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YoY shift: Neutral
Year-over-year tone shift - average net-tone change across Risk Factors and MD&A vs the prior 10-K. This filing is -0.05pp more bearish than last year's.
Why YoY instead of absolute: the LM lexicon has ~6.6× more negative words than positive (legal/risk-disclosure language is heavy on hedging), so every 10-K reads bearish on raw tone. Year-over-year change strips that bias and surfaces the actual shift in management's framing.
Tone shift by section
The two components the gauge averages: how Risk Factors and MD&A each shifted in net tone versus last year's 10-K. The headline above is their average, so a green needle over a soft section just means the other section carried it.
Risk Factors
+0.00pp
Flat
Net-tone change vs last year's 10-K.
MD&A
-0.09pp
Flat
Net-tone change vs last year's 10-K.
Per-snippet highlights
Sentence-level sentiment highlighting with category and subcategory filters is coming once the snippet-scoring pipeline lands. For now, dig into the actual section text on the Sections tab.
Risk Factors (Item 1A)
18,534 words
ITEM 1A. RISK FACTORS
We operate in a changing global environment that involves numerous known and unknown risks and uncertainties that could materially adversely affect our financial condition, results of operations, cash flows, and competitive position. The Company’s financial condition, results of operations, cash flows, and competitive position could be significantly affected by the risks below or additional risks not presently known to the Company or by risks that the Company presently deems immaterial.
The risk factors set forth below describe what we believe to be the material risks, and uncertainties related to our financial condition, results of operations, cash flows, and competitive position. We have grouped the risk factors into four categories for ease of reading, and without any reflection on the importance of, or likelihood of, any particular category.
Summary Risk Factors
The following is a summary of what we believe to be the material risks and uncertainties that could materially adversely affect our financial condition, results of operations, cash flows, and competitive position.
Language change vs prior 10-K
MD&A (Item 7) - words with the biggest YoY frequency increase
Negative rising
restatement+3
restated+2
corrects+1
errors+1
Positive rising
No words rose this year.
MD&A (Item 7)
7,650 words
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of our financial statements with a narrative from the perspective of management on the Company’s financial condition, results of operations, liquidity and certain other factors that may affect future results. The following discussion of the Company’s financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes contained in this Annual Report on Form 10-K/A. Certain information contained in the discussion and analysis set forth below includes forward-looking statements. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many factors, including those set forth under “ Note Regarding Forward-Looking Statements”, Item 1A - “Risk Factors” and elsewhere in this Annual Report on Form 10-K/A. Unless otherwise noted, the MD&A compares the year ended December 31, 2020 to the year ended December 31, 2019.
• A loss of contracts, failure to obtain new contracts or reduction of services under existing contracts with the U.S. Government could adversely affect PAE’s operating performance.
• Customers could assert claimsagainst PAE if PAE experiences service failures or fails to properly manage projects.
• PAE’s reputation and its ability to do business may be impacted by the improper conduct of employees, agents, business partners or others working on its behalf.
• Disruptions in supply of key materials and difficulties in the supplier qualification process, as well as increases in prices of materials, could adversely impact PAE’s results of operations.
• If PAE’s subcontractors, prime contractors or joint venture partners fail to perform their contractual obligations or if PAE does not maintain business relationships, then PAE’s performance could be adversely impacted.
• A negative audit or other investigations by the U.S. Government could adversely affect PAE’s ability to receive U.S. Government contracts.
• As a U.S. Government contractor, PAE is subject to various procurement and other laws and regulations and could be adversely affected by failure to comply with these laws.
• PAE is subject to the U.S. Government’s facility and personnel security clearance requirements, which are prerequisites to its ability to perform on classified contracts.
• Some of PAE’s contracts with the U.S. Government are classified, which may limit investor insight into portions of its business.
• PAE is subject to various data privacy and cybersecurity risks that could require significant investment into ongoing compliance activities or result in liability under various laws.
• PAE could incur significant liabilities as a result of environmental laws and regulations.
• PAE is subject to various claims, litigation and other disputes that could be resolved adversely.
• PAE’s business could be adversely affected by bid protests.
• PAE is exposed to risks associated with operating internationally. PAE has operations in the Middle East and in certain regions that may experience turmoil, political unrest and destabilization, insurgency, war or terrorism.
• PAE faces various risks related to public health crises, such as the COVID-19 pandemic.
• The loss of any member of PAE’s senior management could impair its relationships with U.S. Government customers and disrupt the management of its business. PAE may not be able to attract and retain skilled employees or contractors.
• Expiration of collective bargaining agreements may increase operating costs or cause work disruptions.
• PAE may not receive the full amounts estimated in its backlog.
• PAE’s financial results may vary significantly from quarter-to-quarter.
• Changes in estimates when accounting for contracts could have an adverse effect on PAE’s financial results.
• PAE’s earnings and profitability may vary based on the mix of its contracts and may be adversely affected by our failure to recover expenses, time and resources for our contracts.
• PAE could be adversely affected if clients do not approve requests for adjustments or claims.
• PAE may pursue or complete acquisitions, or other transactions, which represent additional risk and could impact future financial results. PAE may be unable to realize any benefit from its restructuring or cost reduction efforts.
• PAE may need additional capital to fund the growth of its business, and financing may not be available on favorable terms or at all.
• PAE may not able to obtain adequate indemnity or insurance coverage.
• Impairment of our goodwill assets could adversely affect PAE.
• Unanticipated changes in PAE’s tax provisions or exposure to additional U.S. and foreign tax liabilities could affect PAE’s profitability.
• Government withholding regulations could adversely affect PAE.
• The level of returns on pension and postretirement plan assets, changes in interest rates and other factors could adversely affect PAE’s earnings and cash flows.
• Unanticipated changes in effective tax rates or adverse outcomes resulting from examination of our income or other tax returns could adversely affect us.
Risks Related to PAE’s Industry
• U.S. Government contracts may be subject to cancellation or delay by customers without penalty, PAE’s contracts are typically subject to recompetition, and PAE may not win the recompetition or may receive a significantly lower workshare.
• The failure by Congress to approve appropriations on a timely basis for the U.S. Government agencies supported by PAE could delay procurement of its services.
• Competition in PAE’s industry could limit its ability to attract and retain customers.
• U.S. Government contracting policies create preferences for various minority-owned, small and disadvantaged businesses that could limit PAE’s ability to be a prime contractor on certain government procurements.
• U.S. Government in-sourcing could result in loss of business opportunities and personnel.
Risks Related to PAE’s Indebtedness
• PAE’s substantial level of indebtedness could adversely affect it and prevent it from making dividends and distributions and payments on its other debt obligations (if any).
• Restrictive covenants in PAE’s credit agreements could restrict its operating flexibility.
• PAE’s credit agreements contain cross default or cross acceleration provisions that may cause all the debt issued under those instruments to become immediately due and payable.
• PAE may not be able to service its indebtedness if it does not generate sufficient cash flows.
• The phase-out of LIBOR may adversely affect PAE’s outstanding debt.
Risks Related to Our Class A Common Stock and Warrants
• Platinum Equity has significant influence over us, including the contractual right to nominate certain directors.
• Anti-takeover provisions contained in our certificate of incorporation and bylaws, as well as provisions of Delaware law, could impair a takeover attempt. Our bylaws include a forum selection clause, which may impact your ability to bring actions against us.
• The terms of the Warrants may be amended in a manner that may be adverse to warrant holders, and we may redeem unexpired Warrants at a time that is disadvantageous to warrant holders.
• If the Warrants are exercised, it would increase the number of shares eligible for future resale in the public market and result in dilution to our stockholders.
I. Risks Related to PAE’s Business
a. Risks Related to Performance and Operations
PAE relies on contracts with U.S. Government entities for substantially all of its revenue. A loss of contracts, a failure to obtain new contracts or a reduction of services provided under existing contracts with the U.S. Government, including as a result of a reduction in U.S. Government spending, could adversely affect PAE’s operating performance and result in a loss of expected revenue.
Substantially all of PAE’s revenue is derived from services ultimately provided to the U.S. Government. For the year ended December 31, 2020, PAE generated approximately 89.5% of its total revenue from contracts with the U.S. Government, with 35.7% of its total revenue from the DoD and 18.7% of its total revenue from the DoS. PAE’s largest single contract accounts for approximately 9.0% of its total revenue. The remainder of its revenue is derived from other U.S. agencies, including DHS, National Aeronautics and Space Administration (“NASA”), U.S. intelligence agencies, the National Science Foundation, non-governmental organizations and U.S. Government allies. PAE expects that U.S. Government contracts will continue to be its primary source of revenue for the foreseeable future. The continuation and renewal of PAE’s existing U.S. Government contracts and entrance into new U.S. Government contracts are, among other things, contingent upon the availability of adequate funding for various U.S. Government agencies. Changes in U.S. Government spending could directly affect PAE’s operating performance and result in a loss of expected revenue. The loss or significant reduction in government funding of a program in which PAE participates could also result in a material decrease to PAE’s future sales, earnings and cash flows.
U.S. Government contracts are also conditioned upon the approval of spending by the U.S. Congress. In addition, Congress usually appropriates funds for a given program on a September 30 fiscal year basis, even though contract periods of performance may extend over many years. Consequently, at the beginning of a major program, the contract is usually partially funded and additional monies are normally committed to the contract by the procuring agency only as appropriations are made by Congress for future fiscal years. The factors that could impact U.S. Government spending and reduce PAE’s U.S. Government contracting business include: (i) policy and/or spending changes implemented by the incoming administration, any subsequent administration or Congress; (ii) a significant decline in, or reapportioning of, spending by the U.S. Government in general; (iii) changes, delays or cancellations of U.S. Government programs, requirements or policies; (iv) the adoption of new laws or regulations that affect companies that provide services to the U.S. Government; (v) U.S. Government shutdowns or other delays in the government appropriations process; (vi) changes in the political climate, including with regard to the funding or operation of the services PAE provides; and (vii) general economic conditions, including a slowdown in the economy or unstable economic conditions in the United States or in the countries in which PAE operates.
A change in any number of public policy objectives, including with respect to national security and foreign aid, could impact PAE’s business positively or negatively. For example, if the U.S. Government withdraws from Afghanistan or Iraq, PAE’s business could be materially impacted. Also, by way of example, changes in immigration policy and border protection in the United States could negatively impact PAE’s business.
These or other factors could cause U.S. Government agencies to reduce their purchases under PAE’s contracts, to exercise their right to terminate PAE’s contracts in whole or in part, to issue temporary stop-work orders or to decline to exercise options to renew PAE’s contracts. The loss or significant curtailment of PAE’s material U.S. Government contracts, the decision by PAE’s customers not to renew existing contracts or a failure to enter into new contracts could adversely affect PAE’s operating performance and result in a loss of expected revenue.
If PAE experiences service failures or fails to properly manage projects, its customers could assert claimsagainst it for damages or refunds and its reputation could be harmed.
PAE’s engagements often involve large-scale, highly complex projects and PAE designs, implements and maintains service solutions that are often critical to PAE’s customers’ operations. The quality of PAE’s performance on such projects depends in large part upon its ability to manage the relationship with its customers, and to effectively manage the project and deploy appropriate resources, including third-party contractors and PAE’s own personnel, in a timely manner. PAE has experienced, and may in the future experience, service failures or schedule delays and other problems in connection with its work. If PAE experiences these problems, it may: (i) lose revenue due to adverse customer reaction; (ii) be required to provide additional services to a customer at no charge; (iii) cause customers to postpone, cancel or fail to renew contracts; and/or (iv) receive negative publicity, which could damage PAE’s reputation and adversely affect its ability to attract or retain customers. If a project experiences a performance problem, PAE may not be able to recover the additional costs it will incur, which could exceed revenues realized from a project. Finally, if PAE underestimates the resources or time it needs to complete a project with capped or fixed fees, it may not be able to recover such overage and its operating results could be seriouslyharmed.
Additionally, any errors or failure to meet customers’ expectations could result in claims for substantial damagesagainst PAE. PAE’s U.S. Government contracts generally limit its liability for damages that arise from negligent acts, errors, mistakes or omissions in rendering services to its customers to claims based on the contract itself (excluding fraud or false claim liabilities). However, PAE cannot be sure that these contractual provisions will protect it from liability for damages in the event it is involved in a dispute with a customer. PAE’s errors and omissions and product liability insurance coverage may not be adequate, may not continue to be available on commercially reasonable terms or otherwise, or may not be in sufficient amounts to cover one or more significant claims. In addition, the insurer may disclaim coverage as to some types of future claims, or the liability may be less than the insurance retention.
The successful assertion of any significant claim against PAE could seriouslyharm its business. Even if not successful, these claims could result in significant legal and other costs, may be a distraction to PAE’s management and may harm PAE’s reputation.
PAE’s reputation and its ability to do business may be impacted by the improper conduct of employees, agents, business partners or others working on its behalf.
PAE’s employees, agents and others working on its behalf may take actions or engage in conduct that could violate the applicable laws of the jurisdictions in which PAE operates, including laws governing improper payments to government officials, the protection of export controlled or classified information, cost accounting and billing, competition, data privacy, post-employment restrictions for government employees and protection of proprietary information of former employers or third parties. In addition, PAE’s employees, agents or others may engage in fraud or self-dealing activities that damage the Company. PAE may not be able to prevent all such misconduct committed by its employees, agents or others working on its behalf, and the risk of misconduct may increase in the current economic and geopolitical environment and as PAE continues to expand globally.
Such improper actions could subject PAE to civil and criminalpenalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. Government and other foreign governments and organizations, which could materially and negatively impact PAE’s reputation, operating performance, and ability to conduct business and could have an adverse effect on its financial position, results of operations and/or cash flows.
Disruptions in the supply of PAE’s key materials and difficulties in the supplier qualification process, as well as increases in prices of materials, could adversely impact its results of operations.
PAE’s business is affected by the price and availability of materials, such as fuel, water, food and component parts that it uses to provide its various services. The prices of PAE’s materials and other supplies are subject to fluctuations attributable to, among other things, changes in supply and demand, transportation and logistics accessibility and affordability, weather conditions and U.S. and other governmental incentives and controls. PAE’s business, therefore, could be adversely impacted by factors affecting its suppliers (such as, but not limited to, delays due to a pandemic such as COVID-19, the destruction of its suppliers’ facilities or their distribution infrastructure, a work stoppage or strike by its suppliers’ employees or the failure of its suppliers to provide materials of the requisite quality), or by increased costs of such materials or components if PAE was unable to pass along such price increases to its customers. PAE’s business could also be adversely affected if it was unable to obtain these materials and components from its suppliers in the quantities it requires or on favorable terms.
Supplier qualification and management is a key element of successful and compliant federal contracting. This requires extension of many of the same regulatory requirements that apply to PAE to its supplier base, incorporation of applicable regulatory requirements into contractual documents, screening of suppliers for violations of law and regulation, and active inspection of supplier business practices. In addition, PAE is reliant on a small number of key suppliers to provide unique source materials such as aircraft components, cameras, and communication devices which are not available from other sources and must be protected from tampering or counterfeiting. PAE’s failure to secure its supply chain againstdisruption due to regulatory noncompliance, physical threats, or cyber threats could have an adverse impact on PAE’s financial position, results of operations and/or cash flows.
If PAE’s subcontractors, prime contractors or joint venture partners fail to perform their contractual obligations, or if PAE does not maintain business relationships, then PAE’s performance and its ability to obtain future business could be materially and adversely impacted.
