UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

FORM 10-K

 

 

Commission File Number 001-33002

 

 

 

 

L-1 IDENTITY SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (203)-504-1100

 

Securities registered pursuant to Section 12(b) of the Act: Common Stock $.001 par value NYSE

 

Securities registered pursuant to Section 12(g) of the Act: None

 

 

 

 

Indicate by a check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes  x No

 

Indicate by a check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. o  Yes  x No

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x  Yes  o No

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference into Part III of this Form 10-K or any amendment to this Form 10-K.

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by a check mark whether the Registrant is a shell Company (as defined in Rule 12b-2). o  Yes þ No

 

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2010, was approximately $630.3 million.

 

As of February 24, 2011, the registrant had 90,311,719 shares of Common Stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information contained in the Proxy Statement for the 2011 Annual Meeting of Stockholders of the registrant is incorporated by reference into Part III of this Form 10-K.

 

 

INDEX

 

[THIS PAGE INTENTIONALLY LEFT BLANK.]

 

 

 

In this Annual Report on Form 10-K, the words “L-1” and the “Company” refer to L-1 Identity Solutions, Inc. and, except as otherwise specified herein, to L-1 subsidiaries. L-1’s fiscal year ended on December 31, 2010.

 

Business Overview

 

L-1 Identity Solutions, Inc. (“L-1” or the “Company”) is a provider of technology, products, systems and solutions, and services that protect and secure personal identities and assets. Through its divisions, L-1 delivers the full range of offerings required for solving complex problems associated with managing identity. Depending upon customer needs, L-1 services can be bundled with identity solutions, product and services offerings to create an integrated solution.

 

In September 2010, the Company announced that it entered into an agreement to be acquired by Safran in a merger transaction providing for stockholders to receive $12.00 per share in cash, for an aggregate enterprise value of approximately $1.6 billion, inclusive of outstanding debt. The per share consideration of $12.00 incorporates the purchase price received pursuant to the sale of the L-1 Intel Business referred to under the headings of “Discontinued Operations” and “Recent Transactions” later in this document for additional information. The per share price represents a premium of 24 percent over L-1’s closing stock price on the NYSE on September 17, 2010 and a premium of 66 percent over the closing stock price on January 5, 2010, the day prior to L-1’s announcement of its strategic alternatives review process. In February 2011, the Company sold its Intel Business to BAE Systems for cash of $295.8 million (inclusive of acquired cash), the proceeds of which were used to repay $289.3 million of debt outstanding under the Credit Agreement.

 

The Company operates in two reportable segments: Solutions and Services.

 

Solutions

 

The Solutions segment consists of the Secure Credentialing and Biometrics / Enterprise Access Divisions. Solutions from these divisions are marketed to Federal agencies, State and Local government agencies (including law enforcement and department of corrections), foreign governments, and commercial entities (such as financial and health care institutions and casinos). Solutions revenue includes products and related services, which comprise hardware, components, consumables and software, as well as maintenance, consulting and training services.

 

Secure Credentialing Solutions are used by many government customers to produce the most secure identity documents possible. The division builds and maintains an end-to-end secure credentialing solution that starts with identity proofing, vetting, and enrollment; incorporating biometric-based recognition and identity database management; card design and production; and inspection and authentication. More than two billion government-issued IDs have been produced to date using L-1 solutions. These include more than 80 percent of U.S. driver’s licenses (including Enhanced Driver’s Licenses), the U.S. Passport, U.S. Passport Card and Border Crossing Card, and other citizen credentials such as National and Voter IDs, passports and more.

 

States continue to look to L-1 to help improve the security of their processes and systems, while increasing efficiencies and improving the customer experience. As a result, momentum in the North American driver’s license business in 2010 was driven primarily by developing and delivering solutions that include infrastructure, automated testing and screening, facial recognition, document authentication and card production. The division installed and went live with seven end-to-end DL systems in 2010 and upgraded the systems of four other States with additional enterprise solutions consisting of a combination of knowledge testing, skills testing, and facial recognition. In addition, self-service kiosks designed to offer a more convenient method for replacing and renewing driver’s licenses were deployed in 2010.

 

One of the most significant State contracts of 2010 was a five year contract extension valued at $56.9 million by the Florida Department of Highway Safety and Motor Vehicles to modernize the currently

installed secure driver’s license solution. L-1 expects to produce in excess of 28 million licenses for Floridians over the term of the contract. L-1’s efforts with Florida to enhance current security features and the State’s driver’s license solution positioned the customer for a Homeland Security Award by the Coalition for a Secure Driver’s License (CSDL) on July 19, 2010.

 

Other highlights for the division during the year included winning a significant international credentialing contract with a large African nation to provide its first biometric-based secure drivers license solution.

 

The division also introduced ExianSmart, the industry’s first contactless smart card with a 15 year life. Self-service kiosks designed to offer a more convenient method for replacing and renewing driver’s licenses that were introduced in late 2009 gained momentum, more than tripling the number of deployments in 2010.

 

Biometric Solutions protect and secure personal identities and assets with state-of-the art technologies to capture, store, manage and distribute biometric data for positive, rapid ID and tracking of persons of interest as part of large-scale identity management programs. The solutions play an important role within many of the world’s largest identity-related programs today as part of civilian and criminal identification in border management, national identity, credentialing, law enforcement and military applications. Biometric solutions also encompass access control readers that enable businesses and governments to secure facilities and restricted areas preventing unauthorized entry.

 

L-1 biometric-based identity management solutions encompass finger, face, full hand, palm, iris and vein recognition. The solutions combine the power of industry leading ABIS (Automated Biometric Identification System) software with advanced biometric readers, capture and authentication devices and access control units. L-1 hardware and software components can be combined to create customized biometric solutions to meet any customer requirement. Highlights for the division in 2010 include:

 

 

 

Services

 

The Services segment consists of the Enrollment Services Division that offers a proven, reliable and cost-effective alternative for governments and commercial businesses that seek to outsource the collection of civilian biometric and identification data required for civilian applications for government-issued ID cards, Visas and Passports, permits and other entitlement benefits. L-1’s convenient, secure and customer-friendly centers in the U.S. and Canada offer faster data submissions with fewer rejections and simplified processing. As a result, individuals are vetted quickly and with confidence. More than 10 million people have been processed to date through L-1 enrollment services. This includes:

 

 

At December 31, 2010, the division had approximately 1100 collection sites, including adding centers in six new States and launching Beta Super Sites that offer extended service offerings such as Child ID, notary services, FBI hard cards, I-9 verification and more. The division also processed 2.2 million prints, up from 1.9 million in 2009. Volume continues to increase among existing State contracts, with New York and Texas among the highest. L-1 expects to see additional State growth across the U.S. from adoption by new groups, such as elder care and handgun permits.

 

At the Federal level, there is an upward trend in the Transportation Security Authority (TSA) Hazardous Materials Endorsement (HazPrint) program, where the division enrolled nearly 200,000 Ground Transportation workers. The division also continued its stewardship of the Transportation Worker Identification Credential (TWIC) program, enrolling over 300,000 maritime workers into the TSA’s system in 2010.

Discontinued Operations

 

As a result of the BAE transaction described below, the Government Consulting Services businesses have been accounted as discontinued operations. Government Consulting Services includes the businesses of Advanced Concepts (Information Technology Solutions), McClendon (Engineering & Analytical Solutions), and SpecTal (Intelligence Services). Government Consulting Services offer comprehensive consulting, program management, information analysis, training, security, technology development, and information technology solutions to the U.S. intelligence community.

