settlement of any challenge can result in no change, a complete disallowance, or a partial adjustment reached through negotiations or litigation. Our tax reserves reflect the difference between the tax benefit claimed on tax returns and the amount recognized in the financial statements. The accounting standards provide guidance for the recognition and measurement in financial statements of uncertain tax positions taken or expected to be taken in a tax return. The evaluation of a tax position is a two-step process, the first step being recognition. We determine whether it is more likely than not that a tax position will be sustained upon tax examination, including resolution of any related appeals or litigation, based on only the technical merits of the position. The technical merits of a tax position are derived from both statutory and judicial authority (legislation and statutes, legislative intent, regulations, rulings, and case law) and their applicability to the facts and circumstances of the tax position. If a tax position does not meet the more likely than not recognition threshold, the benefit of that position is not recognized in the financial statements. The second step is measurement. A tax position that meets the more likely than not recognition threshold is measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate resolution with a taxing authority. As the examination process progresses with tax authorities, adjustments to tax reserves may be necessary to reflect taxes payable upon settlement. Tax reserve adjustments related to positions impacting the effective tax rate affect the provision for income taxes. Tax reserve adjustments related to positions impacting the timing of deductions impact deferred tax assets and liabilities.
Recently Adopted Accounting Pronouncements
See Note 1 in the consolidated financial statements in Item 8 of this Report for information relating to our discussion of the effects of recent accounting pronouncements.
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Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Policies and Procedures
As an element of our normal business practice, we have established policies and