PAE subcontracts with other companies to perform a portion of the services on some of PAE’s contracts. Subcontractors, which represented 22.8% of PAE’s direct costs for the year ended December 31, 2020, generally perform niche or specialty services for which they have more direct experience, such as catering services or specialized technical services, or otherwise have local knowledge of the region in which a contract will be performed. Often, PAE enters into subcontract arrangements to comply with requirements to award certain categories of services to small businesses. PAE generally does not have long-term contractual commitments with subcontractors, and skilled subcontractors may not continue to be available at reasonable rates and in the areas in which PAE conducts its operations. The inability to contract with skilled subcontractors at reasonable costs on a timely basis could have an adverse effect on PAE’s financial position, results of operations and/or cash flows. During performance of a contract, failure by a subcontractor to satisfactorily and timely deliver the agreed-upon supplies or services, violation of applicable U.S. Government procurement rules (such as, but not limited to, Combating Trafficking in Persons laws), or failure to pay lower tier subcontractors in a timely fashion may result in early termination of the agreement with that subcontractor or may harm PAE’s reputation and materially and adversely impact the Company’s ability to perform its obligations as the prime contractor. Government decisions to remove elements of work from a
contract due to dissatisfaction with performance, funding limitations, or changes in contracting practices and priorities may also result in a need to terminate subcontract agreements. Such subcontractor performance deficiencies could also result in a customer terminating PAE’s contract for default. A termination for default could expose PAE to liability and adversely affect PAE’s operating performance and result in a loss of expected revenue.
In addition, PAE often enters into joint ventures so that it can jointly bid and perform on a particular project or projects. The success of these and other joint ventures depends, in large part, on the satisfactory performance of the contractual obligations by PAE’s joint venture partners. PAE may not be able to effectively influence the operations of its joint ventures, or if PAE’s partners do not meet their obligations, the joint ventures may be unable to adequately perform and deliver their contracted services. Under these circumstances, PAE may be required to make additional investments and provide additional services to ensure the adequate performance and delivery of the contracted services. These additional obligations could result in reduced profits or, in some cases, significant losses for PAE with respect to such joint venture, which could also affect its reputation in the industries PAE serves.
Maintaining relationships with other U.S. Government contractors, who may also be its competitors, is important to PAE’s business and its failure to do so could have an adverse effect on PAE’s financial position, results of operations and/or cash flows. To the extent that PAE fails to maintain good relationships with its subcontractors or other prime contractors due to either perceived or actual performance failures or other conduct, they may refuse to hire PAE as a subcontractor in the future or to work with PAE as a subcontractor. In addition, other contractors may choose not to use PAE as a subcontractor or choose not to perform work for PAE as a subcontractor for any number of additional reasons, including because they choose to establish relationships with PAE’s competitors or because they choose to directly offer services that compete with PAE’s business.
A negative audit or other investigations by the U.S. Government could adversely affect PAE’s ability to receive U.S. Government contracts and its future operating performance, and could result in financial or reputational harm, including disbarment from receiving government contracts.
PAE operates in a highly regulated environment and is routinely audited and reviewed by the U.S. Government and its agencies, such as the DCAA, the DCMA, the Defense Criminal Investigative Service, the DoD Inspector General, other agency inspectors general, the Special Inspector General for Afghanistan Reconstruction, the Special Inspector General for Iraq Reconstruction, the Office of Federal Contract Compliance Programs and the DoL. These agencies review performance under PAE’s contracts, PAE’s cost structure and PAE’s compliance with applicable laws, regulations and standards, as well as the adequacy of, and PAE’s compliance with, its internal control systems and policies. Costs ultimately found to be unallowable or improperly allocated to a specific contract will not be paid or must be refunded or credited to the U.S. Government if already disbursed PAE has received in the past, and may receive in the future government audit findings that include millions of dollars of questioned costs.
Audits may also review the adequacy of, and PAE’s compliance with, its internal control systems and policies, including PAE’s labor, billing, accounting, purchasing, property, estimating, compensation and management information systems. Any costs found to be improperly allocated to a specific contract will not be paid. In addition, payments received by PAE for allowable direct and indirect costs are subject to adjustment after audit by U.S. Government auditors and repayment to the U.S. Government may be required if the payments do not comply with restrictions on allowable costs as provided in U.S. Government contracts. PAE’s audit risk with respect to these issues increases when it is performing services or supplying goods outside of the United States in contingency environments and other especially demanding circumstances. Any negative results from any audit of PAE’s control systems and policies by any U.S. Government agency, including any findings that PAE has not complied with any required
policies or procedures, could delay or materially adversely affect PAE’s ability to invoice and receive timely payment on its contracts, perform contracts or compete for future contracts with the U.S. Government and could have an adverse effect on PAE’s operating performance.
U.S. Government contractors that provide support services in theaters of conflict such as Iraq and Afghanistan have come under increased scrutiny by agency inspectors general, special inspectors general, U.S. Government auditors, congressional committees, and public advocacy groups. Investigations pursued by any or all of these groups may result in adverse publicity and reputational harm for PAE, regardless of the underlying merit of the allegations being investigated. As a matter of general policy, PAE has cooperated and expects to continue to cooperate with government inquiries of this nature.
Obtaining a designation from the DCMA that a contractor’s purchasing system has been certified as satisfactory is a significant advantage for a government contractor, enabling competition on government contracts that would otherwise be prohibitively difficult or costly to bid, or that would require disclosure of competitively sensitive information. Certified Purchasing System Reviews (“CPSRs”) are highly detailed and commonly result in findings recommending improvements or corrective actions. A significantly negative CPSR may result in decertification of the purchasing system that would result in a far more burdensome business development and proposal process. The requirements for these systems and audits are frequently evolving, and in compliance with such requirements may materially increase PAE’s costs.
As a U.S. Government contractor, PAE is subject to various procurement and other laws and regulations and could be adversely affected by failure to comply with these laws and regulations or changes in such laws and regulations.
U.S. Government contractors must comply with many significant procurement regulations and other specific legal requirements. These regulations and requirements, although customary in U.S. Government contracting, increase PAE’s performance and compliance costs and are regularly evolving. For example, certain U.S. Government contracts that PAE performs in the United States are subject to the Service Contract Act, which requires hourly employees to be paid certain specified wages and benefits, and the Davis Bacon Act, which requires the “prevailing wage” to be paid for construction workers on federal projects as well as submission of a certification to the DoL. If the DoL determines that PAE violated any such laws or the DOL’s implementing regulations, PAE could be suspended from being awarded new U.S. Government contracts or renewals of existing contracts for a period of time, which could adversely affect its future operating performance.
PAE is subject to, and expected to perform in compliance with, a vast array of federal and state civil and criminal laws, including:
• the Truthful Cost or Pricing Data requirements (commonly referred to as the “Truth in Negotiations Act”);
• the Procurement Integrity Act;
• the Anti-Kickback Act;
• the CAS;
• the FAR and agency FAR supplements;
• the International Traffic in Arms Regulations promulgated under the Arms Export Control Act;
• the Close the Contractor Fraud Loophole Act;
• the Services Contract Act;
• the FCA;
• the Davis-Bacon Act; and
• federal and state employment laws and regulations (including equal opportunity and affirmative action requirements).
Actions under many of these laws may be brought by the government or by individuals (including PAE employees or former employees) on behalf of the government (who may then share a portion of any recovery). If PAE fails to comply with any of these laws and regulations, it may be subject to civil and criminalpenalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. Government, or may also sufferharm to its reputation, any of which could impair its ability to win awards of contracts in the future or receive renewals of existing contracts. If PAE is subject to civil and criminalpenalties and administrative sanctions or suffersharm to its reputation, it could have an adverse effect on its financial position, results of operations and/or cash flows.
In addition, PAE is subject to the FCPA, which prohibits improper payments or offers of payments to foreign governments and their officials and political parties for the purpose of obtaining or retaining business. In addition, PAE may also be subject to anti-corruption laws in other jurisdictions, such as the U.K. Bribery Act of 2010. PAE has operations and deals with governmental personnel in countries known to experience, or that may be susceptible to, government corruption. PAE’s activities in these countries create the risk of unauthorized payments or offers of payments by its employees, consultants or contractors that could be in violation of various laws including the FCPA and other anti-corruption laws, even though these parties are not always subject to PAE’s control. In addition, if PAE’s data protection practices become subject to new or different restrictions, and to the extent such practices are not compliant with the laws of the countries in which PAE processes data PAE could face increased compliance expenses and face penalties for violating such laws or be excluded from those markets altogether, in which case its operations could be adversely affected.
Under PAE’s U.S. Government contracts, PAE is required to report significant overpayments it receives from the U.S. Government and other specified violations to the relevant agency inspector general. In 2020, PAE made four mandatory disclosures relating to subcontractor trafficking in persons compliance, subcontractor vendor’s fees, and missing program equipment. In addition, PAE’s compliance with procurement laws and regulations as well as its performance under the terms of its government contracts and subcontracts is periodically reviewed by U.S. Government agencies. PAE is currently, and may, from time to time, be subject to government investigation or litigation brought by or on behalf of the government under the federal regulations. See “Legal Proceedings” for additional information.
New laws, regulations or procurement requirements, or changes to current laws and regulations and requirements (including, for example, regulations related to allowability of compensation costs, counterfeit parts, specialty metals and conflict minerals) can increase PAE’s costs and risks and reduce its profitability. Compliance with diverse and changing legal requirements is costly, time-consuming and requires significant resources. PAE also conducts business in certain identified growth areas, such as national security and national intelligence, which are highly regulated and may expose it to increased compliance risk. Violations of one or more of these diverse legal requirements in the conduct of PAE’s business could result in civil and criminalpenalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. Government, as well as damage to its reputation. Violations of these regulations or contractual obligations related to regulatory compliance in connection with the performance of customer contracts could also result in liability for significant monetary damages, unfavorable publicity and allegations by PAE’s customers that it has not performed its contractual obligations.
PAE is subject to the U.S. Government’s facility and personnel security clearance requirements, including the DoD’s National Industrial Security Program Operating Manual which are prerequisites to its ability to perform on classified contracts for the U.S. Government.
A facility security clearance is required for a company to perform on classified contracts for the DoD and certain other agencies of the U.S. Government. Security clearances are subject to regulations and requirements including the National Industrial Security Program Operating Manual (the “NISPOM”), which specifies the requirements for the protection of classified information released or disclosed in connection with classified U.S. Government contracts. The DCSA manages the facility clearance process under the NISPOM and conducts various facility audits and inspections throughout the lifecycle of a respective facility clearance.
PAE requires certain facility and personnel security clearances to perform its classified U.S. Government business. Any facility that is not audit ready, that is not staffed by appropriately cleared personnel, and/or that fails a routine DCSA inspection places its U.S. Government contracts in jeopardy. As such, PAE must comply with the requirements of the NISPOM and other applicable U.S. Government industrial security regulations. If PAE was to violate the terms and requirements of the NISPOM or such industrial security regulations (which apply to it under the terms of classified contracts), or if one or more of PAE’s facility or personnel security clearances is invalidated or terminated, it may not be able to continue to perform its existing classified contracts and may not be able to enter into new classified contracts, which could adversely affect its revenues. Failure to comply with the NISPOM or other security requirements may result in loss of access to classified information and subject PAE to civil and criminalpenalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. Government, which could have an adverse effect on its financial position, results of operations and/or cash flows.
Some of PAE’s contracts with the U.S. Government are classified, which may limit investor insight into portions of its business.
PAE derives a portion of its revenues from programs with the U.S. Government that are subject to security restrictions (classified programs) that preclude the dissemination of information that is classified for national security purposes. PAE is limited in its ability to provide details about these classified programs, their risks or any disputes or claims relating to such programs. As a result, investors will have less insight into PAE’s classified programs than its other programs and, therefore, less ability to fully evaluate the risks related to its classified business.
Implementation of various data privacy and cybersecurity laws could require significant investment into ongoing compliance activities, trigger potential liability under such laws and limit PAE’s ability to use personal data.
Any failure by PAE, its vendors or other business partners to comply with international, federal, or state laws regarding data privacy or cybersecurity could result in regulatory actions or lawsuits against it, legal liability, fines, damages and other costs. PAE may incur substantial expenses in implementing and maintaining compliance with such laws. Additional, PAE’s international operations also involve activities involving the transmittal of information, which may include personal data, that may expose PAE to data privacy laws in the jurisdiction in which it operates. For example, the General Data Protection Regulation (the “GDPR”), implemented on May 25, 2018 across the European Union (“E.U.”), imposes more stringent data protection obligations on companies that process personal data in the E.U. The GDPR created new compliance obligations, requires investment into ongoing data protection activities and documentation requirements, and creates the potential for significantly increased fines for noncompliance. In addition, California has enacted the California Consumer Protection Privacy Act of 2018 (the “CCPA”), which provides new consumer privacy rights to natural persons
residing in California. The CCPA is the most prescriptive general privacy law in the United States and may lead to similar laws being enacted in other U.S. states or at the federal level. It is possible that the CCPA or similar laws will be deemed applicable to some aspects of PAE’s business, which would impose new compliance obligations and require additional investment into data protection activities. The CCPA went into effect on January 1, 2020. Any obligations that may be imposed on PAE under the CCPA or similar laws may be different from or in addition to those required by the GDPR, which may cause additional expense for compliance across various jurisdictions. The GDPR, the CCPA, and the laws of other U.S. states also impose obligations to maintain a cybersecurity program at a certain level of quality, as well as obligations that may require giving notice to affected individuals and to certain regulators in the event of a data breach.
In addition, many of the systems and networks that PAE develops, installs and maintains for its customers involve managing and protecting personal information and information relating to national security and other sensitive government functions. Cybersecurity threats are significant and evolving and include, among others, malicious software, attempts to gainunauthorized access to data and other electronic security breaches that could lead to disruptions in mission critical systems, unauthorized release of confidential or otherwise protected information and corruption of data. In addition to security threats, PAE is also subject to other potential systems failures, including network, software or hardware failures, whether caused by PAE, third-party service providers (including operators of data centers and physical storage sites), natural disasters, power shortages, terrorist attacks or other events. PAE has been, and expects that it will be in the future, the target of social engineering attacks, including attempts by cybercriminals to spoof Company email accounts and impersonate Company executives in order to gain access to PAE funds. Insurance may have specified sub-limits or exclusions in these cases that limit the recovery of lost funds. While PAE has organizational and technical measures designed to comply with relevant privacy and cybersecurity laws and restrictions, the potential unavailability of PAE’s information or communications systems and/or the failure of these systems to perform as anticipated or any significant breach of data security could cause loss of data, disrupt PAE’s operations, lead to financial losses from remedial actions, require significant management attention and resources, subject PAE to claims for breach of contract, damages, penalties or contract termination, negatively impact PAE’s reputation among its customers and the public and prevent PAE from being eligible for further work on sensitive or classified programs for U.S. Government customers, which could have an adverse effect on PAE’s financial position, results of operations and/or cash flows. PAE has experienced cybersecurity attacks and other systems interruptions in the past and may experience them in the future. If a system or network that it develops, installs or maintains were to fail or experience a security breach or service interruption, whether caused by it, third-party service providers, cybersecurity threats or other events, PAE may experience reputational damage, reimbursement or other compensatory costs, loss of revenue, remediation costs or additional compliance costs or face claims for damages or contract termination. PAE’s insurance may be inadequate to compensate it for all the damages that it may incur and, as a result, could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Environmental laws and regulations may cause PAE to incur significant costs and liabilities that could adversely affect PAE’s operating performance and result in a loss of expected revenue.
PAE’s operations are subject to environmental, health and safety laws, regulations and other requirements in the United States as well as other jurisdictions where it does business. These include requirements governing the use, management and disposal of hazardous, radioactive and explosive substances and wastes, emissions and discharges of pollutants to the air and water, investigation or clean-up of contamination at host sites, and the maintenance of a safe workplace, including the use of personal protective equipment. PAE could incur substantial costs, including costs to install or retrofit pollution control equipment or to address contamination, fines, penalties and/or damageclaims as a result of violations of, or liabilities
under, environmental laws, and these costs and liabilities could have an adverse effect on its financial position, results of operations and/or cash flows.