 

Recent Transactions

 

In January 2010, L-1 announced that one of its strategic goals and objectives for 2010 was to explore strategic alternatives to enhance shareholder value. Subsequently, on September 19, 2010, the Company entered into an agreement (the “Merger Agreement”) with Safran SA (“Safran”) and Laser Acquisition Sub Inc. (“Merger Sub”), a wholly owned subsidiary of Safran, pursuant to which, subject to the terms and conditions set forth in the Merger Agreement, the Company is to be acquired by Safran in a merger transaction providing for shareholders to receive $12.00 per share in cash, for an aggregate enterprise value of approximately $1.6 billion, inclusive of outstanding debt. Completion of the merger remains subject to certain conditions, including, among others, (i) termination or expiration of the Committee on Foreign Investment in the United States (“CFIUS”) review period pursuant to the Exon-Florio Provision of the Defense Production Act of 1950; (ii) no Company Material Adverse Effect (as defined in the Merger Agreement) having occurred since the date of the Merger Agreement; (iii) subject to certain materiality exceptions, the accuracy of the representations and warranties made by the Company and Safran and compliance by the Company and Safran with their respective obligations under the Merger Agreement; (iv) no law or government order prohibiting the merger; and (v) other customary conditions.

 

In February 2011, the Company completed its previously announced sale of SpecTal/McClendon and Advanced Concepts (the “Intel Business”) to BAE Systems Information Solutions, Inc. (“BAE”) (a subsidiary of BAE Systems, Inc., the U.S. affiliate of BAE Systems plc). Pursuant to the terms of the Purchase Agreement, dated as of September 19, 2010 (the “BAE Purchase Agreement”), by and between the Company and BAE, the Company sold the Intel Business to BAE for a purchase price of $295.8 million in cash (inclusive of acquired cash) and approximately $7.2 million in assumed obligations, the net proceeds of which were used to repay $289.3 million of outstanding debt under the Company’s credit agreement.

 

The accompanying financial data reflect the impact of the sale of the Intel Business, whose operating results have been reflected as discontinued operations for all periods presented. However, the consolidated financial statements do not reflect the pro forma effect of the sale of the Intel Business or the repayment of the long-term debt in accordance with the terms of the Credit Agreement. Unless otherwise noted, revenues and expenses presented herein exclude amounts attributable to discontinued operations. See Notes 1 and 15 to the consolidated financial statements for additional information.

 

Markets and Trends in Biometrics Solutions

 

Government-issued “breeder documents” (such as birth certificates and social security cards) and IDs granted based on these documents (such as driver’s licenses or passports) serve as the primary means for confirming the identity of an individual. The integrity, however, of these documents and credentials can be compromised because they can be counterfeited or altered, issued under false pretenses and historically have rarely been linked to an identity database. Failure to provide adequate identification protection can lead to breaches of security and identity theft, the consequences of which can range from national security threats and loss of life to significant economic loss. Within this context, L-1 believes that there is increasing pressure on governments and businesses to accelerate the adoption of advanced technology identity solutions to validate identities.

 

A core element to the L-1 identity management value proposition is biometrics. Biometrics are unique, individual physiological or behavioral characteristics, such as fingerprints, palm prints, facial characteristics,

iris and voice patterns, hand geometry and handwriting patterns, which can be used to determine or verify an individual’s identity. Technology digitally captures and encodes these individual biometric characteristics and then compares that uniquely personal characteristic against previously encoded biometric data to determine or validate an individual’s identity.

 

Each biometric is unique to each person, making it the best means possible today to verify that a person is whomever he/she claims to be. Furthermore, biometric technology provides improved accuracy and security of the credential, as well as convenience and cost-effectiveness for the individual, overcoming the limitations inherent in traditional identification and authentication processes such as paper credentials, passwords, PIN codes and magnetic access cards.

 

Governments and their agencies were the early adopters of biometrics and today remain the primary customers for the industry. For law enforcement, biometric technology permits more efficient criminal booking and processing and also allows officers in the field to identify potential suspects more reliably and efficiently. Within the military, biometrics are used for the verification and identification of military personnel and contractors and collection and processing of biometrics from non-military personnel for the purpose of identifying potential hostile persons. At the national level, governments throughout the world have taken steps to improve security in response to heightened concerns over public safety from the threat of terrorism. National governments have mandated increased spending on security measures, implemented new regulations and placed greater emphasis on technology to address growing security concerns.

 

L-1 believes that the market for biometrics will continue to grow significantly. L-1 believes that this growth is a function of customer demand and the ability for the industry to meet the demand. L-1 believes that major drivers of biometric growth in the future will include:

 

 

In addition, L-1 believes that identity-related mandates within the government will increase demand for biometric solutions. The Company anticipates the government will recommend and in some cases mandate the use of secure authentication, such as biometrics, as a key component of identity verification. Some of the programs include the U.S. Visitor and Immigrant Status Indicator Technology program (U.S. VISIT), which uses biometric data as part of its screening procedures for non-U.S. citizens entering the United States; Department of State (DoS) Western Hemisphere Travel Initiative (WHTI) Passport Card and Border Crossing Card (BCC) programs that issue limited use passports in a wallet size format for use in crossing U.S. borders; Transportation Workers Identification Credential (TWIC) for transportation workers; Transportation Security Administration (TSA) Hazardous Material Threat Assessment Program (HAZMAT) mandating fingerprinting and security threat assessment of commercial truck drivers applying for, renewing or transferring the hazardous materials endorsement (HME) on State-issued Commercial Driver’s Licenses (CDL); Homeland Security Presidential Directive 12 (HSPD-12), which mandates that a common identification card be utilized by all Federal government employees and contractors; and the REAL ID Act, signed into law in May 2005, which mandates authentication of a person’s identity before they are issued a driver’s license.

While fingerprints are expected to continue to be the most prevalent biometric technology in the U.S. in the near term, iris, face, palm and other technologies are being adopted and combined with fingerprinting in multi-biometric applications to provide an additional level of security and accuracy and to allow for increased flexibility for applications where fingerprints are not suitable.

 

Automated Biometric Identification Systems (ABIS) and Live Scan Systems are the largest market space for biometrics. These are large scale and highly complex systems used in law enforcement, background checks, and civil identification programs. Live scans are deployed as a front end to most ABIS systems and include hardware and software that capture and process fingerprint images prior to submission. The ABIS and Live Scan market is considerably more mature than any other biometric market sector. Increasingly, multiple biometrics are also being incorporated into these systems, augmenting fingerprints with hand/palm prints, facial images and iris patterns.

 

Internationally, many countries have established or are establishing more secure national identification, driver’s license, passport, border crossing control and voter registration programs and many of these systems are expected to utilize biometric technologies. In addition to protecting citizens, some of these programs are also aimed at helping identify potential terrorist threats. The U.S. established legislation requiring biometric identifiers to be included in the passports of current Visa Waiver countries (countries where citizens are not required to obtain a Visa prior to entering the U.S.). L-1 offers a range of solutions, products and technologies that can be utilized in national identification and/or passport and border crossing programs to enroll and verify citizens, visitors and potential threats and/or to add biometric identifiers to national identification and/or passport programs. Accordingly the Company believes that international markets provide an opportunity for revenue growth.