PAE is subject to various claims, litigation and other disputes that could ultimately be resolved against it.
The size, nature and complexity of PAE’s business make it highly susceptible to claims, litigation and other disputes. For example, PAE is and may become subject to various administrative, civil or criminallitigation, employment litigation, environmental claims, income tax matters, compliance matters, claims and investigations, which could divert financial and management resources and result in fines, penalties, compensatory, treble or other damages or non-monetary relief. U.S. Government regulations also provide that certain allegationsagainst a contractor may lead to suspension or debarment from U.S. Government contracts or suspension of export privileges for PAE or one or more of its components. Suspension or debarment could have an adverse effect on PAE because of its reliance on U.S. Government contracts and authorizations. An adverse resolution or outcome of any of these lawsuits, claims, demands or investigations could have an adverse effect on its financial position, results of operations and/or cash flows. Any investigation, claim, demand or litigation, even if fully indemnified or insured, could negatively impact PAE’s reputation among its customers and the public, and make it more difficult for it to compete effectively or obtain adequate insurance in the future.
PAE’s business could be adversely affected by bid protests.
U.S. Government contract awards are frequently subject to bid protests from unsuccessful bidders on new program awards. It can take many months for the relevant U.S. Government agency to resolveprotests by one or more of PAE’s competitors of contract awards it receives. Bid protests may result in significant expense to PAE and termination or cancellation of an awarded contract as a result of the award being overturned. Even if PAE does not lose the awarded contract, the resulting delay in the startup and funding of the work under these contracts could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
In addition, PAE may protest the contract awards of its competitors when it believes it is prudent to do so to protect its rights and interest in the competition. This process requires the time, effort and attention of PAE’s management and employees and incurs additional costs.
PAE is exposed to risks associated with operating internationally.
A large portion of PAE’s business is conducted internationally. Consequently, PAE is subject to a variety of risks that are specific to international operations, including the following: (i) the burden and cost of compliance with export regulations; (ii) compliance with regulations enforced by the U.S. Department of the Treasury’s Office of Foreign Assets Control; (iii) the burden and cost of compliance with foreign laws, including employment laws, tax regulations, treaties and technical standards and changes in the foregoing; (iv) potential uncertainty with respect to laws and regulations due to a high degree of the difficulty of enforcing agreements and collecting receivables through some foreign legal systems; (v) discretion on the part of governmental authorities, which could result in arbitrary or selective actions against PAE, including suspension or termination of operating licenses; (vi) contract award and funding delays; (vii) potential restrictions on transfers of funds; (viii) import and export duties and value added taxes; (ix) transportation delays and interruptions; (x) uncertainties arising from foreign local business practices and cultural considerations; (xi) the adoption of regulations or enactment of other actions by certain governments that would have a direct or indirect adverse impact on PAE’s business and market opportunities, including nationalization of private enterprise; and (xii) potential military conflicts, civil strife, acts of terrorism and political risks. Similar to PAE’s U.S. Government contracts, many of its contracts with foreign governments are subject to
procurement laws and regulations and governmental funding authorizations and provide such customers the right to terminate contracts at any time without cause.
PAE has operations in the Middle East and in certain regions that may experience turmoil, political unrest and destabilization, insurgency, war or terrorism.
The services PAE provides internationally are sometimes in countries with unstable governments, in areas of military conflict, in hostile and unstable environments, including war zones, or at military installations. Political unrest and destabilization and insurgent activities in the areas in which PAE operates may cause further destabilization in these regions. These factors increase the risk of an incident resulting in damage or destruction to PAE’s work or living sites or resulting in injury or loss of life to its employees, subcontractors or other third parties. PAE maintains insurance to mitigate risk and potential liabilities related to its international operations, but coverage may not be adequate to cover these claims and liabilities and it may be forced to bear substantial costs arising from those claims. Substantial claims in excess of PAE’s related insurance coverage could have an adverse effect on its financial position, results of operations and/or cash flows.
In certain circumstances, including civil war or increased insurgent activities in Iraq or Afghanistan, the U.S. Government may decide to terminate some or all U.S. Government activities, including PAE’s operations under applicable U.S. Government contracts, in a location, country or region and to withdraw all personnel. Acts of terrorism and threats of armed conflicts in or around various areas in which PAE operates could limit or disrupt markets and its operations, including disruptions resulting from the evacuation of personnel, cancellation of contracts or the loss of key employees, contractors or assets. Furthermore, PAE may experience liability arising from accidents or incidents, which could involve significant potential injury, involving its employees or third parties. PAE also may incur material costs to maintain the safety of its personnel or be subject to increasing insurance costs.
We face various risks related to public health crises, such as the coronavirus (“COVID-19”), that could disrupt PAE’s business and result in loss of revenue or higher expenses.
Our operations face risks related to public health crises, such as the global outbreak of COVID-19 and other pandemics and epidemics. The ability of our personnel to work effectively and travel and the continued adequacy of our supply chains have been adversely impacted by the pandemic and responses thereto, such as the travel restrictions resulting from the COVID-19 virus. Additionally, as a result of COVID-19, we have experienced, and expect that we will experience in the future, delays, or partial reductions or full suspensions of contract work, which have caused and could result in decreases of revenue and/or profit and may have a material adverse impact on our business. We have experienced increased medical, housing, facility cleaning, and other costs due to quarantine requirements imposed by various jurisdictions and exposure of our personnel to pandemics such as COVID-19. In addition, we are permitting employees to telework who can meet our customer commitments remotely, and many of our employees are teleworking. Due to COVID-19, we are uncertain when and how many teleworking employees will return to work in person. Moreover, we may be subject to additional cybersecurity risks as a result of a significant portion of our workforce working remotely. In addition, the resulting volatility in the global capital markets could, among other things, restrict our access to capital and/or increase our cost of capital. At this time, we cannot predict the impact of the COVID-19 pandemic or the duration of time that the pandemic and its impacts will last, but it could have a material adverse effect on our business, financial position, results of operations and/or cash flows. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Trends and Factors Affecting PAE’s Future
Performance - Impact of COVID-19” for additional discussion of management’s assessment of the COVID-19 pandemic.
The loss of any member of PAE’s senior management could impair its relationships with U.S. Government customers and disrupt the management of its business .
PAE believes that the success of its business and its ability to operate profitably depends on the continued contributions of the members of its senior management. PAE relies on its senior management to generate business and execute programs successfully. In addition, the relationships and reputation that many members of its senior management team have established and maintain with U.S. Government personnel contribute to PAE’s ability to maintain strong customer relationships and to identify new business opportunities. The loss of any member of PAE’s senior management could impair its ability to identify and secure new contracts, maintain good customer relations and otherwise manage successfully its business.
If PAE fails to attract and retain skilled employees or contractors, it might not be able to perform under its contracts or win new business.
The growth of PAE’s business and revenue depends in large part upon its ability to attract and retain sufficient numbers of highly qualified individuals, including personnel that are in high demand, such as those with military and law enforcement experience and specialized technical skill sets. In addition, certain U.S. Government contracts require it, and certain of its employees, to maintain security clearances. Obtaining and maintaining security clearances for employees is a lengthy process, and it is challenging to identify, recruit and retain employees who already hold security clearances. If PAE’s employees are unable to obtain or retain security clearances or if its employees who hold security clearances terminate employment with it, PAE’s ability to perform the work under certain U.S. Government contracts may be adversely affected, and the customer whose work requires cleared employees could terminate the contract or decide not to renew it upon its expiration. Further, some of PAE’s U.S. Government contracts contain provisions requiring it to staff an engagement with personnel that the customer considers key to its successful performance under the contract. In the event PAE is unable to provide these key personnel or acceptable substitutions, where permitted, the customer may terminate the contract. As a result, if PAE is unable to recruit and retain a sufficient number of qualified employees, its ability to maintain and grow its business could be limited.
Moreover, in a tight labor market, PAE’s labor costs could increase and it may be required to engage large numbers of subcontractor personnel, which could cause its profit margins to suffer. If PAE’s employees are over-utilized, it could have a negative impact on employee morale and attrition. Conversely, if PAE maintains or increases its staffing levels in anticipation of one or more projects and the projects are delayed, reduced or terminated, PAE may underutilize the additional personnel, which would increase its general and administrative expenses and could have an adverse effect on its financial position, results of operations and/or cash flows.
The expiration of PAE’s collective bargaining agreements could result in increased operating costs or work disruptions, which could potentially affect its operating performance.
As of December 31, 2020, PAE had a workforce of approximately 20,000, and approximately 13.0% of its employees are covered by collective bargaining agreements. As of December 31, 2020, PAE had approximately 55 collective bargaining agreements with its unions. The length of these agreements varies, with the longest expiring in September 2023. PAE cannot predict how stable its union relationships will be or whether it will be able to successfully negotiate successor agreements without impacting its financial condition, and may, in the future, experience labor disruptions associated with the expiration or renegotiation of collective bargaining agreements or otherwise, which may cause a significant disruption of operations. In addition, PAE may face
increased operating costs as a result of higher wages or benefits paid to union members, which could adversely affect its financial position, results of operations and/or cash flows.
b. Risks Related to Financial Results and Reporting
PAE may not receive the full amounts estimated under the U.S. Government contracts in its backlog, which could reduce its revenue in future periods below the levels anticipated and which makes backlog an uncertain indicator of future operating results.
As of December 31, 2020, PAE’s total backlog was approximately $7,915.4 million, of which $1,423.3 million was funded. Due to the U.S. Government’s ability not to exercise contract options or to terminate, modify or curtail PAE’s programs or contracts and the rights of its non-U.S. Government customers to cancel contracts and purchase orders in certain circumstances, PAE may realize less than expected or may never realize revenues from some of the contracts that are included in its backlog. PAE’s unfunded backlog, in particular, is not exact or guaranteed, and is based upon, among other things, management’s experience under such contracts and similar contracts, the particular customers, the type of work and budgetary expectations.
PAE’s management may not accurately assess these factors or estimate the revenue it will realize from these contracts. In addition, backlog is typically subject to large variations from quarter- to-quarter, and comparisons of backlog from period to period are not necessarily indicative of future revenues. The timing of receipt of revenues, if any, on projects included in backlog could change due to the scheduling of projects, and cancellation of or adjustments to contracts may occur. As a result, PAE’s funded, unfunded and total backlog as of any particular date may not reflect the actual revenue ultimately received from these contracts and therefore may not be an accurate indicator of PAE’s future earnings. If PAE fails to realize as revenues amounts included in its backlog, it could have an adverse effect on its financial position, results of operations and/or cash flows.
PAE’s financial results may vary significantly from quarter-to-quarter.
PAE expects its sales and operating results to vary from quarter-to-quarter. Reductions in revenue in a quarter could lead to lower profitability in that quarter because PAE may not be able to reduce its expenses proportionately, or at all, for that quarter, as a relatively large amount of its expenses are fixed in the short-term. PAE may also incur additional expenses when contracts are terminated or expire and are not renewed.
Payments due to PAE from its customers may be delayed due to billing cycles or as a result of failures of U.S. Government appropriations to gain congressional and administration approval in a timely manner. The U.S. Government may have to suspend, and has in the past suspended, engagements that PAE is working on because federal appropriations were not timely approved. The U.S. Government’s September 30 fiscal year end may also trigger increased purchase requests from customers for equipment and materials due to expiring funds. Any increased purchase requests it received as a result of the U.S. Government’s fiscal year end would serve to increase PAE’s third or fourth quarter revenue but may lead to reductions in revenue in the first quarter.
PAE uses estimates when accounting for contracts and any changes in such estimates could have an adverse effect on PAE’s profitability and its overall financial performance.
When agreeing to contractual terms, PAE’s management makes assumptions and projections about future conditions and events, many of which extend over long periods. In order to make these projections it must assess the labor productivity and availability, the complexity of the work to be performed, the availability of materials, the length of time to complete the performance obligation, execution by subcontractors, the availability and timing of funding from customers
and overhead cost rates, among other variables. Contract accounting requires judgment relative to assessing risks, estimating contract revenues and costs, and making assumptions for schedule and technical issues.
For service type contracts, performance obligations are typically satisfied as services are rendered and the Company uses a contract cost-based input method to measure progress. The Company reviews the progress and execution of performance obligations under the estimate at completion process to determine changes in estimated revenues and costs. As part of this process, the Company reviews information including, but not limited to, key contract terms and conditions, program schedule, progress towards completion and identified risks and opportunities. The risks and opportunities include judgments about the ability and cost to achieve the contract milestones and other technical contract requirements.
Because of the significance of the judgments, assumptions and estimation processes described above, it is possible that materially different amounts could be obtained if different assumptions were used or if the underlying circumstances were to change. Changes in underlying assumptions, circumstances or estimates may have an adverse effect upon the profitability of one or more of the affected contracts, future period financial reporting and performance. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies” for additional information.
PAE’s earnings and profitability may vary based on the mix of its contracts and may be adversely affected by a failure to accurately estimate or otherwise recover the expenses, time and resources for its contracts.
PAE enters into several different types of U.S. Government contracts including cost-reimbursable, fixed-price and time-and-materials. For the year ended December 31, 2020, PAE derived approximately 49.7%, 34.9% and 15.4% of its revenue from cost-reimbursable, fixed-price and time-and-materials contracts, respectively. Each of these types of contracts, to varying degrees, involves the risk that PAE could underestimate its cost of fulfilling the contract, which may reduce the profit it earns or lead to a financial loss on the contract and adversely affect PAE’s operating performance and result in a loss of expected revenue.
Under cost-reimbursable contracts, PAE is reimbursed for allowable costs up to a ceiling and paid a fee, which may be fixed or performance- based. If PAE’s actual costs exceed the contract ceiling or are not allowable under the terms of the contract or applicable regulations, it may not be able to recover those costs. In particular, there is increasing focus by the U.S. Government on the extent to which government contractors, including PAE, are able to receive reimbursement for employee compensation, including rules that substantially limit the level of allowable compensation cost for executive-level and other employees. In addition, there is risk of compensation being deemed unallowable or payments being withheld as a result of government audit, review, or investigation.
Under fixed-price contracts, PAE performs specific tasks for a pre-determined price. Compared to time-and-materials and cost-reimbursable contracts, fixed-price contracts generally offer higher margin opportunities because PAE receives the benefits of any cost savings and operating efficiencies, but involve greater financial risk because it bears the impact of any cost overruns. Because PAE assumes the risk for cost overruns and contingent losses on fixed-price contracts, an increase in the percentage of fixed-price contracts in its contract mix could increase its risk of sufferinglosses. In addition, U.S. Government procurement policies have focused on requiring disclosure of cost and pricing data in the context of fixed-price contracting, which can impact the profitability of those contracts.
Under time-and-materials contracts, PAE is reimbursed for the hours worked using pre-determined hourly rates for each labor category and typically reimbursed for other direct contract costs and expenses at cost. PAE assumes financial risk on time-and-materials
contracts because its cost of performance may exceed these negotiated hourly/daily rates. If PAE’s material costs on time-and-materials contracts grow at a faster rate than its labor- related costs, its overall profit margins may decrease and its profitability could be adversely affected.
Additionally, PAE’s profits could be adversely affected if its costs under any of these contracts exceed the assumptions it used in bidding for the contract. For example, PAE may miscalculate the costs, resources, or time needed to complete projects or meet contractual milestones as a result of delays on a particular project, including delays in designs, engineering information, or materials provided by the customer or a third party, delays or difficulties in equipment and material delivery and schedule changes, some of which are beyond its control. Further, PAE cannot recover unallowable costs under any contracts, as direct contract charges or overhead. An increase in PAE’s unallowable costs could have an adverse effect on its financial position, results of operations and/or cash flows.
Furthermore, many of PAE’s U.S. Government contracts are IDIQ contracts. IDIQ contracts are essentially umbrella contracts that set forth the basic terms and conditions under which an agency may order goods and services from one, or in many cases, more than one, contractor from time to time during the term of such contract. Therefore, the award of an IDIQ contract does not represent a firm order for services. Generally, under an IDIQ contract, the customer is obligated to pay only a de minimis fee or order a de minimis amount of services or supplies from its contractor, irrespective of the total estimated contract value. There can be no assurance that PAE’s existing IDIQ contracts will result in actual revenue during any particular period or at all.
PAE has recorded provisions in its consolidated financial statements for losses on its contracts, as required under U.S. generally accepted accounting principles, but PAE’s contract loss provisions may not be adequate to cover all actual losses that it may incur in the future. Actual losses could have an adverse effect on its financial position, results of operations and/or cash flows.
PAE sometimes submits requests for equitable adjustments or claims to clients for work it performed beyond the initial scope of some of its contracts. If these clients do not approve these requests or claims, it could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
PAE typically has pending requests for equitable adjustments (“REAs”) or claims submitted under some of its contracts for payment of work performed beyond the initial contractual requirements for which it has already recorded revenue. PAE cannot guarantee that such REAs or claims will be approved in whole, in part, or at all. Often, these REAs or claims can be the subject of lengthy proceedings, and it is difficult to accurately predict when they will be fully resolved. When these types of events occur and unresolved REAs or claims are pending, PAE has used working capital to cover cost overruns pending the resolution of the relevant REAs or claims. If these REAs or claims are not approved, PAE’s revenue may be reduced in future periods.
PAE may pursue or complete acquisitions, or other transactions, which represent additional risk and could impact future financial results.
PAE’s business strategy includes the potential for future acquisitions or other transactions, such as PAE’s acquisitions of CENTRA and Metis in November 2020. Acquisitions involve a number of risks, including integration of the acquired company with PAE’s operations and unanticipated liabilities or contingencies related to the acquired company. PAE cannot ensure that the expected benefits of any future acquisitions will be realized. Costs could be incurred on pursuits or proposed acquisitions that have not yet closed or may not close which could significantly impact PAE’s financial position, results of operations and/or cash flows. Additionally, after an acquisition, unforeseen issues could arise that adversely affect the anticipated returns or that
are otherwise not recoverable as an adjustment to the purchase price. Even after careful integration efforts, actual operating results may vary significantly from initial estimates. Furthermore, PAE may engage in other strategic business transactions. Such transactions could cause unanticipated costs and difficulties, may not achieve intended results and may require significant time and attention from management that could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Furthermore, sustaining PAE’s growth has placed significant demands on its management, as well as on its administrative, operational and financial resources. For PAE to continue to manage its growth, it must continue to improve its operational, financial and management information systems and expand, motivate and manage its workforce. If PAE is unable to manage its growth while maintaining its quality of service and profit margins, or if new systems that it implements to assist in managing its growth do not produce the expected benefits, it could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
PAE may be unable to realize any benefit from its cost reduction and restructuring effort and its profitability may be hurt or its business otherwise might be adversely affected.
PAE has engaged in cost reduction and restructuring activities in the past and may engage in other cost reduction restructuring activities in the future such as headcount reductions. These types of cost reduction and restructuring activities are complex. If PAE does not successfully manage its current cost reduction and restructuring activities, or any other cost reduction and restructuring activities that it may undertake in the future, any expected efficiencies and benefits might be delayed or not realized, and its operations and business could be disrupted. In addition, the costs associated with implementing cost reduction and restructuring activities might exceed PAE’s initial estimates, which could result in additional future charges. Furthermore, the costs of restructuring activities in some cases may not be reimbursable under government cost allowability regulations.
PAE may need additional capital to fund the growth of its business, and financing may not be available on favorable terms or at all.
PAE currently anticipates that its available capital resources, including under the 2020 Credit Agreements (as defined below) and from operating cash flow, will be sufficient to meet its expected working capital and capital expenditure requirements for at least the next 12 months. However, these resources may not be sufficient to fund the long-term growth of PAE’s business. If PAE determines that it is necessary to raise additional funds, either through an expansion or refinancing of its 2020 Credit Agreements or through public or private debt or equity financings, additional financing may not be available on terms favorable to PAE, or at all.
Disruptions in the capital and credit markets could adversely affect PAE’s ability to access these markets. Limitations on PAE’s borrowing base contained in the 2020 Credit Agreements may limit its access to capital, and PAE could fall out of compliance with financial and other covenants contained in its existing revolving credit facility which, if not waived, would restrict PAE’s access to capital and could require it to pay down its existing debt under its existing revolving credit facility. PAE’s lenders may not agree to extend additional or continuing credit under its existing revolving credit facility or waive restrictions on its access to capital. If adequate funds are not available or are not available on acceptable terms, PAE may not be able to take advantage of available opportunities, develop new products or otherwise respond to competitive pressures, which could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
PAE may not be able to obtain adequate indemnity or insurance coverage.
Many of PAE’s contracts require it to maintain minimum insurance coverage levels. If any of the third-party insurers fail, suddenly cancel PAE’s coverage or otherwise are unable to provide adequate insurance coverage, then its overall risk exposure could increase and the management of its business operations could be disrupted. In addition, there can be no assurance that any of PAE’s insurance coverage will be renewable or obtainable on commercially reasonable terms or at all upon the expiration of the applicable coverage period.
In addition, PAE may incur significant liabilities, including liabilities related to doing business in developing countries. In some, but not all, circumstances, PAE may be entitled to indemnification from its customers, such as through contractual provisions. The amount of insurance coverage that PAE maintains or indemnification to which it may be contractually or otherwise entitled may not be adequate to cover all claims or liabilities, and it is not possible to obtain insurance or indemnification coverage to protect against all operational risks and liabilities. Additionally, PAE’s insurance policies and indemnification arrangements often require it to pay a retention or deductible out-of- pocket. Accordingly, PAE may be forced to bear substantial costs resulting from risks and uncertainties of its business which could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Goodwill represents a significant portion of PAE’s assets and any impairment of these assets could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
As of December 31, 2020, PAE’s goodwill was approximately $590.7 million, which represented approximately 32.3% of its total assets. PAE tests goodwill for impairment on an annual basis, or whenever events or changes in circumstances indicate that the carrying value of goodwill may not be recoverable. PAE estimates the fair value of the reporting unit used in the goodwill impairment test using an income approach and market approach, and as a result, the fair value measurements depend on revenue growth rates, future operating margin assumptions, risk-adjusted discount rates, future economic and market conditions, and identification of appropriate market comparable data. Because of the significance of PAE’s goodwill, any future impairment of this asset could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Unanticipated changes in PAE’s tax provisions or exposure to additional U.S. and foreign tax liabilities could affect PAE’s profitability.
PAE and its subsidiaries are subject to various taxes, including but not limited to income, gross receipts and payroll withholding taxes in the United States and many foreign jurisdictions. Significant judgment is required in determining PAE’s worldwide provision or benefit for taxes. In the ordinary course of PAE’s business, there are many transactions and calculations where the ultimate tax determination is uncertain. Furthermore, changes in domestic or foreign tax laws and regulations, or their interpretation and enforcement, could result in higher or lower taxes assessed or changes in the taxability of certain revenue or the deductibility of certain expenses, thereby affecting PAE’s tax expense and profitability. In addition, PAE is frequently subject to audits by tax authorities, including the audit currently being conducted by the Afghan tax authorities. The final determination of tax audits and any related litigation could be materially different from PAE’s historical tax provisions and accruals. Additionally, changes in the geographic mix of PAE’s revenue could also impact its tax liabilities and affect its overall tax expense and profitability.
In 2017, the U.S. tax legislation significantly changed the U.S. federal income taxation of U.S. corporations, including by reducing the U.S. corporate income tax rate, limiting interest deductions, adopting elements of a territorial tax system, limiting net operating loss carry
forwards and introducing new anti-base erosion provisions. Many of these changes only became effective for tax years beginning after December 31, 2017. The legislation is unclear in many respects and could be subject to potential amendments and technical corrections, as well as interpretations and implementing regulations by the U.S. Department of the Treasury and Internal Revenue Service, any of which could lessen or increase certain adverse impacts of the legislation. Further, it is reasonable to expect that non-U.S. taxing authorities will be reviewing current law for potential modifications in reaction to the implementation of the recent U.S. tax legislation. Changes to U.S. or foreign tax regulations, or the interpretation or implementation thereof, could adversely affect PAE’s financial position, results of operations and/or cash flows.
Government withholding regulations could adversely affect PAE’s operating performance and result in a loss of expected revenue.
Approximately 39.9% of PAE’s revenues for the year ended December 31, 2020 were derived from U.S. Government contracts that are subject to a Defense Federal Acquisition Regulation Supplement rule that permits the withholding of a percentage of payments when a contractor’s business system has one or more significant deficiencies, which the DoD defines as a “shortcoming in the system that materially affects the ability of officials of the DoD to rely upon information produced by the system that is needed for management purposes.” In accordance with the rule, contracting officers may withhold 5% of contract payments for one or more significant deficiencies in any single contractor business system or up to 10% of contract payments for significant deficiencies in multiple contractor business systems. If PAE has significant deficiencies and contract payments are withheld, it could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
The level of returns on pension and postretirement plan assets, changes in interest rates and other factors could affect PAE’s earnings and cash flows.
A portion of PAE’s current and retired employee population, including employees of certain of its joint ventures, is covered by pension and other postretirement benefit plans (including multi-employer plans), the costs of which are dependent upon various assumptions, including estimates of rates of return on benefit plan assets, discount rates for future payment obligations, rates of future cost growth and trends for future costs. In addition, funding requirements for benefit obligations of PAE’s pension and other postretirement benefit plans are subject to legislative and other government regulatory actions. Variances from these estimates could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Because PAE owns a minority interest in some of the joint ventures with such plans, it has limited ability to control the management of those plans. One joint venture in which PAE has a minority interest operates in the United Kingdom, and its pension plan is subject to U.K. laws and regulations.
Additionally, due to government regulations, pension plan cost recoveries under PAE’s U.S. Government contracts occur in different periods from when those pension costs are recognized for financial statement purposes or when pension funding is made. These timing differences could have an adverse effect on PAE’s cash flows.
Due to PAE’s participation in multi-employer pension plans, PAE may have exposure under those plans that extends beyond what its obligations would be with respect to its employees. PAE currently contributes to 17 multi-employer pension plans. In the event of a partial or complete withdrawal by PAE from any plan which is underfunded, it would be liable for a proportionate share of such plan’s unfunded vested benefits. Based on the limited information available from plan administrators, which it cannot independently validate, PAE believes that its portion of the contingent liability in the case of a full withdrawal or termination would be material to its financial position and results of operations. In the event that any other contributing
employer withdraws from any plan that is underfunded, and such employer (or any member in its controlled group) cannot satisfy its obligations under the plan at the time of withdrawal, then PAE, along with the other remaining contributing employers, might be liable for its proportionate share of such plan’s unfunded vested benefits. PAE has experienced such an event in the past with one of its multi-employer pension plans and expects that it would experience it again in the future. Even if PAE does not take any actions that would subject it to withdrawal liabilities, another contributing employer could take such actions.
In addition, if a multi-employer plan fails to satisfy the minimum funding requirements, the Internal Revenue Service, pursuant to Section 4971 of the Internal Revenue Code of 1986, as amended (the “Code”), will impose an excise tax of 5% on the amount of the accumulated funding deficiency. Under Section 413(c)(5) of the Code, the liability of each contributing employer, including PAE, will be determined in part by each employer’s respective delinquency in meeting the required employer contributions under the plan. The Code also requires contributing employers to make additional contributions in order to reduce the deficiency to zero, which may, along with the payment of the excise tax, adversely impact on PAE’s financial results.
Further, PAE’s earnings may be positively or negatively impacted by the amount of expense or income recorded for employee benefit plans, primarily pension plans and other postretirement plans. PAE’s pension and other post- retirement benefit income or expense can also be affected by legislation or other regulatory actions. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies” for additional information on how PAE’s consolidated financial statements can be affected by pension plan accounting policies.
Unanticipated changes in effective tax rates or adverse outcomes resulting from examination of our income or other tax returns could adversely affect our financial condition and results of operations.
We are subject to income taxes in the United States and other jurisdictions, and our tax liabilities will be subject to the allocation of expenses in differing jurisdictions. Our future effective tax rates could be subject to volatility or adversely affected by a number of factors, including:
• changes in the valuation of our deferred tax assets and liabilities;
• expected timing and amount of the release of any tax valuation allowances;
• tax effects of stock-based compensation;
• costs related to intercompany restructurings;
• changes in tax laws, regulations or interpretations thereof; and
• lower than anticipated future earnings in jurisdictions where we have lower statutory tax rates and higher than anticipated future earnings in jurisdictions where we have higher statutory tax rates.
In addition, we may be subject to audits of our income, sales and other transaction taxes by taxing authorities. Outcomes from these audits could have an adverse effect on our financial condition and results of operations.
II. Risks Related to PAE’s Industry
U.S. Government contracts differ materially from standard commercial contracts and may be subject to cancellation or delay by PAE’s customers without penalty.
PAE’s contracts with the U.S. Government and its agencies contain terms that differ materially from standard commercial contracts. Under the terms of PAE’s contracts with the U.S. Government and its agencies, the U.S. Government and its agencies may unilaterally, among other actions: (i) delay the payment of PAE’s invoices by government payment offices; (ii) reduce the value of existing contracts through partial termination; (iii) terminate or modify existing contracts; (iv) suspend PAE from receiving new contracts pending the resolution of allegedviolations of procurement laws or regulations; (v) debar PAE from receiving new contracts for a period of time; (vi) audit and deny recovery of contract-related costs and fees; and (vii) terminate contracts awarded to PAE if the contracts are protested by a competitor.
As noted above, the U.S. Government can terminate or modify any of its contracts with PAE either for its convenience or if PAE defaults by failing to perform under the terms of the applicable contract. A termination arising out of PAE’s default could expose it to liability and could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
PAE’s U.S. Government contracts typically have an initial term of one year with multiple option periods, exercisable at the discretion of the customer at previously negotiated prices. The U.S. Government and its agencies may, in their sole discretion, choose not to exercise the option periods. At the time of completion of any U.S. Government contract, PAE will often have to recompete for the contract, even if it had been the incumbent service provider. If the U.S. Government chooses not to exercise its option period, terminates and/or materially modifies any of PAE’s contracts or if PAE fails to win a recompete, it will not be entitled to any damages which it might be entitled to if the contract were a standard commercial contract, and it may not be able to win new business that would replace the revenue generated from such contract, which could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
In addition, U.S. Government contracts are usually awarded only after formal competitive bidding processes, which have been and may continue to be protracted and typically impose provisions that permit cancellation in the event that necessary funds are unavailable to the government agency. Competitive procurements impose substantial costs and managerial time and effort in order to prepare bids and proposals for contracts that may not be awarded to PAE. In many cases, unsuccessful bidders for U.S. Government contracts are provided the opportunity to formally protest certain contract awards through various agencies, administrative and judicial channels. The protest process may substantially delay a successful bidder’s contract performance, result in cancellation of the contract award entirely and distract management. PAE may not be awarded contracts for which it bids and substantial delays or cancellation of contract awards may follow its successful bids as a result of such protests.