 

While L-1 anticipates consistent opportunities for revenue growth, the following may adversely affect the rate of this growth:

 

 

Customers — Continuing Operations

 

Over 94 percent of L-1 sales are to Federal, State, Local and foreign governments and government agencies. Contracts with governments and agencies generally allow the customer to terminate the contract for convenience or failure of the government to appropriate funds.

 

For the year ended December 31, 2010, U.S. Federal government agencies accounted for 36 percent of L-1’s continuing operations revenues. Historically, L-1 has experienced minimal customer turnover and the Company believes this is a result of its strong solutions and emphasis on customer service and support.

 

L-1 customers include:

 

 

As a percentage of L-1 revenue, excluding the domestically focused service businesses, L-1’s international sales in products and solutions have grown from 12 percent in 2006 to 21 percent in 2010. The trend reflects an increased international marketing focus, which we expect to continue.

 

Competition

 

The market for L-1 solutions and services is extremely competitive. L-1’s ability to differentiate from the competition is predicated on a number of factors, the most significant of which are described below.

 

In-house development of core biometric technologies.  L-1 is the only company that directly offers Fingerprint and Palm print (AFIS/APIS), facial and iris recognition technologies and remains at the forefront of innovation through its strong and focused internal development team. Because of L-1’s in depth knowledge of the core identity technologies, L-1 can offer customers speed of operation and value for identity solutions. Accordingly, L-1 can provide a complete turnkey solution that include software, hardware, back end system design, workflow management and support services.

 

State-of-the-art technologies are encapsulated in standards-based, open-architecture solutions.  L-1’s identification platform is based on open standards allowing for ease of system delivery, maintenance and scalability to accommodate future needs.

 

The flexibility to use products and services together as a complete solution or as modular components within an existing solution.  A customer-focused solution set approach enables L-1 to customize and integrate its products and services to solve the unique identity challenges of customers in Federal, civil, State and Local, criminal, border management and commercial markets.

 

Strong and tenured relationships with customers and partners.  Today L-1 customers include Federal agencies and branches of the U.S. military, many international governments, the majority of U.S. State Departments of Motor Vehicle (DMV) and local law enforcement agencies, and other commercial customers. The pervasiveness of L-1 relationships makes the Company a trusted choice for customers and partners seeking relationships with proven vendors. L-1 is on several teams for Biometric Operations Systems and Services (BOSS) program.

 

L-1 believes its ability to offer multi-modal identity solutions incorporating finger, face, palm/hand and iris technologies, together with search and matching software to work with large databases, is a significant differentiator for the Company.

 

The comprehensive nature of L-1 solutions, products and services encompass the full spectrum of identity management needs, including:

 

 

L-1 faces competition from a number of companies that are actively engaged in developing and marketing identity management related solutions and services. Many of L-1’s competitors have greater financial resources than L-1, including large system integrators who may enter markets L-1 competes in.

 

The markets for L-1 solutions and services are characterized by rapid technological change as a result of technical developments exploited by competitors, the changing technical needs of the customers, and frequent introductions of new features. L-1 expects competition to increase as other companies introduce products that are more price competitive, may have increased performance or functionality, or that incorporate technological advances not yet developed or implemented by L-1. To compete effectively in this environment, L-1 must

continually develop and market new and enhanced products at competitive prices, and have the resources to invest in significant research and development activities.

 

L-1 competes based on technology (with particular emphasis on speed and accuracy), service and support, product quality, price, reliability, capability to work with large database systems and flexibility in accommodating customer technical and business needs.

 

Business Development, Marketing and Sales, Bids and Proposals

 

Marketing and Sales

 

L-1 solutions and services are marketed through a direct sales and business development force, channel partners, and strategic partnerships and alliances.

 

The direct sales force markets and sells the entire identity solutions and services portfolio. The worldwide sales force delivers solutions and services to markets in North and South America, Europe, the Middle East, Africa, and Asia Pacific. A dedicated U.S. Federal sales team in Washington, D.C. markets and sells to U.S. government agencies such as the Department of Defense, Department of State, Department of Justice and Department of Homeland Security, among others. A dedicated team of sales and services professionals operating from locations in Europe, Middle East and the Far East strengthen global sales coverage and access to the international markets.

 

The Company also adopted a coordinated team approach to pursuing intelligence agency opportunities to provide broader and stronger service offerings.

 

Sales plans are developed by market by division focusing on Federal, State and Local, international and commercial. The emphasis is on maintaining responsibility within the divisional profit and loss centers for accountability of performance.

 

Within the divisions, the sales organizations are supported by functional groups which architect solutions or services and/or design, engineer, source manufacture, market, fulfill and support market-specific offerings. Sales teams are further supported by a professional service group which customizes solutions for each market and a field service group that ensures ongoing performance of L-1 systems.

 

At the end of 2010, L-1 employed 128 professionals in business development, sales and marketing.

 

Strategic Partnerships

 

L-1 has strategic partnerships and distribution channels that broaden coverage and increase market opportunities globally. L-1 established Original Equipment Manufacturer (OEM) distribution arrangements with partners to leverage L-1 technologies. L-1 uses channels of distribution for its document authentication products to expand markets outside of the U.S. L-1 also works with systems integrators, solution providers and service organizations to deliver identity solutions in combination with their core capabilities to expand access to pre-existing relationships, marketing resources and credibility in new markets. Local partners are also utilized to expand L-1’s international access to market opportunities internationally.

 

Bids and Proposals

 

Most of the Company’s business is won through submission of formal competitive bids. Commercial bids are frequently negotiated as to terms and conditions for schedule, specifications, delivery and payment. However, in most cases the client specifies the terms and conditions and form of contract. In situations where the client-imposed contract type and/or terms appear to expose L-1 to inappropriate risk, the Company may seek alternative arrangements or opt not to bid for the work. L-1 contracts and subcontracts are primarily firm fixed and fixed unit price contracts.

The majority of L-1 sales to new customers are the result of competitive bidding for contracts pursuant to public sector procurement rules. In some cases, L-1 may be competing with an entity that has a pre-existing relationship with a potential customer, which could put L-1 at a significant competitive disadvantage. In other cases, L-1 may have pre-existing relationships with customers, which gives the Company an advantage over the competition. All material bids and proposals are subject to review and approval by senior corporate management prior to submission.

 

Research, Engineering and Development

 

Research and development activities are organized into centers of excellence located across, and managed by the Company’s divisions, primarily the Biometrics and Secure Credentialing Divisions.

 

The research, engineering and development team totals approximately 300 developers, scientists and engineers distributed among these centers. Activities are coordinated at the corporate level under the Company’s Chief Strategic Officer to ensure support of the overall innovation goals and mission of L-1 and the realization of synergies in the research engineering and development investment.

 

Research, engineering and development efforts are focused on critical components for advanced technology identity solutions. These include, but are not limited to:

 

 

The Company invests in the development of capture technologies for finger, palm and iris. L-1 maintains an active program for the development of new security features for credentials.

 

L-1 believes the next generation biometric matching algorithms for fingerprint, facial, and iris recognition technology will be more reliable and cost effective than current technology, as well as provide additional functionality, including the storage of fingerprint and/or facial and iris templates on smart cards and similar storage devices. In addition, L-1 focuses on expanding its capabilities in solutions for the civil identification, and border management markets.