Certain of PAE’s U.S. Government contracts also contain “organizational conflict of interest” clauses that have in the past limited, and in the future may limit, PAE’s ability to compete for certain related follow-on contracts. Organizational conflicts of interest arise when PAE engages in activities that may make it unable to render impartial assistance or advice to the U.S. Government, impair PAE’s objectivity in performing contract work or provide PAE with an unfair competitive advantage. A conflict of interest issue that precludes PAE’s competition for or performance on a significant program or contract could harm its prospects. While PAE actively monitors its contracts to avoid these conflicts, it cannot guarantee that it will be able to avoid all organizational conflict of interest issues. To the extent that organizational conflicts of interest laws, regulations and rules limit PAE’s ability to successfully compete for new contracts or task orders with the U.S. Government and/or commercial entities or require PAE to exit certain existing contracts or task orders or wind down certain existing contracts or task orders, either
because of organizational conflicts of interest issues arising from PAE’s business or because companies with which PAE is affiliated or with which it otherwise conducts business create organizational conflicts of interest issues for PAE, it may have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
PAE’s contracts are typically subject to recompetition, and PAE may not win the recompetition or may receive a significantly lower workshare after the recompetition.
When the terms of PAE’s contracts expire, the customer typically recompetes the work on either a full-and-open basis or as a small business set-aside. There is a risk that PAE may not be successful in the recompetition, or may not be eligible to compete (for example, because the work has been set aside for small business). In some cases PAE may enter into a joint venture or a subcontract with another contractor for the recompetition, in which case PAE’s workshare would be reduced from its workshare on the original contract. PAE has in the past lost recompetitions and has also had to accept lower workshare as the result of recompetitions.
The failure by Congress to approve appropriations on a timely basis for the U.S. Government agencies supported by PAE could delay procurement of its services and cause it to lose future revenues, profitability and growth prospects.
On an annual basis, Congress must approve appropriations that govern spending by the U.S. Government agencies to which PAE provides services. When Congress is unable to agree on budget priorities and unable to pass annual appropriations on a timely basis, it typically enacts a continuing resolution. A continuing resolution allows U.S. Government agencies to operate at spending levels approved in the previous appropriations. When the U.S. Government operates under a continuing resolution, funding may not be available for new projects and U.S. Government agencies may delay funding PAE expects to receive from customers on work it is already performing. Any such delays would likely result in new business initiatives being delayed or, in some cases, canceled and could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Furthermore, a failure to complete the appropriations process or to fund U.S. Government operations pursuant to a continuing resolution may result in a U.S. Government shutdown, such as the 35-day partial shutdown from December 2018 to January 2019.
Finally, while Congress may pass a continuing resolution to end a shutdown, it is possible that no agreement on annual appropriations may be reached and the U.S. Government could shut down again. A U.S. Government shutdown may result in PAE incurring substantial costs without reimbursement under its contracts and the delay or cancellation of key programs, which could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
Competition in PAE’s industry could limit its ability to attract and retain customers.
PAE competes with various entities across geographic and business lines including, for example, large prime contractors to the U.S. Government, original equipment manufacturers, government services providers and construction companies. PAE competes on a number of factors, including its broad range of services, geographic reach and mobility.
Some of PAE’s competitors may have greater resources or are otherwise better positioned to compete for contract opportunities. For example, original equipment manufacturers that also provide aftermarket support services have a distinct advantage in obtaining service contracts for items they have manufactured, as they frequently have better access to replacement and service parts, as well as an existing technical understanding of the platform they have manufactured. In addition, PAE is at a disadvantage when bidding for contracts up for recompetition for which it is not the incumbent provider, because incumbent providers are frequently able to capitalize on customer relationships, technical knowledge and pricing
experience gained from their prior service. If these competitive pressures cause PAE to lose recompetes or new business, it could have an adverse effect on PAE’s financial position, results of operations and/or cash flows.
U.S. Government contracting policies create preferences for various minority-owned, small and disadvantaged businesses that could limit PAE’s ability to be a prime contractor on certain governmental procurements .
U.S. Government contracting policies include various socioeconomic programs that establish contracting preferences for particular groups including small businesses as well as minority-owned, women-owned, service-veteran-owned and Native-American-owned businesses, among others. In furtherance of these socioeconomic policies, the U.S. Government may decide to set-aside or otherwise restrict certain procurements only to bidders that meet certain socioeconomic qualifications or may provide other competitive advantages to such businesses even if the procurement is not set-aside or restricted. As a result, PAE would not be eligible to perform as a prime contractor on those programs, may be limited in its ability to perform as a subcontractor, or be at other competitive disadvantage on those programs. An increase in the amount of procurements under set-aside programs may impact PAE’s ability to bid on new procurements as a prime contractor or restrict its ability to recompete on incumbent work that is placed in the set-aside programs. In addition, even if PAE is qualified to work on a U.S. Government contract, it may not be awarded the contract because of existing government policies designed to assist small businesses and other designated classifications of business. PAE has experienced in the past, and may experience in the future, new opportunities and follow-on procurements for U.S. government contracts that are subject to socioeconomic preferences for which PAE is not eligible.
U.S. Government in-sourcing could result in loss of business opportunities and personnel.
The U.S. Government may decide to reduce the percentage of contracted services in favor of more federal employees through a practice referred to as “in-sourcing.” Over time, in-sourcing could have an adverse effect on PAE’s financial position, results of operations and/or cash flows. Specifically, as a result of in-sourcing, government procurements for services could be fewer and smaller in the future. In addition, work PAE currently performs could be in-sourced by the U.S. Government and, as a result, PAE’s revenues could be reduced. Moreover, PAE’s employees working on contracts could also be hired by the government. This potential loss of PAE’s employees would necessitate the need to retain and train new employees. Accordingly, the potential effect of in-sourcing could have a materially adverse effect on PAE’s financial position, results of operations and/or cash flows.
III. Risks Related to PAE’s Indebtedness
PAE’s substantial level of indebtedness could adversely affect it and prevent it from making dividends, distributions and payments on its other debt obligations (if any).
PAE has a substantial amount of debt. As of December 31, 2020, PAE has approximately $866.3 million of indebtedness, consisting of amounts outstanding under its senior secured credit facilities. PAE’s substantial level of indebtedness could have important consequences. For example, it could:
• make it more difficult for PAE to satisfy its obligations;
• increase PAE’s vulnerability to adverse economic and industry conditions;
• limit PAE’s ability to obtain additional financing for future working capital, capital expenditures, strategic acquisitions and other general corporate requirements;
• expose PAE to interest rate fluctuations because the interest on certain of its debt is variable;
• require PAE to dedicate a substantial portion of its cash flow from operations to payments on its debt, thereby reducing the availability of its cash flow for operations and other purposes;
• make it more difficult for PAE to satisfy its obligations to its lenders, resulting in possible defaults on and acceleration of such indebtedness;
• limit PAE’s ability to refinance indebtedness or increase the associated costs;
• require PAE to sell assets to reduce debt or influence its decision about whether to do so;
• limit PAE’s flexibility in planning for, or reacting to, changes in its business and the industry in which it operates or prevent PAE from carrying out capital spending that is necessary or important to its growth strategy and efforts to improve operating margins; and
• place PAE at a competitive disadvantage compared to any competitors that have less debt or comparable debt at more favorable interest rates and that, as a result, may be better positioned to withstand economic downturns.
In addition, the agreements governing PAE’s indebtedness contain restrictive covenants that will limit PAE and its subsidiaries’ ability to engage in activities that may be in their long-term best interests.
Furthermore, PAE may be able to incur substantial additional debt in the future. On October 19, 2020, PAE refinanced its credit agreements and entered into a new senior secured credit facility. The revolving credit agreement, dated as of October 20, 2016, by and among PAE Holding Corporation (“PAE Holding”), certain other borrowers from time to time party thereto, certain financial institutions from time to time party thereto and Bank of America, N.A. (“BofA”), as the administrative agent and the collateral agent (as amended and restated, supplemented or otherwise modified, including as amended by Amendment No. 3, dated as of October 19, 2020, by and among the Company and certain of its domestic subsidiaries, certain financial institutions from time to time party thereto and BofA, as the administrative agent and the collateral agent) (the “2020 ABL Credit Agreement”) and the First Lien Term Loan Credit Agreement, dated as of October 19, 2020 (as amended and restated, supplemented or otherwise modified), by and among the Company and certain of its domestic subsidiaries, certain financial institutions from time to time party thereto and BofA, as the administrative agent and the collateral agent (the “2020 First Lien Term Loan Credit Agreement”, and together with the 2020 ABL Credit Agreement, the “2020 Credit Agreements”) contain restrictions on the incurrence of additional indebtedness, but these restrictions are subject to a number of qualifications and exceptions and do not fully prohibit PAE from so incurring substantial additional debt. Depending on borrowing base availability, net of outstanding letters of credit, PAE has the ability to draw up to $175.0 million under its 2020 ABL Credit Agreement, all of which would be secured. PAE also has the ability to incur incremental loans under the term loan agreement subject to availability under certain fixed dollar baskets and/or the satisfaction of a maximum first lien net leverage ratio on a pro forma basis, all of which would be secured. If new debt is added to PAE’s current debt levels, the related risks that PAE now faces could intensify.
Restrictive covenants in PAE’s credit agreements could restrict its operating flexibility.
The agreements governing PAE’s senior secured credit facilities limit PAE’s ability to take certain actions. These restrictions may limit PAE’s ability to operate its businesses, prohibit or limit its ability to enhance its operations or take advantage of potential business opportunities as they arise and cause PAE to take actions that are not favorable to stockholders.
These agreements restrict, among other things and subject to certain exceptions, PAE’s and its restricted subsidiaries’ ability to:
• incur additional indebtedness;
• pay dividends or other payments on capital stock;
• guarantee other obligations;
• grant liens on assets;
• make loans, acquisitions or other investments;
• transfer or dispose of assets;
• make optional payments or modify certain debt instruments;
• engage in transactions with affiliates;
• amend organizational documents;
• engage in mergers or consolidations;
• enter into arrangements that restrict the ability of PAE’s subsidiaries to pay dividends;
• engage in business activities that are materially different from existing business activities;
• change the nature of the business conducted by it; and
• designate subsidiaries as unrestricted subsidiaries.
Under the 2020 Credit Agreements, PAE could be required to make periodic prepayments based on excess cash flow (as defined therein), thereby limiting the amount of cash flow that can be reinvested in its business. In addition, under the 2020 ABL Credit Agreement, if availability goes below a certain threshold, PAE will be required to comply with a minimum “consolidated fixed charge coverage ratio” financial covenant as calculated therein. Moreover, if availability were to fall below a certain threshold for a specified number of business days, PAE could be required to remit its cash funds to a dominion account maintained by the administrative agent under the 2020 ABL Credit Agreement, which would then require daily review and approval of operating disbursements by the administrative agent.
PAE’s ability to comply with the covenants and restrictions contained in agreements governing its indebtedness may be affected by economic conditions and by financial, market and competitive factors, many of which are beyond PAE’s control. Its ability to comply with these covenants in future periods will also depend substantially on the revenues generated by its contracts, its success at implementing cost reduction initiatives and its ability to successfully implement its overall business strategy. The breach of any of these covenants or restrictions could result in a default under one or more of the agreements governing PAE’s indebtedness that would permit the applicable lenders to declare all amounts outstanding thereunder to be due and payable, together with accrued and unpaid interest. In that case, PAE may be unable to borrow under its 2020 ABL Credit Agreement or otherwise, may not be able to repay the amounts due under the agreements governing its indebtedness, and may not be able make cash available by dividend, debt repayment or otherwise. In addition, PAE’s lenders could proceed against the collateral securing that indebtedness. Any of the foregoing could have an adverse effect on PAE’s financial position, results of operations and/or cash flows and could cause it to become bankrupt or insolvent.
The 2020 Credit Agreements contain cross default or cross acceleration provisions that may cause all the debt issued under those instruments to become immediately due and payable because of a default under an unrelated debt instrument.
The 2020 Credit Agreements contain numerous covenants, and require PAE, if availability goes below a certain threshold, to comply with a minimum “consolidated fixed charge coverage ratio” financial covenant as calculated in the 2020 ABL Credit Agreement. PAE’s failure to comply with the obligations contained in these agreements or other instruments governing its indebtedness could result in an event of default under the applicable instrument, which could result in the related debt and the debt issued under other instruments (together with accrued and unpaid interest and other fees) becoming immediately due and payable. In such event, PAE would need to raise funds from alternative sources, which funds may not be available to PAE on favorable terms, on a timely basis or at all. Alternatively, such a default could require PAE to sell assets
and otherwise curtail its operations in order to pay its creditors. These alternative measures could have an adverse effect on PAE’s business, financial position, results of operations and/or cash flows.
If PAE does not generate sufficient cash flows, it may not be able to service all of its indebtedness.
To service its indebtedness, PAE will require a significant amount of cash. PAE’s ability to generate cash, make scheduled payments or to refinance its indebtedness depends on PAE’s successful financial and operating performance, which will be affected by a range of economic, competitive and business factors, many of which are outside of its control.
If PAE’s cash flow and capital resources are insufficient to fund its debt service obligations or to repay indebtedness when it matures, PAE may have to undertake alternative financing plans, such as refinancing or restructuring its debt, selling assets or operations, reducing or delaying capital investments or seeking to raise additional capital. PAE may not be able to refinance its debt and any refinancing of its debt could be at higher interest rates and may require it to comply with more restrictive covenants that could further restrict its business operations and its ability to make cash available for dividends distributions and payments on its other debt obligations (if any). PAE’s ability to implement successfully any such alternative financing plans will be dependent on a range of factors, including general economic conditions, the level of activity in mergers and acquisitions and capital markets generally, and the terms of its various debt instruments then in effect. In addition, a significant portion of PAE’s outstanding indebtedness is secured by substantially all of its and its subsidiaries’ assets and any successor credit facilities are likely to be secured on a similar basis. As such, PAE’s ability to seek additional financing or its ability to make cash available for dividends and distributions and payments on its other debt obligations (if any) could be impaired as a result of such security interests and the agreements governing such security interests. Moreover, as a result of these security interests, the underlying assets would only be available to satisfyclaims of PAE’s general creditors or holders of its equity securities if it were to become insolvent to the extent the value of such assets exceeded the amount of its indebtedness and other obligations.
PAE’s inability to generate sufficient cash flow to satisfy its debt obligations or to refinance its obligations on commercially reasonable terms could have an adverse effect on PAE’s business, financial position and results of operations .
The phase-out of LIBOR may adversely affect our outstanding debt
The London InterBank Offered Rate, or LIBOR, is scheduled to be phased out by the end of 2021. In the United States, the Alternative Reference Rates Committee, the working group formed to recommend an alternative rate to LIBOR, has identified the Secured Overnight Financing Rate (“SOFR”) as its preferred alternative rate for LIBOR. Our debt instruments have interest rates that are based on LIBOR and will not have matured prior to the phase-out of LIBOR. Our debt agreement states that the LIBOR successor rate shall be forward-looking Term SOFR plus the related relevant adjustment. The LIBOR successor rate will be applied in a manner consistent with market practice. Changes in the method of determining LIBOR, or the replacement of LIBOR with an alternative floating borrowing rate, may adversely affect our borrowing costs. We cannot predict the effect of the potential changes to LIBOR or the establishment and use of alternative floating borrowing rates on our outstanding debt that is based on LIBOR. Transitioning to a different borrowing rate may result in less favorable pricing on our debt instruments and could have an adverse effect on our financial results and cash flows.
IV. Risks Related to Our Class A Common Stock and Warrants
Platinum Equity has significant influence over us, including the contractual right to nominate certain directors.
Platinum Equity beneficially owns approximately 25.2% of our Class A Common Stock. As long as Platinum Equity owns or controls a significant percentage of our outstanding voting power, it will have the ability to influence all corporate actions requiring stockholder approval, including the election and removal of directors and the size of our Board, any amendment to our certificate of incorporation or bylaws, or the approval of any merger or other significant corporate transaction, including a sale of substantially all of our assets.