 

The Company benefits from the development activities of manufacturers of the components integrated into L-1 systems. This includes cameras, database software and computers. L-1 performs research and development for customers, including efforts for the U.S. government and pursuant to grants from certain European government agencies. Gross research, engineering and development expenditures aggregated to $50.1 million for the year ended December 31, 2010 compared to $46.9 million in the prior year. Virtually all of L-1 research, engineering and development costs are attributable to the Solutions segment. As a percentage of Solutions revenues, gross research and development costs were 15 percent for years ended December 31, 2010 and 2009.

 

Intellectual Property

 

L-1 relies on patent, copyright, trademark and trade secrets and contract law to establish and maintain proprietary rights in technology products and manufacturing processes. The success of the business will depend in part on this proprietary technology and protection of that technology.

While intellectual property rights are important to success, L-1 believes that neither its business as a whole, nor any business segment is materially dependent on any particular patent, trademark, license or other intellectual property right.

 

The Company owns a portfolio of 257 U.S. and foreign patents. In addition, L-1 has 133 U.S. and foreign patent applications in process for biometrics and document authentication technologies. While the duration of patents varies, the Company believes that the duration of its patents is adequate relative to the expected lives of L-1 products. L-1 owns the registered trademarks for “L-1” and “L-1 Identity Solutions”, and owns a broad portfolio of other vital registered and pending trademarks in the U.S. and foreign jurisdictions.

 

Backlog

 

Backlog represents sales value of firm orders for products and services not yet delivered and, for long term executed contractual arrangements (contracts, subcontracts, and customer commitments), the estimated future sales value of estimated product shipments, transactions processed and services to be provided over the term of the contractual arrangements, including renewal options expected to be exercised.

 

For contracts with indefinite quantities, backlog reflects estimated quantities based on current activity levels. Backlog will not necessarily result in future revenue because firm orders may be cancelled, firm orders from governmental agencies are subject to funding options, appropriations may not be exercised by the customers, and the quantities ordered, the volume of transaction processed or services to be provided may be less than estimated. Backlog includes deferred revenues.

 

Contractual arrangements could be cancelled by customers without penalty for lack of performance. Contracts terminated by customers for convenience generally would result in recovery of actual costs incurred and profit, if any, on work performed through the date of cancellation.

 

At December 31, 2010 backlog attributable to continuing operations, determined as described above, approximated $0.9 billion of which approximately $282.0 million is expected to be realized in 2011. Backlog at December 31, 2009 was $1.0 billion.

 

Manufacturing

 

L-1 engineers and designs the hardware products it sells, and develops the software embedded in them. L-1 either concentrates its manufacturing activities to the assembly, repair, and testing of these products, or manages production through contract manufacturers. In either case, L-1 qualifies suppliers for the core components which typically have established supply chains. L-1 believes this permits rapid expansion of production capacity to meet any significant increase in product demand and minimizes both development costs and the cost of scaling of manufacturing capabilities. L-1 believes that these costs will decline if manufacturing volumes increase.

 

L-1 engineers, designs and produces most of the card products used for the production of secure credentials that have proprietary features and/or functionality and which account for over 60 percent of L-1 identity document volume. The remaining consumable materials are purchased from established sources. L-1 produces driver licenses in 7 secure central issuance facilities in Texas, Florida, North Carolina, Pennsylvania, Indiana, California, Georgia, and Washington. In 2010, the Company opened a new central issuance facility in Massachusetts to accommodate States converting, or expected to convert, to central issuance in 2010 and 2011. L-1 also produces the Mexican voter identification credentials in a central issuance facility in Mexico City.

 

L-1 purchases certain components, sub-assemblies and finished products used in manufacturing and supply chain operations from sole source suppliers. While L- 1 is careful to partner with stable, reliable suppliers, the partial or complete loss of supplies available from sole sources or limited sources of supply, or the delay in receiving supplies from these sources could result in delays in manufacturing and product shipments. This may result in the assessment of liquidated damages in certain contracts and may require the incurrence of development and other costs to establish alternative sources of supply. While L-1 makes every effort to maintain inventory of sole sourced components at the appropriate level, it may take the Company

several months to locate alternative suppliers if required, or redesign products to accommodate components from different suppliers.

 

Seasonality

 

In general, the L-1 business is not seasonal. However, L-1 is impacted by the fiscal funding and appropriation cycles of major customers. For example, the U.S. government’s fiscal year ends on September 30 of each year, and it is not uncommon for government agencies to award extra tasks or complete other contract actions in the weeks before the end of the fiscal year in order to avoid the loss of unexpended fiscal year funds. Moreover, in years when the U.S. government does not complete its budget process before the end of its fiscal year, government operations typically are funded pursuant to a continuing resolution that authorizes agencies of the U.S. government to continue to operate, but traditionally does not authorize new spending initiatives. When much of the U.S. government operates under a continuing resolution, delays can occur in procurement of products and services, and such delays can affect L-1 revenue and profit during the period of delay.

 

Financial Information About Foreign And Domestic Operations and Export Sales

 

For the years ended December 31, 2010, 2009 and 2008, foreign and export sales from continuing operations were approximately $70.8 million, $56.0 million, and $47.7 million, respectively.

 

Foreign operations and export sales may increase in relative and absolute terms in the future due to L-1’s increased focus on markets outside the United States. See Note 12 to L-1’s consolidated financial statements for additional information.

 

Reportable Segments and Geographic Information

 

See Note 12 of Consolidated Financial Statements provided in response to Item 8 of this annual report on Form 10-K.

 

Recent Acquisitions

 

Except for the acquisition of assets from Retica Systems, during 2010, L-1 did not consummate any acquisitions. See Note 13 of L-1’s Consolidated Financial Statements provided in response to Item 8 of this annual report on Form 10-K.

 

Capital Requirements

 

L-1’s most significant capital requirements arise primarily from acquisitions in support of its business strategy, capital expenditures for new secure credentialing contracts, expenditures for research and development and working capital needs. For example, L-1 must commit to provide up-front capital expenditures in order to install systems necessary to perform when bidding on new State driver’s license contracts. The most significant capital expenditures are related to the Secure Credentialing business, which has increased in size and scope due to the acquisition of the ID Systems business of Digimarc Corporation (“Old Digimarc”) in August 2008. In 2010, L-1’s capital expenditures were $45.0 million compared to $55.0 million in 2009 and are expected to approximate $40.0 million in 2011. L-1 expects capital expenditures to decline in 2012, as it completes the build out of systems for recently awarded contracts.

 

L-1 expects to meet L-1’s capital requirements from operating cash flows and financing arrangements. See Item 7, Liquidity and Capital Resources.

 

Environmental Protection Regulations

 

L-1 believes that compliance with Federal, State and Local environmental regulations will not have a material adverse effect on the Company’s financial position or results of operations.

Employees

 

As of December 31, 2010, L-1 had 1,352 full time employees in its continued operations and 1,086 employees in its discontinued operations. No employees are covered by collective bargaining agreements. The Company believes that its relations with employees are good.

 

Officers

 

L-1 executive officers are appointed by the Board of Directors and serve until their successors have been duly appointed and qualified.

 

Robert V. LaPenta, 65, has served as the Chairman of the Board since December 2005, President and Chief Executive Officer of L-1 since August 2006. Mr. LaPenta is the founder and Chief Executive Officer of L-1 Investment Partners, LLC, a private investment management firm. From April 1997 to April 2005, Mr. LaPenta served as President, Chief Financial Officer and a Director of L-3 Communications Holdings, Inc., which he co-founded in April 1997. From April 1996 when Loral Corporation was acquired by Lockheed Martin Corporation, until April 1997, Mr. LaPenta was a Vice President of Lockheed Martin and was Vice President and Chief Financial Officer of Lockheed Martin’s Command, Control, Communications and Intelligence and Systems Integration Sector. Prior to the April 1996 acquisition of Loral, he was Loral’s Senior Vice President and Controller, a position he held since 1991. He joined Loral in 1972 and was named Vice President and Controller of its largest division in 1974. He became Corporate Controller in 1978 and was named Vice President in 1979. Mr. LaPenta is on the Board of Trustees of Iona College, the board of directors of Core Software Technologies and the board of directors of Leap Wireless International, Inc.

 

Dr. Joseph Atick, 46, joined L-1 in August 2006 as Executive Vice President and Chief Strategic Officer effective with the merger of Identix with L-1. Prior to that, he served as President & Chief Officer of Identix since June of 2002. Prior to that, he had co-founded one of the original facial recognition companies, Visionics Corporation. Over the years, Dr. Atick co-founded and managed several companies focused on technology transfer and development, and has served as a technical advisor to many high-tech enterprises and organizations, including NATO. He had also led the Computational Neuroscience Laboratory at Rockefeller University and the Neural Cybernetics Group at the Institute for Advanced Study in Princeton, New Jersey. Dr. Atick holds a Ph.D. in Mathematical Physics from Stanford University.

 

James A. DePalma, 59, joined L-1 as Executive Vice President, Chief Financial Officer and Treasurer effective with the merger of Identix with L-1. He brings three decades of operational and finance experience in the defense and technology industries to his role within the Company. Prior to joining L-1, Mr. DePalma was a founding partner of L-1 Investment Partners. Prior to the formation of L-1 Investment Partners, Mr. DePalma served as a consultant to L-3 Communications Holdings, Inc. and was Chief Executive Officer of Core Software Technology, a leading software provider to the intelligence community and an equity investment of L-3 Communications Holdings, Inc. Mr. DePalma has also held high level executive positions with Westinghouse Electric Corporation, CBS Corporation and Viacom International. He also was a senior partner at PricewaterhouseCoopers.

 

Doni L. Fordyce, 51, joined L-l as Executive Vice President of Corporate Communications effective with the merger of Identix with L-1. Prior to August 2006, she was a founding partner of L-1 Investment Partners and brings two decades of senior executive and investment management experience to the Company, serving most recently as Chief Executive Officer, President and Chief Operation Officer of Bear Stearns Asset Management (BSAM) Inc. Prior to that Ms. Fordyce was Vice President of Goldman Sachs Inc. from 1986 to 1996 where she was one of the founders of the asset management business. She has also worked in IT solutions consulting, specializing networking, data management and printing for investment banks and financial institutions.

 

Mark S. Molina, 51, joined L-1 in August 2006 as Executive Vice President, Chief Legal Officer and Secretary in August 2006 effective with the merger of Identix with L-1. Prior to joining L-1, he was Executive Vice President, Chief Legal Officer and Secretary at Identix, which he joined as Vice President and General Counsel in 1999. Mr. Molina is a business and technology lawyer with over 20 years experience structuring

and negotiating mergers, acquisition, dispositions, joint ventures, technology licenses, financings and investments. He has considerable experience with public offerings and private placements as well as SEC reporting compliance and obligations of publicly traded companies.

 

Joseph Paresi, 55, joined L-1 in August 2006 as Executive Vice President and Chief Marketing Officer effective with the merger of Identix with L-1. He was a founding partner of L-1 Investment Partners LLC. Mr. Paresi brings three decades of executive management, product development, and design engineering experience in the technology and defense industries to his role with the Company. Prior to joining L-1 Investment Partners, he served as Corporate Vice President of product development for L-3 Communications and as President of L-3 Security & Detection Systems from 1997 to 2005.

 

Vincent A. D’Angelo, 66, joined L-1 as Senior Vice President of Finance in August 2006 effective with the merger of Identix with L-1. Prior to that, he was a consultant for L-1 Investment Partners. Prior to that, Mr. D’Angelo was a Senior Audit Partner with PricewaterhouseCoopers for more than 35 years where he was involved in all facets of the business, including client service, management, operations, governance, SEC filings, and mergers and acquisitions.

 

There are no family relationships among any of L-1’s executive officers and directors.

 

On April 23, 2007, the Company entered into an employee arrangement with Mr. Robert LaPenta, Jr., the son of the Company’s Chief Executive Officer, to serve as Vice President, M&A/Corporate Development.

 

Internet Website

 

L-1 maintains a corporate website with the address www.L1id.com. Its intended use is as a regular means of disclosing material non-public information and for complying with disclosure obligations under Regulation FD promulgated by the SEC. Such disclosures will be included on the website under the heading “Investor Relations — Events and Presentations.” Accordingly, investors should monitor such portions of the website, in addition to following the Company’s press releases, SEC filings and public conference calls and webcasts.

 

L-1 is not incorporating information contained in the website by reference into this Annual Report on Form 10-K. The Company makes available, free of charge through the website, its Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments to these reports as soon as reasonably practicable after electronically filing such material with, or furnishing such material to, the Securities and Exchange Commission.

 

Materials filed with the SEC can be read and copies made at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further information about the Public Reference Room. The SEC also maintains a website, www.sec.gov containing the reports, proxy and other information filed with the SEC.

 

 

This Annual Report on Form 10-K contains or incorporates a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which L-1 operates and management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that management, we or L-1 “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements and should be read in conjunction with consolidated financial statements and notes to consolidated financial statements included in this report. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below. The risks and uncertainties described below are not the only ones L-1 faces. Additional risks and uncertainties, including those not presently known to L-1 or that the Company currently deems immaterial,

may also impair the business. L-1 expressly disclaims any obligation to update any forward-looking statements, except as may be required by law.

 

Business Risks

 

There are risks and uncertainties associated with the Safran transaction.

 

There are risks and uncertainties associated with the Safran transaction, including that such transaction may not be consummated, or may not be consummated as currently anticipated, as a result of several potential risks, including but not limited to: (i) the inability to obtain approval in respect of the Committee on Foreign Review in the United States or to obtain such approval without conditions that are not currently anticipated; or (ii) the failure to satisfy the other conditions for closing set forth in the Merger Agreement.

 

Under certain circumstances, if the Merger Agreement with Safran is terminated, we may be required to pay Safran a termination fee of $25.0 million or reimburse Safran for up to $12.5 million of Safran’s documented out-of-pocket expenses. If the merger agreement is terminated and all conditions to the consummation of the merger transaction have been satisfied other than those conditions related to regulatory approvals (and those to be satisfied immediately prior to the closing), Safran has agreed to pay the Company a termination fee of $75.0 million.

 

Lawsuits have been filed and other lawsuits may be filed against us and Safran challenging the Safran merger and seeking, among other things, injunctive relief enjoining the Safran transaction, and an adverse ruling in any such lawsuit may prevent the Safran transaction from being completed. See Item 3, Legal Proceedings.