Platinum Equity’s influence over our management could have the effect of delaying or preventing a change in control or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could cause the market price of our securities to decline or prevent security holders from realizing a premium over the market price for such securities. Because our certificate of incorporation opts out of Section 203 of the Delaware General Corporation Law (“DGCL”) regulating certain business combinations with interested stockholders, Platinum Equity may transfer shares to a third party by transferring their securities without the approval of our Board or other stockholders, which may limit the price that investors are willing to pay in the future for our securities.
Pursuant to the Investor Rights Agreement, dated as of February 10, 2020, by and between the Company and PE Shay Holdings, LLC (the “Platinum Stockholder”), the Platinum Stockholder has the right to nominate up to two directors to the Board. The remaining three directors are independent directors initially nominated by the Platinum Stockholder and reasonably acceptable to the Company. In addition, for so long as the Platinum Stockholder has the right to nominate a director, it will also have the right to: (i) designate the chairman of the Board (who need not be a nominee of the Platinum Stockholder); (ii) appoint one representative to each committee of the Board of other than the audit committee; (iii) subject to applicable law and stock exchange requirements, appoint one observer to each committee of the Board; and (iv) subject to applicable law and stock exchange requirements, require that the Board does not exceed five directors. The Platinum Stockholder’s right to designate directors to the Board is subject to its ownership percentage of the total outstanding shares of Class A Common Stock. If the Platinum Stockholder holds: (a) 10% or greater of the outstanding Class A Common Stock, it will have the right to appoint two directors; (b) less than 10% but greater than or equal to 5% of the outstanding Class A Common Stock, it will have the right to appoint one director; or (c) less than 5% of the outstanding Class A Common Stock, it will not have the right to appoint any directors.
Platinum Equity’s interests may not align with our interests as a company or the interests of our other stockholders. Accordingly, Platinum Equity could cause us to enter into transactions or agreements of which our stockholders would not approve or make decisions with which our stockholders would disagree. Further, Platinum Equity is in the business of making investments in companies and may acquire and hold interests in businesses that compete directly or indirectly with us. Platinum Equity may also pursue acquisition opportunities that may be complementary to our business, and, as a result, those acquisition opportunities may not be available to us. In recognition that principals, members, directors, managers, partners, stockholders, officers, employees and other representatives of Platinum Equity and its affiliates and investment funds may serve as our directors or officers, our restated certificate of incorporation provides, among other things, that none of Platinum Equity or any principal, member, director, manager, partner, stockholder, officer, employee or other representative of Platinum Equity has any duty to refrain from engaging directly or indirectly in the same or similar business activities or lines of business that we do. In the event that any of these persons or entities acquires knowledge of a potential transaction or matter which may be a corporate opportunity for itself and us, we will not have any expectancy in such corporate opportunity, and
these persons and entities will not have any duty to communicate or offer such corporate opportunity to us and may pursue or acquire such corporate opportunity for themselves or direct such opportunity to another person. These potential conflicts of interest could have a material adverse effect on our business, financial condition and results of operations if, among other things, attractive corporate opportunities are allocated by Platinum Equity to themselves or their other affiliates.
Anti-takeover provisions contained in our certificate of incorporation and bylaws, as well as provisions of Delaware law, could impair a takeover attempt.
Our certificate of incorporation contains provisions that may discourage unsolicited takeover proposals that stockholders may consider to be in their best interests. We are also subject to anti-takeover provisions under Delaware law, which could delay or prevent a change of control. Together, these provisions may make the removal of management more difficult and may discourage transactions that otherwise could involve payment of a premium over prevailing market prices for our securities. These provisions include:
• no cumulative voting in the election of directors, which limits the ability of minority stockholders to elect director candidates;
• a classified Board with three-year staggered terms, which could delay the ability of stockholders to change the membership of a majority of the Board;
• the requirement that directors may only be removed from the Board for cause;
• the right of our Board to elect a director to fill a vacancy created by the expansion of our Board or the resignation, death or removal of a director in certain circumstances, which prevents stockholders from being able to fill vacancies on our Board;
• a prohibition on stockholder action by written consent, which forces stockholder action to be taken at an annual or special meeting of our stockholders;
• a prohibition on stockholders calling a special meeting and the requirement that a meeting of stockholders may only be called by members of our Board, which may delay the ability of our stockholders to force consideration of a proposal or to take action, including the removal of directors;
• the requirement that changes or amendments to certain provisions of our certificate of incorporation or bylaws must be approved by holders of at least two-thirds of our Class A Common Stock; and
• advance notice procedures that stockholders must comply with in order to nominate candidates to our Board or to propose matters to be acted upon at a meeting of stockholders, which may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer’s own slate of directors or otherwise attempting to obtain control of us.
Our bylaws include a forum selection clause, which may impact your ability to bring actions against us.
Subject to certain limitations, our bylaws provide that, unless we consent in writing to the selection of an alternative forum, the Court of Chancery in the State of Delaware will be the sole and exclusive forum for any stockholder (including a beneficial owner) to bring: (a) any derivative action or proceeding brought on our behalf; (b) any action asserting a claim of breach of fiduciary duty owed by any of our directors, officers or other employees or our stockholders; (c) any action asserting a claim arising pursuant to any provision of the DGCL or our certificate
of incorporation or bylaws; or (d) any action asserting a claim governed by the internal affairs doctrine. In addition, our bylaws provide that unless we consent in writing to the selection of an alternative forum, the federal district courts of the United States will be the exclusive forum for resolving any complaint asserting a cause of action arising under the federal securities laws of the United States against us, our officers, directors, employees or underwriters. These limitations on the forum in which stockholders may initiate action against us could create costs, inconvenience or otherwise adversely affect your ability to seek legal redress.
Section 22 of the Securities Act creates concurrent jurisdiction for federal and state courts over all suits brought to enforce any duty or liability created by the Securities Act or the rules and regulations thereunder. As a result, a court may decline to enforce these exclusive forum provisions with respect to suits brought to enforce any duty or liability created by the Securities Act or any other claim for which the federal and state courts have concurrent jurisdiction, and our stockholders may not be deemed to have waived our compliance with the federal securities laws and the rules and regulations thereunder. If a court were to find the exclusive forum provisions to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions.
We may amend the terms of the Warrants in a manner that may be adverse to holders with the approval by the holders of at least 50% of the then-outstanding Public Warrants (as defined below). As a result, the exercise price of a holder’s Warrants could be increased, the exercise period could be shortened and the number of shares of our Class A Common Stock purchasable upon exercise of a Warrant could be decreased, all without the approval of that warrant holder.
Our 13,333,333 warrants included in the public units issued in the IPO, each of which is exercisable for one share of Class A Common Stock at an exercise price of $11.50 per share of Class A Common Stock (the “Public Warrants”), were issued in registered form under a warrant agreement between Continental Stock Transfer & Trust Company, as warrant agent, and us. The warrant agreement provides that the terms of the Warrants may be amended without the consent of any holder to cure any ambiguity or correct any defective provision, but requires the approval by the holders of at least 50% of the then-outstanding Public Warrants to make any change that adversely affects the interests of the registered holders or any amendment to the terms of the warrants held by Gores Sponsor III LLC (the “Former Sponsor”) that were issued to Former Sponsor on the IPO Closing Date (the “Private Placement Warrants” and, together with the Public Warrants, the “Warrants”). Accordingly, we may amend the terms of the Warrants in a manner adverse to a holder if holders of at least 50% of the then-outstanding Public Warrants approve of such amendment. Although our ability to amend the terms of the Warrants with the consent of at least 50% of the then-outstanding Public Warrants is unlimited, examples of such amendments could be amendments to, among other things, increase the exercise price of the Warrants, shorten the exercise period or decrease the number of shares of Class A Common Stock purchasable upon exercise of a Warrant.
We may redeem unexpired Warrants prior to their exercise at a time that is disadvantageous to warrant holders, thereby making their Warrants worthless.
We have the ability to redeem outstanding Public Warrants and, unless held by the Former Sponsor or its permitted transferees, the Private Placement Warrants, at any time after they become exercisable and prior to their expiration, at a price of $0.01 per Warrant; provided that the last reported sales price of our Class A Common Stock equals or exceeds $18.00 per share for any 20 trading days within a 30 trading-day period ending on the third trading day prior to the date on which we give proper notice of such redemption to the warrant holders and provided certain other conditions are met. If and when the Warrants become redeemable by us, we may exercise our redemption right even if we are unable to register or qualify the underlying securities for sale under all applicable state securities laws. Redemption of the outstanding Warrants could force the warrant holders: (i) to exercise their Warrants and pay the exercise
price therefor at a time when it may be disadvantageous for them to do so; (ii) to sell their Warrants at the then-current market price when they might otherwise wish to hold their Warrants; or (iii) to accept the nominal redemption price which, at the time the outstanding Warrants are called for redemption, is likely to be substantially less than the market value of their Warrants.
If the Warrants are exercised, it would increase the number of shares eligible for future resale in the public market and result in dilution to our stockholders.
We issued Public Warrants to purchase 13,333,333 shares of Class A Common Stock as part of our IPO and, on September 11, 2018 (the “IPO Closing Date”), we issued Private Placement Warrants to the Former Sponsor to purchase 6,666,666 shares of our Class A Common Stock, in each case at $11.50 per share. We issued approximately 23,913,044 shares of our Class A Common Stock to certain “accredited investors” (as defined in Rule 501 under the Securities Act) (“Private Placement Investors”) in a private placement pursuant to Section 4(a)(2) of the Securities Act, for gross proceeds to the Company in an aggregate amount of approximately $220.0 million (the “Private Placement”), upon consummation of the Business Combination. The shares of Class A Common Stock issued in the Private Placement and additional shares of our Class A Common Stock issued upon exercise of our Warrants will result in dilution to the then existing holders of Class A Common Stock of the Company and increase the number of shares eligible for resale in the public market. Sales of substantial numbers of such shares, or other shares registered for resale with the SEC, in the public market could adversely affect the market price of our Class A Common Stock.
The Private Placement Warrants are identical to the Public Warrants sold as part of the public units issued in our IPO except that, so long as they are held by the Former Sponsor or its permitted transferees: (i) they will not be redeemable by us; (ii) they (including the Class A Common Stock issuable upon exercise of these warrants) may not, subject to certain limited exceptions, be transferred, assigned or sold by the Former Sponsor until 30 days after the completion of the Business Combination; (iii) they may be exercised by the holders on a cashless basis; and (iv) they are subject to registration rights.
Cautionary
This MD&A generally discusses 2020 and 2019 items and year-over-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K/A can be found in “Management’s Discussion and Analysis of Financial Condition and Results or Operations” in the Company’s Annual Report on Form 8-K/A filed with the SEC on March 11, 2020. As used in this MD&A, unless the context indicates otherwise, the financial information relating to the year ended December 31, 2019, are those of Shay and its subsidiaries, and the financial information and data for the year ended December 31, 2020 includes the financial information and data of Shay and its subsidiaries for the period prior to the Closing and the financial information and data of PAE Incorporated for the period subsequent to the Closing. See Note 1 - “Description of Business” and Note 6 - “Business Combinations and Acquisitions” for additional information.
Restatement of Previously Issued Consolidated Financial Statements
This Form 10-K/A reflects the restatement of our consolidated financial statements as of and for the year ended December 31, 2020. The restatement of the Original Form 10-K, filed on March 16, 2021, reflected in this amendment corrects accounting errors related to the accounting for Warrants.
Business Overview
PAE is a leading, highly diversified, global company that provides a broad range of operational solutions and outsourced services to meet the critical enduring needs of the U.S. government, other allied governments, international organizations and companies. PAE merges technology with advanced business practices to deliver faster, smarter and more efficient managed services. Whether clients require high-profile support to operate the largest U.S. embassies around the world or need technical solutions for programs that monitor bioterrorism agents, PAE delivers for its customers. PAE leverages its scale, over 65 years of experience and talented global workforce of approximately 20,000 to provide the essential services PAE’s clients need to tackle some of the world’s toughest challenges.
Basis of Presentation
PAE provides a wide variety of integrated support solutions, including defense and military readiness, diplomacy, intelligence support, business process outsourcing, counter-terrorism solutions, peacekeeping, development, host nation capacity building, aircraft and ground equipment maintenance and logistics, and operations and maintenance of facilities and infrastructure. Customers include agencies of the U.S. Government, such as the Department of Defense and Department of State, the National Aeronautics and Space Administration,
Department of Homeland Security, intelligence community agencies and other civilian agencies, as well as allied foreign governments and international organizations.
PAE’s operations are currently organized into two reportable segments, Global Mission Services (“GMS”) and National Security Solutions (“NSS”).
• The GMS segment generates revenues through contracts under which PAE provides customers with logistics and stability operations, force readiness and infrastructure management.
• The NSS segment generates revenues through contracts under which PAE provides customers with counter-threat solutions, intelligence solutions and information optimization.
Segment performance is based on consolidated revenues and consolidated operating income. For additional information regarding PAE’s reportable segments, refer to Note 18 - “Segment Reporting” of the notes to PAE’s consolidated financial statements.
Factors Affecting PAE’s Operating Results
Business Combinations and Acquisitions
Business Combination
Merger Consideration
As described in Note 1 - “Description of Business” and Note 6 - “Business Combinations and Acquisitions” of the notes to the consolidated financial statements, the Company completed the Business Combination on February 10, 2020. Pursuant to the terms of the Merger Agreement, the aggregate merger consideration paid for the Business Combination was approximately $1,427.0 million. The consideration paid to the Shay Stockholders consisted of a combination of cash and stock consideration. The aggregate cash consideration paid to the Shay Stockholders at the Closing was approximately $424.2 million, consisting of (a) approximately $408.0 million of cash available to Gores III from its trust account, after giving effect to income and franchise taxes payable in respect of interest income earned in the trust account and redemptions that were elected by Gores III’s public stockholders, plus (b) all of Gores III’s other cash and cash equivalents, plus (c) gross proceeds of approximately $220.0 million from a private placement offering conducted by Gores III in which investors purchased an aggregate of 23,913,044 shares of Class A Common Stock for $9.20 per share, less (d) certain transaction fees and expenses, including the payment of deferred underwriting commissions agreed to at the time of Gores III’s initial public offering, less (e) certain payments to participants in the 2016 Participation Plan, less (f) approximately $136.5 million used to repay a portion of the indebtedness of Shay immediately prior to the Closing, less (g) approximately $33.8 million of transaction fees and expenses of Shay. The remainder of the consideration paid to the Shay Stockholders consisted of 21,127,823 newly issued shares of Class A Common Stock.
In addition to the foregoing consideration paid on the Closing Date, Shay Stockholders are entitled to receive additional Earn-Out Shares (as both terms are defined in Note 13 - “Stockholders’ Equity - Earn Out Agreement” of the notes to the consolidated financial statements) of up to an aggregate of four million shares of Class A Common Stock, if the price of Class A Common Stock trading on the Nasdaq exceeds certain thresholds during the five-year period following the completion of the Business Combination or if there is an Acceleration Event, as defined in Note 13 - “Stockholders’ Equity - Earn-Out Agreement” of the notes to the consolidated financial statements. For further information, refer to Note 13 - “Stockholders’ Equity - Earn-Out Agreement” of the notes to the consolidated financial statements.
During the third quarter, pursuant to the post-closing adjustment provisions contained in the Merger Agreement, the Company made a post-closing adjustment payment of $20.2 million to the Shay Stockholders. Additionally, during the third quarter, the Company paid $1.0 million to certain members of PAE management in connection with the post-closing adjustment, and such amount was recorded as compensation expense.
Incentive Plan
For a discussion of the 2020 Incentive Plan, see Note 14 - “Stock-Based Compensation” of the notes to the consolidated financial statements, which is incorporated by reference herein.