 

Because we have consummated the BAE transaction, if we fail to consummate the merger with Safran, we will be required to continue to operate the Company without the Intel Business, which could adversely affect our financial condition, results of operations and share price.

 

Our business could be adversely impacted as a result of uncertainty related to the Safran transaction.

 

The Safran transaction (including the risks and uncertainties related to the consummation of the transaction) could cause disruptions in our business, which could have an adverse effect on our results of operations and financial condition. Our employees may experience uncertainty about their future roles at the Company, which might adversely affect our ability to retain and hire key managers and other employees. Our customers and suppliers may experience uncertainty about the Company’s future and may seek alternative business relationships with third parties or seek to alter their business relationships with the Company. In addition, the attention of our management may be directed to transaction-related considerations and may be diverted from the day-to-day operations of our business. The occurrence of any of these events, individually or in combination, could adversely affect our financial condition, results of operations and share price.

 

The Merger Agreement also restricts us from engaging in certain activities and taking certain actions without Safran’s approval, which could adversely affect our ability to manage our operations effectively in light of changes in economic or market conditions or to execute our business strategy or prevent us from pursuing opportunities or other strategic alternatives that may arise prior to the closing of the transaction.

 

We have incurred, and will continue to incur, significant fees for professional services and other transaction costs in connection with the merger with Safran, and many of these fees and costs are payable by us regardless of whether we consummate the transaction. In addition, our stock price rose upon announcement of the proposed merger with Safran and any failure to consummate the merger could result in a drop in our stock price.

 

L-1 has a history of operating losses.

 

L-1 has a history of operating losses before income taxes. The business operations began in 1993 and, except for 1996 and 2000, have resulted in losses before income taxes in each year, which have included significant asset impairments, amortization of intangible assets and stock-based compensation expense, and in

2010 strategic alternative costs. At December 31, 2010, L-1 had an accumulated deficit of approximately $643.9 million. L-1 will continue to invest in the development of secure credential and biometric technologies, as well as government services and will make significant capital expenditures to meet the requirements of recently awarded secure credentialing contracts. The need for these expenditures to grow the business will affect the ability to report operating profit and reduce the accumulated deficit.

 

Over 94 percent of L-1 revenue from continuing operations is derived from government contracts which are often non-standard, involve competitive bidding, may be subject to cancellation with or without penalty and may produce volatility in earnings and revenue.

 

More than 94 percent of L-1’s continuing business involves providing solutions and services under contracts with U.S. Federal, State, Local and foreign government agencies. Obtaining contracts from government agencies is challenging and government contracts often include provisions that are not standard in commercial transactions.

 

For example, government contracts may:

 

 

Securing government contracts can be a protracted process involving competitive bidding. In many cases, unsuccessful bidders may challenge contract awards, which can lead to increased costs, delays and possible loss of the contract for the winning bidder. Protests, and similar delays, regarding any future government contracts of a material nature that may be awarded to L-1 could result in materially adverse revenue volatility, making management of inventory levels, cash flows and profitability inherently difficult. Outright loss of any material government contract through the protest process or otherwise, could have a material adverse effect on financial results and stock price.

 

In addition, government contracts may specify performance criteria that must be satisfied before the customer accepts the products and services. Collection of accounts receivable may be dependent on meeting customer requirements, which may be unpredictable, subject to change by the customer, and may be misinterpreted by L-1 which could result in the incurrence of unexpected costs that may be uncompensated and could negatively affect profit margins and liquidity.

 

Government contracts are subject to continued appropriations by Congress and availability of funding for State and Local programs. Reduced funding or changes in procurement policies that curtail the use of outside contractors could result in terminated, delayed or de-scoped contracts with L-1 and adversely affect the ability for L-1 to meet sales and earnings goals.

 

For the year ended December 31, 2010 and 2009, U.S. Federal government agencies, directly or indirectly, accounted for 36 percent and 39 percent of L-1 consolidated revenues from continuing operations, respectively. Future sales under existing and future awards of U.S. government contracts are conditioned upon the continuing availability of Congressional appropriations, which could be affected by current or future political and economic conditions. Failure to approve budgets or raise debt limits may result in a suspension of funding of government operations.

 

In addition, while spending authorizations defense-related programs by the Federal government has increased in recent years, particularly after the 2001 terrorist attacks and more recently in support of U.S. war efforts in Southwest Asia, future levels of expenditures, mission priorities and authorizations for these programs may decrease, remain constant or shift to programs in areas where L-1 does not currently provide

products or services. Current Federal government spending levels for defense-related programs are in part related to the U.S. military operations in Afghanistan and Iraq, and may not be sustainable, as a result of changes in government leadership, policies or priorities.

 

Similar to Federal government contracts, State and Local government agency contracts may be contingent upon availability and appropriation of funds provided by Federal, State or Local entities. In the current economic and political environment, States may reduce or suspend expenditures which may result in cancellation or deferral of projects. State and Local law enforcement and other government agencies are subject to political, budgetary, purchasing and delivery constraints which may result in quarterly and annual revenue and operating results that may be irregular and difficult to predict. Such revenue volatility makes management of inventory levels, cash flows and profitability inherently difficult. In addition, if L-1 is successful in winning such procurements, there may be unevenness in delivery schedules, as well as potential delays and changes in the timing of deliveries and recognition of revenue, or cancellation of such procurements.

 

The full amount of L-1 revenues reflected in backlog may not be realized, which could harm operations and significantly reduce future revenues.

 

There can be no assurances that backlog estimates will result in actual revenues in any particular fiscal period because clients may modify or terminate projects and contracts and may decide not to exercise contract options or estimate of quantities may not materialize.

 

L-1 backlog represents sales value of firm orders for products and services not yet delivered and, for long term executed contractual arrangements (contracts, subcontracts, and customer’s commitments), the estimated future sales value of estimated product shipments, transactions processed and services to be provided over the term of the contractual arrangements, including renewal options expected to be exercised. For contracts with indefinite quantities backlog reflects estimated quantities based on current activity levels. Backlog includes estimates of revenues that are dependent on future government appropriation, option exercise by clients and/or is subject to contract modification or termination. Due to current economic environment and potential spending constraints experienced by State and Local governments, in particular, realization of backlog may be adversely impacted. At December 31, 2010, L-1 backlog from continuing operations was approximately $0.9 billion of which approximately $282.0 million is expected to be realized in 2011. These estimates are based on L-1 experience under such contracts and similar contracts, and the Company believes such estimates to be reasonable in the circumstances. However, L-1 believes that the estimate of revenues reflected in backlog for the following twelve months will generally be more reliable than the estimate for periods thereafter.

 

If L-1 does not realize a substantial amount of backlog, operations could be harmed and expected future revenues could be significantly reduced.

 

Quarterly results are difficult to predict due to factors including long sales cycles; if quarterly financial expectations are missed, the L-1 stock price could decline.

 

Quarterly revenue and operating results are difficult to predict and fluctuate from quarter to quarter. The sales cycle for solutions and services is typically long and subject to a number of significant risks and potential delays over which the Company has no or little control. While potential customers are evaluating L-1 products, the Company may incur substantial selling and marketing costs and expend significant management resources in an effort to obtain sales order and contracts that may never materialize. In addition, as operating expenses are based on anticipated revenue levels, fluctuations in revenues as a result of the timing of contract awards and the exercise of options and task orders can cause operating results to vary significantly between periods. Factors which may delay procuring decisions include:

 

 

 

Due to the factors described above, operating results in some periods may not meet investor expectations. If this happens, the market price of L-1 common stock could be adversely impacted. Fluctuations in future quarterly operating results may also be caused by many other factors, including:

 

 

The Company must fund substantial capital expenditures for the secure credentialing business.

 

The installation of secure credentialing systems requires significant capital expenditures. The need to fund such capital expenditures increased following the 2008 acquisition of the secure credentialing business of Digimarc.

 

For the year ended December 31, 2010, capital expenditures were $45.0 million, as compared to $55.0 million in the prior year. Capital expenditures are expected to approximate $40.0 million for the year ending December 31, 2011. While L-1 expects to fund capital requirements primarily from operating cash flows and borrowings under its revolving credit facility, in the near term, cash otherwise available to fund strategic opportunities and repay long-term debt is reduced. At December 31, 2010, L-1 had cash and cash equivalents of $3.1 million and availability under its existing credit agreement of $68.9 million, subject to continuing compliance with covenants contained in the agreement. While the Company believes it has adequate capital resources to meet current working capital and capital expenditure requirements and has been successful in the past in obtaining financing for acquisitions, L-1 expects to have increased capital needs as it continues to expand its business.

 

In addition, if the Safran transaction is not consummated, the Company may be unsuccessful in raising additional financing to fund growth or it may have difficulty in obtaining financing at attractive rates or on terms that are not excessively dilutive to existing shareholders. Failure to secure additional financing in a timely manner and on favorable terms could have a material adverse effect on its growth, financial performance and stock price and could require the Company to delay or abandon expansion.

 

Covenants in the Company’s credit facility may restrict financial and operating flexibility and the Company may not be able to comply with its financial covenants.

 

L-1 is a party to a credit agreement which, after the repayment of the term loans in February 2011, provides for up to $135.0 million in borrowings through 2013, of which $68.9 million was available at December 31, 2010, subject to continuing compliance with debt covenants. Under the agreement, L-1 is required to maintain specific financial covenants related to leverage and debt service coverages as of the end of each fiscal quarter. On August 30, 2010, L-1 entered into an amendment and consent (the “Third Amendment”) to the Second Amended and Restated Credit Agreement dated as of August 5, 2008, among L-1 Identity Solutions Operating Company, the Company, Bank of America, N.A., the Lenders party thereto, Wachovia Bank, National Association, Banc of America Securities LLC and Wachovia Capital Markets LLC (as amended, the “Credit Agreement”). The Third Amendment extended the time period during which

previously modified financial covenants will apply under the Credit Agreement due to the Company having entered into a definitive agreement providing for the sale of all or substantially all of the assets and operations of the Company and its subsidiaries in connection with its strategic alternatives review on September 19, 2010. The Third Amendment provides that L-1 must maintain the minimum Consolidated Debt Service Coverage Ratio of 1.65 to 1.00 as of the end of the fourth fiscal quarter of 2010, after which L-1 must maintain a minimum Consolidated Debt Service Coverage Ratio of 2.25 to 1.00 as of the end of each fiscal quarter thereafter, and L-1 must maintain a maximum Consolidated Leverage Ratio of 3.85 to 1.00 as of the end of the fourth fiscal quarter of 2010, after which L-1 must maintain a maximum Consolidated Leverage Ratio shall return to 2.75 to 1.00 for each fiscal quarter thereafter.

 

At December 31, 2010 the Company’s Consolidated Debt Service Coverage Ratio was 1.79:1.00 and the Consolidated Leverage Ratio was 3.50:1.00; accordingly the Company was in compliance with the modified financial covenants. After giving effect to the sale of the Intel Businesses to BAE and the required prepayment of L-1’s term loan facility using the net proceeds of such sale, the Company believes it will achieve compliance with the financial covenants applicable in the first quarter of 2011 and thereafter. The ability to satisfy these financial ratios in the future can be affected by events beyond the Company’s control and it cannot assure meeting these ratios. If the merger with Safran does not occur, the Company expects to refinance its debt on a long term basis or otherwise take other actions to repay or amend the term loans and other debt. There is no assurance that a refinancing or other action to repay or modify the loan can be successfully executed.

 

The credit agreement also places limitations on additional borrowings, mergers and related-party transactions, on payment of dividends and with respect to capital expenditures. Borrowings under the agreement are collateralized by Company’s assets and bear interest at the Eurodollar Rate, or the lender’s base rate, plus market-rate spreads that are determined by reference to the Company’s leverage ratio.

 

Default under the credit facility could allow the lenders to declare all amounts outstanding to be immediately due and payable. L-1 has pledged substantially all of its assets to secure the debt under the credit facility. If the lenders declare amounts outstanding under the credit facility to be due, the lenders could proceed against those assets. Any event of default, therefore, could have a material adverse effect on the business if the creditors determine to exercise their rights. The Company also may incur future debt obligations that might subject L-1 to restrictive covenants that could affect financial and operational flexibility, restrict ability to pay dividends on common stock, or subject L-1 to other events of default.

 

L-1 is subject to government regulation and failure to comply with applicable regulations could subject the Company to penalties that may restrict its ability to conduct business.

 

L-1 is affected by and must comply with various government regulations that impact operating costs, profit margins and the internal organization and operation of the business.

 

Failure to comply with applicable regulations, rules and approvals could result in the imposition of penalties, the loss of government contracts or disqualification as a U.S. government contractor, all of which could adversely affect the business, financial condition and results of operations. Among the most significant regulations affecting the business are:

 

 

 

These regulations affect how L-1 and its customers do business and, in some instances, impose added costs to L-1. Any changes in applicable laws and regulations could restrict the ability for L-1 to conduct business. Any failure by L-1 to comply with applicable laws and regulations could result in contract termination, price or fee reductions or suspension, debarment or disqualification from contracting with the Federal, State and Local governments.

 

The Company could be adversely affected by a negative audit by the U.S. government.

 

U.S. government agencies, including the Defense Contract Audit Agency and various agency Inspectors General, routinely audit and investigate government contractors. These agencies review a contractor’s performance under its contracts, cost structure and compliance with applicable laws, regulations, and standards. The U.S. government also reviews the adequacy of, and a contractor’s compliance with, its internal control systems and policies, including the contractor’s management, purchasing, property, estimating, compensation, accounting, and information systems. If an audit or investigation uncovers improper or illegal activities, L-1 may be subject to civil or criminal penalties 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. In addition, L-1 could suffer serious reputational harm if allegations of impropriety were made.

 

Biometric technologies have not yet achieved widespread commercial acceptance and the strategy of expanding the biometric business could adversely affect L-1 business operations and financial conditions.

 

L-1’s strategy includes the enhancement of the Company’s leadership in biometric technologies. Pursuing this strategy involves risks. For example, to date biometric technologies have not yet gained widespread commercial acceptance. Although there has been more commercial activity recently, there is no assurance that this activity will continue or expand. Some of the obstacles to the use of biometric technologies include a perceived loss of privacy and public perceptions as to the usefulness of biometric solutions. Whether the market for biometric technologies and solutions expands is dependent upon factors such as:

 

 

L-1 does not know when, if ever, biometric solutions and services will gain widespread commercial acceptance. Certain groups have publicly objected to the use of biometric solutions and services for some applications on civil liberties grounds and legislation has been proposed to regulate the use of biometric security solutions. Biometric technologies have been the focus of organizations and individuals seeking to

curtail or eliminate such technologies on the grounds that they may be used to diminish personal privacy rights. If such initiatives result in restrictive legislation, the market for biometric solutions may be adversely affected. Even if biometric technologies gain wide market acceptance, L-1 biometric solutions and services may not adequately address the requirements of the market and may not gain widespread commercial acceptance.