Debt
In connection with the Business Combination, Shay was required to amend its 2016 credit agreements (comprised of (i) a first lien term loan credit agreement, as amended; (ii) a second lien term loan credit agreement, as amended; and (iii) a revolving credit facility, as amended, each dated as of October 26, 2016) (the “2016 Credit Agreements”) and reduce its outstanding indebtedness under its credit facilities such that the total indebtedness under the facilities, minus cash on hand at the consummation of the transaction would not be greater than $572.1 million. Immediately after the closing of the Business Combination, Shay reduced the outstanding balance on the 2016 Credit Agreements by approximately $136.5 million to a principal balance of $128.8 million.
CENTRA Technology, Inc. Business Acquisition
On October 26, 2020, Pacific Architects and Engineers, LLC, a Delaware limited liability company (the “PAE, LLC”), an indirect wholly owned subsidiary of the Company, entered into a stock purchase agreement (the “Stock Purchase Agreement”) by and among PAE, LLC, CENTRA Technology, Inc., a Maryland corporation (“CENTRA”), certain stockholders of CENTRA, and Barbara Rosenbaum as the sellers representative. CENTRA provides mission critical services to the U.S. intelligence community and other U.S. national and homeland security customers. The Company completed the acquisition on November 20, 2020. Pursuant to the Stock Purchase Agreement, the consideration paid to acquire all of the shares of CENTRA was approximately $208.0 million (net of tax benefits) in cash, subject to customary purchase price adjustments as set forth in the Stock Purchase Agreement.
The Stock Purchase Agreement contains customary representations, warranties and covenants of the parties. The Stock Purchase Agreement also contains customary indemnities, and PAE, LLC has obtained representation and warranty insurance, subject to exclusions, policy limits and certain other terms and conditions, to obtain coverage for losses that may result from a breach of certain representations and warranties made by the sellers in the Stock Purchase Agreement. An aggregate of $5.0 million of the purchase price was deposited into an escrow account to satisfy purchase price adjustments, if any.
CENTRA’s’ financial results have been included in our consolidated financial statements from November 20, 2020. The impact of the acquisition of CENTRA on PAE’s results of operations is further discussed below.
Metis Solutions Corporation Business Acquisition
On November 16, 2020, PAE, LLC entered into an Agreement and Plan of Merger (the “Metis Merger Agreement”) by and among PAE, LLC, Metis Solutions Corporation, a Delaware corporation (“Metis”), Rising Tide Merger Sub, Inc., a Delaware corporation, and Christopher Wynes, solely in his capacity as the representative of the sellers. Metis provides services focused on supporting intelligence community, security and defense customers. The Company
completed the acquisition on November 23, 2020. Pursuant to the Metis Merger Agreement, the consideration paid to acquire Metis was approximately $92.0 million in cash, subject to customary purchase price adjustments as set forth in the Metis Merger Agreement.
The Metis Merger Agreement contains customary representations, warranties and covenants of the parties. The Metis Merger Agreement also contains customary indemnities, and PAE, LLC has obtained representation and warranty insurance, subject to exclusions, policy limits and certain other terms and conditions, to obtain coverage for losses that may result from a breach of certain representations and warranties made by the sellers in the Metis Merger Agreement. An aggregate of $2.5 million of the purchase price was deposited into an escrow account to satisfy purchase price adjustments, if any.
Metis’ financial results have been included in our consolidated financial statements from November 23, 2020. The impact of the acquisition of Metis on PAE’s results of operations is further discussed below.
DZSP 21 LLC Minority Interest Acquisition
On January 31, 2021, PAE Aviation and Technical Services LLC, a Delaware limited liability company, an indirect wholly owned subsidiary of the Company, acquired the 49% minority interest of Parsons Government Services, Inc. in the DZSP 21 LLC joint venture. See Note 23 - “Subsequent Events” of the notes to the consolidated financial statements for more details on this transaction.
Financial and Other Highlights
As of December 31, 2020, PAE had a contract base of more than 679 active contracts and task orders. PAE served as the prime contractor on approximately 96.0% of its contracts. The DoD and DoS are PAE’s largest customers and accounted for 36.0% and 19.0% of its revenue during the year ended December 31, 2020, respectively and 39.0% and 24.0% of its revenue during the year ended December 31, 2019, respectively. International Logistics and Stabilization, Infrastructure and Logistics, Readiness and Sustainment, and Business Process Solutions were PAE’s largest contributors by service area, representing 37.0%, 26.0%, 14.0%, and 10.0% of its revenue, respectively during the year ended December 31, 2020, and representing 35.0%, 26.0%, 15.0%, and 15.0% of its revenue, respectively during the year ended December 31, 2019.
From December 31, 2019 to December 31, 2020, PAE’s overall contract backlog increased by 24.6% from $6,351.8 million to $7,915.4 million, of which $1,423.3 million was funded as of December 31, 2020. This increase was primarily due to the acquisitions of CENTRA and Metis, which added $1,150.5 million of acquired backlog at year end December 31, 2020. Backlog is an operational measure representing PAE’s estimate of the amount of revenue that it expects to realize over the remaining life of awarded contracts and task orders; the funded backlog refers to the value on contracts for which funding is appropriated less revenues previously recognized on these contracts. Unfunded backlog represents the estimated future revenues to be earned from negotiated contracts for which funding has not been appropriated or authorized, and unexercised priced contract options. The total backlog consists of remaining performance obligations plus unexercised options. PAE believes backlog is a useful metric for investors because it is an important measure of business development performance and revenue growth. This metric is used by management to conduct and evaluate its business during its regular review of operating results for the periods presented. See Note 4 - “Revenues" of the notes to the consolidated financial statements for more information.
The estimated value of PAE’s total backlog was as follows (in thousands) :
December 31,
December 31,
Global Mission Services:
Funded GMS backlog
Unfunded GMS backlog
Total GMS backlog
National Security Solutions:
Funded NSS backlog
Unfunded NSS backlog
Total NSS backlog
Total:
Funded backlog
Unfunded backlog
Total backlog
Trends and Factors Affecting PAE’s Future Performance
External Factors
PAE’s business primarily focuses on providing services to the U.S. Government and allied nations and organizations; PAE’s performance is inherently linked to governmental missions and goals. We have concentrated our business efforts on those missions and goals that are enduring and that have limited exposure to abrupt policy changes. For example, PAE has supported U.S. embassies since the 1970s. We are also trusted by our customers to support them on major policy initiatives that require immediate response to solve an acute crisis. Examples of this work include our rapid establishment and operation of Ebola treatment units in Liberia in 2015 and our work beginning in 2020 supporting COVID-19 testing and care, including on behalf of the state of Georgia converting a convention center to a COVID-19 treatment center in less than one week, mobilizing trained-and-ready test teams to conduct COVID-19 testing for the Southeastern Conference of the National Collegiate Athletic Association, and serving as the joint logistics and medical integrator for the Navajo Nation Department of Health’s COVID-19 response.
Over most of the last two decades, the U.S. Government has increased its reliance on the private sector for a wide range of professional and support services. This development has been driven by a variety of factors, including lean-government initiatives launched in the 1990s, surges in demand during times of national crisis, the increased complexity of missions conducted by the U.S. military and the DoS, increased focus of the U.S. military on war-fighting efforts and loss of skills within the government caused by workforce reductions and retirements.
Although the size of future U.S. Government department and agency budgets remains subject to change, current indications are that overall U.S. Government spending will remain largely consistent with current spending levels. PAE believes the following industry trends will result in continued strong demand in the target markets for the types of services it provides:
• new U.S. Government policies and program, both within the United States and overseas, to provide services to address health and other social issues;
• the continued transformation of military forces, leading to continued performance of non-combat functions by government contractors, including life-cycle asset management functions ranging from organizational to depot level maintenance;
• an increased level of coordination between the DoS and DoD on key national security initiatives and foreign policies;
• increased maintenance, overhaul and upgrade needs to support aging military platforms; and
• the on-going evolution of international relations that may require enhanced or new policy initiatives.
Current Economic Conditions
PAE believes that its industry and customer base are less likely to be affected by many of the factors generally affecting business and consumer spending. PAE’s contract awards typically extend to five years, including options, and it has a strong history of being awarded a majority of these contract options. Additionally, since PAE’s primary customers are departments and agencies within the U.S. Government, it has not historically had significant issues collecting its receivables. However, PAE cannot be certain that the economic environment, government debt levels, or other factors will not adversely impact its business, financial condition or results of operations in the future. The government has taken several financial precautions and measures to combat the current financial market conditions, including in response to the COVID-19 pandemic.
Impact of COVID-19
We continue to work with our stakeholders (including customers, employees, suppliers and local communities) to address this global pandemic. Specifically, we are working closely with our customers, including those within the U.S. Government, to permit continued contract performance and to mitigate the impact of the current COVID-19 pandemic on our operations and personnel. We continue to review our contractual provisions, hold discussions with customers regarding the pandemic’s potential impact on contract operations, and take actions to reduce the impact of COVID-19 on our business, workforce, supply chain, revenues, and results of operations. We are continuing to monitor the impact of the pandemic and other related uncertainties on financial markets, which previously caused us to delay undertaking certain actions in support of our strategic plans. In response to COVID-19, we have taken a number of steps to ensure the protection of employees and customers, as well as to mitigate any operational and financial impacts. In particular, we are:
• Implementing enhanced health and safety protocols, including at customer sites, in order to protect our employees and customers and to maintain continuity of operations;
• Actively monitoring the COVID-19 status of employees and independent contractors;
• Reviewing on an ongoing basis the impact of COVID-19 on programs, facilities and contracts with customers;
• Reducing overhead costs by among other things delaying planned hiring and by cancelling travel that is not directly related to program requirements;
• Developing contingency and business continuity plans in case COVID-19 disruptions increase or key personnel become incapacitated;
• Identifying new business opportunities related to COVID-19, including expanded service offerings for existing customers;
• Entering into contract modifications and advance agreements where applicable to permit recovery of costs relating to COVID-19; and
• Engaging in frequent and ongoing dialogue and contract negotiations with customers to either:
◦ Permit PAE employees to continue to work safely (including remotely); or,
◦ Permit PAE to be reimbursed the costs of paid leave for employees who are unable to work (as provided by Section 3610 of the Coronavirus Aid, Relief and Economic Security Act (as amended, the “CARES Act”).
COVID-19 has had a marginally unfavorable impact on the Company’s results of operations for the year ended December 31, 2020. Although our operations have been disrupted by the COVID-19 pandemic, the impact has been mitigated due to the nature of our business. In particular, our U.S. Government customers have taken steps to ensure the continuance of many of the services provided by us and other contractors, including, but not limited to, designating certain PAE contracts as essential for continued performance and authorizing remote work for contractor personnel that cannot access worksites. In addition, the impact may be further mitigated by Section 3610 of the CARES Act, which allows U.S. government agencies to reimburse contractors such as us at the minimum applicable contract billing rate for costs of certain paid leave for employees who cannot access work sites or telework through September 30, 2021. However, some U.S. Government customers have suspended or reduced work under certain of our contracts.
COVID-19 related costs for us and our subcontractors could be significant, and we are seeking reimbursement of such costs under our U.S. Government contracts through a combination of contract actions and reimbursement of costs under Section 3610 of the CARES Act. Reimbursement of any costs under Section 3610 is not expected to include profit or fee. Costs for employees whose jobs cannot be performed remotely may not be fully recoverable under our contracts. We also have no assurance that Congress will appropriate funds to cover the reimbursement of contractors authorized by the CARES Act.
Management expects that the impact of COVID-19 will be marginally unfavorable on our full year results based on information known to us at this time. Since our primary customers are departments and agencies within the U.S. Government, we have not historically had significant issues collecting our receivables and do not foresee issues collecting our receivables in the foreseeable future. In addition, our contract awards typically extend to at least five years, including options, and we have a strong history of being awarded a majority of these contract options; we do not anticipate that the pandemic will have a materially adverse impact on such awards.
Our liquidity position has not been materially impacted, and we continue to believe that we have adequate liquidity to fund our operations and meet our debt service obligations for the foreseeable future. However, we cannot predict the impact of the COVID-19 pandemic, and the longer the duration of the event and the more widespread in geographic locations where we and our suppliers operate, the more likely it is that it could have an adverse impact on our financial condition, results of operations, and/or cash flows in the future.
Inflation and Pricing
Most of PAE’s contracts provide for estimates of future labor costs to be escalated for any option periods, while the non-labor costs in its contracts are normally considered reimbursable at cost. PAE’s property and equipment consists principally of computer systems equipment, machinery and transportation equipment, leasehold improvements, and furniture and fixtures. PAE does not expect the overall impact of inflation on replacement costs of its property and equipment to be material to its future results of operations or financial condition.
Primary Components of Operating Results
Revenues
The majority of PAE’s revenues are generated from contracts with the U.S. Government and its agencies. PAE enters into a variety of contract types, including fixed price, cost reimbursable, and time and materials contracts.
Cost of revenues
Cost of revenues includes costs related to labor, material, subcontract labor and other costs that are allowable and allocable to contracts under federal procurement standards.
Selling, general and administrative expenses
Selling, general and administrative expenses primarily consist of (i) fringe benefits related to the contract costs; (ii) salaries and wages plus associated fringe benefits and occupancy costs related to executive and senior management, business development, bid and proposal, contracts administration, finance and accounting, human resources, recruiting, information systems support, legal and corporate governance; and (iii) unallowable costs under applicable procurement standards that are not allocable to contracts for billing purposes. Unallowable costs do not generate revenue but are necessary for business operations.
Results of Operations
Comparison of Results for the Year Ended December 31, 2020 and December 31, 2019 (in thousands):
Year Ended December 31,
Dollar Change
Percent Change
(Restated)
Revenues
Cost of revenues
Selling, general and administrative expenses
Amortization of intangible assets
Total operating expenses
Program profit
Other operating income, net
Operating income
Interest expense, net
Other income, net
Income (loss) before income taxes
Expense (benefit) from income taxes
Net income (loss)
Noncontrolling interest in earnings of ventures
Net income (loss) income attributed to PAE Incorporated
Revenues
Revenues for the year ended December 31, 2020, decreased by approximately $49.3 million, or 1.8%, from the comparable period in 2019. The decrease was primarily attributable to a $187.4 million impact from COVID-19, of which approximately $124.5 million was non-labor and $62.9 million was labor, partially offset by $39.2 million of revenue from recent acquisitions, and by a net increase of $98.9 million from net change in contract volume, new business and COVID-19 relief opportunities.
Cost of revenues
Cost of revenues for the year ended December 31, 2020, decreased by approximately $85.4 million, or 3.9%, from the comparable period in 2019. The decrease in cost of revenues was primarily driven by lower revenue volume in the current period and the loss on disposal of PAE ISR LLC (“PAE ISR”) in 2019.
Selling, general and administrative expenses
Selling, general and administrative expenses for the year ended December 31, 2020, decreased by approximately $31.3 million, or 5.9%, from the comparable period in 2019. The decrease in selling, general and administrative expenses was primarily driven by PAE ISR discontinued operations, lower revenue volume and favorable program performance.
Amortization of intangible assets
Amortization of intangible assets for the year ended December 31, 2020, increased by approximately $0.9 million, or 2.9%, from the comparable period in 2019. The increase was associated with amortizing certain customer relationships, development technologies, and trade names related to the Metis and CENTRA acquisitions in the fourth quarter of 2020.
Other operating income, net
Other income, net for the year ended December 31, 2020, decreased by approximately $2.5 million, or 25.7%, from the comparable period in 2019. This decrease was driven by a one-time contract reserve write-off in the prior year period.
Operating income
Operating income for the year ended December 31, 2020, increased by approximately $63.9 million, or 238.4%, from the comparable period in 2019. The increase resulted from the loss on disposal of PAE ISR assets in 2019 and improved program performance in the current period, which increase was partially offset by lower revenue volume and other operating income.
Interest expense, net
Interest expense, net for the year ended December 31, 2020, decreased by approximately $12.2 million, or 14.1%, from the comparable period in 2019. This decrease was primarily driven by reduction in average debt balances year over year and lower interest rates.
Other income, net
Other income, net for the year ended December 31, 2020, increased by approximately $12.6 million driven by changes in fair value of the Warrants.
Net income (loss)
Net income attributed to PAE for the year ended December 31, 2020 was $28.8 million compared with a net loss attributed to PAE of approximately $49.8 million in the comparable period in 2019. The increase in net income for the year ended December 31, 2020, was
primarily driven by factors impacting operating income and changes in fair value of the Warrants.
PAE’s Segments
Comparison of Results by Segments for the Year Ended December 31, 2020, and December 31, 2019 (in thousands) :
December 31, 2020
December 31, 2019
Revenues
% of Total Revenues
Revenues
% of Total Revenues
GMS
NSS
Corporate
Consolidated revenues
Operating Income (Loss)
Profit Margin %
Operating Income (Loss)
Profit Margin %
GMS
NSS
Corporate
Consolidated operating income
Global Mission Services Segment Results
Revenues
Revenues for the year ended December 31, 2020, decreased by $19.3 million, or 0.9%, from the comparable period in 2019. The decrease was attributable to a $147.1 million impact from COVID-19, of which approximately $104.6 million was non-labor and $42.5 million was labor, partially offset by a $127.8 million net increase in contract volume, new business and COVID-19 relief opportunities.
Operating income
Operating income for the year ended December 31, 2020 decreased by $12.3 million, or 13.3%, from the comparable period in 2019. The decrease was driven by higher selling, general and administrative expenses and lower revenue volume, partially offset by increased consolidated venture income.
National Security Solutions Segment Results
Revenues
Revenues for the year ended December 31, 2020 decreased by $30.0 million, or 4.5%, from the comparable period in 2019. The decrease was attributable to a $40.3 million impact from COVID-19, of which approximately $19.9 million was non-labor and $20.4 million was labor, and by a $28.9 million decrease from small business set aside recompete losses, net of new business wins, partially offset by $39.2 million of revenue from recent acquisitions.
Operating income
Operating income for the year ended December 31, 2020 increased by $59.0 million, or 159.8%, from the comparable period in 2019. The increase was primarily due to the loss on disposal of PAE ISR assets in 2019 as well as improved program performance in the current period, which increase was partially offset by lower revenue volume.
Liquidity and Capital Resources
As of December 31, 2020, PAE had cash and cash equivalents totaling $85.9 million and the Company had no outstanding borrowings on its 2020 ABL Credit Agreement.
As of December 31, 2019, PAE had cash and cash equivalents totaling $68.0 million and the Company had no outstanding borrowings on its asset-based revolving loan credit facility.
PAE’s primary sources of liquidity are cash flow from operations and borrowings under its credit facility to provide capital necessary for financing working capital requirements, capital expenditures and making selective strategic acquisitions.
On October 19, 2020 the Company refinanced the 2016 Credit Agreements and entered into new senior secured credit facilities (the “2020 Credit Agreements”). PAE expects the combination of its current cash, cash flow from operations, and the available borrowing capacity under the 2020 Credit Agreements to be sufficient to continue to meet its normal working capital requirements, capital expenditures and other cash requirements. However, significant increases or decreases in revenues, accounts receivable, accounts payable, and merger and acquisition activity could affect PAE’s liquidity. PAE’s accounts receivable and accounts payable levels can be affected by changes in the level of contract work it performs, by the timing of large materials purchases, and subcontractor efforts used in its contracts. Government funding delays can cause delays in PAE’s ability to invoice for revenues earned, presenting a potential negative impact on liquidity.
In connection with the Business Combination, Shay was required to amend its 2016 Credit Agreements and reduce its outstanding indebtedness under its credit facilities such that the total indebtedness under the facilities, minus cash on hand at the consummation of the transaction would not be greater than $572.1 million. Immediately after the closing of the Business Combination the outstanding balance on the 2016 Credit Agreements was reduced by approximately $136.5 million to a principal balance of $128.8 million.
On October 19, 2020 the Company refinanced the 2016 Credit Agreements and entered into new senior secured credit facilities. The 2020 Credit Agreements establish a $740.0 million term loan facility maturing in October 2027, a $150.0 million delayed draw term loan facility maturing in October 2027, and a $175.0 million senior secured revolving credit facility maturing in October 2025.
See Note 12 - “Debt” of the notes to the consolidated financial statements for further information on the terms and availability of PAE’s credit facilities.
As of December 31, 2020, the Company had commitments for capital expenditures in the amount of $4.8 million. These commitments primarily relate to software, equipment, facilities infrastructure and information technology. The Company anticipates funding such commitments through working capital or debt financing sources.
Cash Flows Analysis
Comparison of Results for the Year Ended December 31, 2020, and December 31, 2019 (in thousands) :
Year Ended December 31,
Dollar Change
(Restated)
Net cash provided by operating activities
Net cash used in investing activities
Net cash provided by (used in) financing activities
Effect of exchange rate changes on cash and cash equivalents
Net increase in cash and cash equivalents
Net cash provided by operating activities
Net cash provided by operating activities for the year ended December 31, 2020 decreased by $15.8 million from the comparable period in 2019, primarily as a result of lower cash collections and a decrease in accounts payable, partially offset by net income growth, and increases in customer advances and billings in excess of cost and accrued salaries.
Net cash used in investing activities
Cash used in investing activities for the year ended December 31, 2020 increased by $313.5 million from the comparable period in 2019, primarily driven by the business acquisitions of Metis and CENTRA during the fourth quarter of 2020.
Net cash provided by (used in) financing activities
Cash provided by financing activities for the year ended December 31, 2020 improved by $327.1 million from the comparable period in 2019. The increase was primarily driven by the Recapitalization in the first quarter of 2020 and refinancing of debt during the fourth quarter of 2020, which increase was partially offset by repayments on long term debt.
For a discussion of the Recapitalization, see Note 6 – “Business Combinations and Acquisitions” of the notes to the consolidated financial statements.
Financing
Long-term debt consisted of the following as of the dates presented (in thousands) :
December 31,
December 31,
First Term Loan
Second Term Loan
2020 ABL Credit Agreement
Total debt
Unamortized discount and debt issuance costs
Total debt, net of discount and debt issuance costs
Less current maturities of long-term debt
Total long-term debt, net of current
The following discusses the Company’s borrowing arrangements as of December 31, 2020. During the fourth quarter, the Company completed a refinancing of its existing indebtedness as further discussed below.
During the fourth quarter, the Company refinanced the 2016 Credit Agreements and entered into the 2020 Credit Agreements, which provide for borrowings up to $890.0 million. The 2020 Credit Agreements establish a $740.0 million term loan facility maturing in October 2027 priced at LIBOR plus a spread of 4.5%, a $150.0 million delayed draw term loan facility maturing in October 2027 priced at LIBOR plus a spread of 4.5%, and a $175.0 million senior secured revolving credit facility maturing in October 2025 priced at LIBOR plus a spread of 1.8% to 2.3%.
The Company used the proceeds from the 2020 Credit Agreements to repay the amounts outstanding under its 2016 Credit Agreements, with the remaining amounts to be used for general corporate purposes, mergers and acquisitions, and transaction fees and expenses.
The loans under the 2020 Credit Agreements are secured by a first lien over substantially all of the Company’s assets. The 2020 Credit Agreements also contain affirmative and negative covenants customary for transactions of this type, including (i) affirmative covenants requiring the Company to comply with specified financial covenants under certain circumstances, including the maintenance of certain leverage ratios; and (ii) various non-financial covenants, including affirmative covenants with respect to reporting requirements and maintenance of business activities, and negative covenants that, among other things, may limit or impose restrictions on the Company’s ability to alter the character of the business, consolidate, merge, or sell assets, incur liens or additional indebtedness, make investments, and undertake certain additional actions.
PAE was in compliance with the financial covenants under the 2020 Credit Agreements as of December 31, 2020. See Note 12 - “Debt” of the notes to the consolidated financial statements.
Off-Balance Sheet Arrangements
PAE has outstanding performance guarantees and cross-indemnity agreements in connection with certain aspects of its business. PAE also has letters of credit outstanding principally related to performance guarantees on contracts and surety bonds outstanding principally related to performance and subcontractor payment bonds as described in Note 12 - “Debt” of the notes to the consolidated financial statements.
PAE has entered into various arrangements to provide program management, construction management and operations and maintenance services. The ownership percentage of these ventures is typically representative of the work to be performed or the amount of risk assumed by each venture partner. Some of these ventures are considered variable interest entities. PAE has consolidated all ventures over which it has control. For all others, PAE’s portion of the earnings is recorded in equity in earnings of ventures. See Note 10 - “Consolidated Variable Interest Entities” of the notes to the consolidated financial statements.
PAE does not believe that it has any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that would be material to investors.
Contractual Obligations
The following contractual obligations table summarizes PAE’s contractual obligations as of December 31, 2020 (in thousands) :
Calendar Years
(in thousands)
Thereafter
Total
Bank loan debt
Operating leases
Total
The estimated cash requirement for interest on PAE’s 2020 Credit Agreements is approximately $48.4 million for 2021.
Recently Issued Accounting Pronouncements
For a description of recently announced accounting standards, including the expected dates of adoption and estimated effects, if any, on PAE’s consolidated financial statements, see Note 3 - “Recent Accounting Pronouncements" of the notes to the consolidated financial statements.
Critical Accounting Policies
PAE’s MD&A is based upon its consolidated financial statements, which are prepared in conformity with U.S. generally accepted accounting principles (“ U.S GAAP”). The preparation of these financial statements in accordance with U.S GAAP requires the use of estimates and assumptions which affect the reported amounts in the consolidated financial statements. Due to the size and nature of many of PAE’s programs, the estimation of total revenues and cost at completion is subject to a wide range of variables, including assumptions for schedule and technical issues. Actual results may differ from PAE’s management’s estimates.
PAE has identified the following Significant Accounting Principles and Policies as critical because they require significant judgments and assumptions about highly complex and inherently uncertain matters and the use of reasonably different estimates and assumptions could have a material impact on its results of operations or financial condition.
• Revenue Recognition
• Goodwill and Indefinite-Lived Intangibles
• Income Taxes
Revenue Recognition
The majority of PAE’s revenues are generated from contracts with the U.S. Government and its agencies. PAE enters into a variety of contract types, including fixed price, cost reimbursable, and time and materials contracts.
PAE accounts for a contract when it has been approved by all parties in the arrangement, the rights of the parties and payment terms are identified, and collectability of consideration is probable. At contract inception, PAE identifies distinct goods or services promised in the contract, referred to as performance obligations, and then determines the transaction price for the contract.
PAE’s contracts contain promises to provide distinct goods or services to its customers. These represent separate performance obligations and units of account. PAE’s management evaluates whether a single contract should be accounted for as more than one performance obligation or whether two or more contracts should be combined and accounted for as one single arrangement at the outset of the contract. Most of PAE’s contracts consist of providing a complex set of interrelated goods and services that together provide a single deliverable or solution to the customer, and accordingly are accounted for as a single performance obligation. PAE also may engage with a customer on a contract that contains multiple distinct goods or services. In such circumstance, multiple performance obligations exist, and PAE allocates the contract’s transaction price to the individual performance obligations based on the estimated relative standalone selling price. The primary method used to estimate standalone selling price is the expected cost plus a margin approach, under which PAE forecasts expected costs of satisfying a performance obligation and then adds an appropriate margin for that distinct good or service promised.
Revenue is recognized when, or as, the performance obligation is satisfied. For substantially all of PAE’s contracts, PAE satisfies its performance obligations over time as its customer simultaneously receives and consumes benefits. Revenue is recognized over time when there is a continuous transfer of control to the customer.
For U.S. Government contracts, this continuous transfer of control to the customer is supported by clauses in the contract that allow the U.S. Government to unilaterally terminate the contract for convenience, pay for costs incurred plus a reasonable profit and take control of any work in process. When control is transferred over time, revenue is recognized based on the extent of progress towards completion of the performance obligation. Based on the nature of the products and services provided in the contract, PAE uses judgment to determine if an input measure or output measure best depicts the transfer of control over time.
For service type contracts, performance obligations are typically satisfied as services are rendered and PAE uses a contract cost-based input method to measure progress. Contract costs include labor, material and allocable indirect expenses. Revenue is recognized proportionally as contract costs are incurred plus estimated fees. If a contract does not meet the criteria for recognizing revenue over time, revenue is recognized at the point in time when
control of the good or service is transferred to the customer. Control is considered to have transferred when the customer has legal title and PAE has right to payment.
PAE reviews the progress and execution of performance obligations under the estimate at completion process to determine changes in estimated revenues and costs. As part of this process, PAE reviews information including, but not limited to, key contract terms and conditions, program schedule, progress towards completion and identified risks and opportunities. The risks and opportunities include judgments about the ability and cost to achieve the contract milestones and other technical contract requirements. PAE must make assumptions and estimates regarding labor productivity and availability, the complexity of the work to be performed, the availability of materials, the length of time to complete the performance obligation, execution by subcontractors, the availability and timing of funding from customers and overhead cost rates, among other variables. A significant change in one or more of these estimates could affect the profitability of PAE’s contracts.
Goodwill and Indefinite-Lived Intangibles
PAE evaluates goodwill for potential impairment annually on the first day of the fourth quarter or if an event occurs or circumstances change that indicate that the fair value of a reportable segment may have fallen below its carrying value. The evaluation includes a qualitative assessment to determine if it is more likely than not that the fair value of a reportable segment is less than its carrying amount. If, as a result of the qualitative assessment, it is more likely than not that the fair value of a reportable segment is less than its carrying amount, PAE compares the fair value of each of the reportable segments using a discounted cash flow methodology, or other fair value measures as considered appropriate in the circumstances, to its net book value, including goodwill. If the net book value exceeds the fair value, PAE will measure impairment by comparing the derived fair value of goodwill to its carrying value, and any impairment is recorded in the current period.
During the fourth quarter of 2020, PAE performed the annual quantitative impairment test for both of its reportable segments and found that no impairment existed. There were no events or circumstances during the year ended December 31, 2020 indicating that the carrying amount of goodwill was impaired. The Company has considered the implications of COVID-19 as they relate to the carrying value of goodwill and indefinite-lived intangibles. COVID-19 has had a marginally unfavorable impact on the Company’s results of operations for the year ended December 31, 2020. However, we do not foresee issues collecting our receivables in the foreseeable future and we continue to believe that we have adequate liquidity to fund our operations and meet our debt service obligations for the foreseeable future. However, we cannot predict the impact of the COVID-19 pandemic, and the longer the duration of the event and the more widespread in geographic locations where we and our suppliers operate, the more likely it is that it could have an adverse impact on our financial condition, results of operations, and/or cash flows in the future.
Income Taxes
Income taxes are accounted for using the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the consolidated financial statement carrying amounts of assets and liabilities, and their respective tax bases, and operating loss and tax credit carry forwards. PAE accounts for tax contingencies in accordance with Accounting Standard Codification (“ASC”) 740-10- 25, Income Taxes – Recognition (Topic 740) . Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities due to a change in tax rates is recognized in income in the period that includes the enactment date. Estimates of the realizability of deferred tax assets are based on the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies.
PAE’s effective tax rate will be higher due to establishment of valuation allowance on the disallowed interest expense. Any interest or penalties incurred in connection with income taxes are recorded as part of income tax expense (benefit) on the consolidated statements of operations for financial reporting purposes.