 

L-1 faces intense competition that could result in lower revenues and higher R&D expenditures and could adversely affect results of the Company’s operations.

 

Since the events of September 11, 2001 regulatory and policy changes in the U.S. and abroad have heightened interest in the use of biometric security solutions, and L-1 expects competition in this field, which is already substantial, to intensify.

 

Competitors are developing and marketing semiconductor ultrasonic and optically based direct contact fingerprint image capture devices, or retinal blood vessel, iris pattern, hand geometry, voice or various types of facial structure solutions. L-1 solutions also compete with non-biometric technologies which may be less costly, such as certificate authorities and traditional keys, cards, surveillance systems and passwords. Widespread adoption of one or more of these technologies or approaches in the markets targeted could significantly reduce the potential market for L-1 systems and solutions.

 

Some competitors have significantly more resources than L-1. Competitors may introduce products that are more price competitive, have increased performance or functionality or incorporate technological advances that L-1 has not yet developed or implemented. To remain competitive, L-1 must continue to develop, market and sell new and enhanced solutions at competitive prices, which will require significant research and development expenditures. If L-1 does not develop new and enhanced solutions or if the Company is not able to invest adequately in research and development activities, the business, financial condition and results of operations could be severely and negatively impacted.

 

L-1 must keep pace with changing technologies or risk losing existing and new customers.

 

In order to compete effectively in the biometrics market, L-1 must continually design, develop and market new and enhanced products. Future success will depend, in part, upon the Company’s ability to address the changing and sophisticated needs of customers. Frequently, technical development programs in the biometric industry require assessments to be made of the future directions of technology and technology markets generally, which are inherently risky and difficult to predict. L-1 may not be able to accurately predict which technologies customers will support. If the Company fails to choose correctly among technical directions, or fail to offer innovative solutions at competitive prices in a timely manner, customers may forego purchases of L-1 solutions and purchase those of competitors.

 

Security breaches in systems sold or maintained by L-1 could result in the disclosure of sensitive government information or private personal information that could result in the loss of customers and negative publicity.

 

Many of the systems included in L-1 solutions manage private personal information and protect information involved in sensitive government functions. The protective security measures that are used in these systems may not prevent security breaches, and failure to prevent security breaches may disrupt business, damage reputation, and expose L-1 to litigation and liability. A party that is able to circumvent protective security measures used in these systems could misappropriate sensitive or proprietary information or cause interruptions or otherwise damage L-1 products, services and reputation, and the property and privacy of customers. If unintended parties obtain sensitive data and information, or create bugs or viruses or otherwise sabotage the functionality of systems, L-1 may receive negative publicity, incur liability to customers or lose the confidence of customers, any of which may cause the termination or modification of contracts. Further, insurance coverage may be insufficient to cover losses and liabilities that may result from such events.

 

L-1 may be required to expend significant capital and other resources to protect the Company against the threat of security breaches or to alleviate problems caused by the occurrence of any such breaches. In addition,

protective or remedial measures may not be available at a reasonable price or at all, or may not be entirely effective.

 

Reliance on external suppliers and contract manufacturers may result in delays and loss of sales or customers.

 

The lead-time for ordering certain products and materials and for building many of L-1 products included in the Company’s solutions can be many months. As a result, L-1 must order such products and materials based on forecasted demand. If demand for solutions lags significantly behind forecasts, L-1 may purchase more products than the Company can sell, resulting in increased cash needs and write-downs of obsolete or excess inventory. In addition, if the delivered product purchases are delayed, the Company may lose customers and sales.

 

L-1 relies on contract manufacturers to produce hardware products under short term manufacturing arrangements. Although L-1 believes it can find alternative sources for the manufacturing of hardware, any disruption of contractual arrangements could result in delaying deliveries or in the loss of sales. The Company obtains certain hardware and services, as well as software applications, from a limited group of suppliers. The reliance on these suppliers involves risks, including reduced control over quality and delivery schedules. Any financial instability of suppliers could result in having to find new suppliers. L-1 may experience delays in manufacturing and deliveries of products and services to customers if the Company loses its sources or if supplies and services delivered from these sources are delayed, which could result in the loss of sales or customers.

 

The market for L-1 solutions is still developing and if the biometrics industry adopts standards or a platform different from L-1’s, then the Company’s competitive position would be negatively affected.

 

The market for identity solutions is still developing. The evolution of this market may result in the development of different technologies and industry standards that are not compatible with L-1’s current solutions, products or technologies.

 

Several organizations, such as the International Civil Aviation Organization, sets standards for travel documents that its member States then put into effect, and the National Institute for Standards and Testing, which is part of the U.S. Department of Commerce, set standards for biometrics to be used in identification and documentation. Although L-1 believes that its biometric technologies comply with existing standards for finger, face and iris recognition, these standards may change and any standards adopted could prove disadvantageous to or incompatible with the L-1 business model and current or future solutions, products and services.

 

The L-1 plan to pursue sales in international markets may be limited by risks related to conditions in such markets.

 

For the year ended December 31, 2010, L-1 derived approximately 16 percent of total revenues of continuing operations from international sales and the Company’s strategy is to expand its international operations. There is a risk that the Company may not be able to successfully market, sell and deliver solutions, products and services in foreign countries.

 

Risks inherent in marketing, selling and delivering products in foreign and international markets, each of which could have a severe negative impact on financial results and stock price, include those associated with:

 

 

 

L-1 expects that it will have increased exposure to foreign currency fluctuations. As of December 31, 2010, accumulated other comprehensive gain includes foreign currency translation gains of approximately $0.7 million.

 

In addition, L-1 has significant Japanese Yen denominated transactions with Japanese suppliers of hardware and consumables for the delivery to customers. Fluctuations in foreign currencies, including the Japanese Yen, Canadian Dollar, Indian Rupee and the Euro could result in unexpected fluctuations to results of operations, which could be material and adverse.

 

If L-1 does not successfully expand direct sales and services organizations and partnering arrangements, the Company may not be able to increase sales to meet L-1’s growth expectations.

 

L-1 services are sold and licensed through the Company’s direct business development and sales organization. Future success depends on substantially increasing the size and scope of the direct business development and sales force and partnering arrangements, both domestically and internationally. L-1 may face intense competition for personnel, and the Company cannot guarantee that it will be able to attract, assimilate or retain additional qualified business development and sales personnel on a timely basis.

 

Moreover, given the large-scale deployment required by some customers, L-1 may need to hire and retain a number of highly trained customer service and support personnel. The Company cannot guarantee that it will be able to increase the size of the customer service and support organization on a timely basis to provide the high quality of support required by its customers. The ability to add additional business development and sales and customer service personnel could result in customer dissatisfaction and loss of customers.

 

The Company relies in part upon system integrators, Original Equipment Manufacturers (OEMs) and distribution partners to sell some L-1 solutions, technologies and services; the Company may be adversely affected if those parties do not actively promote the products or pursue installations that do not use L-1 solutions, technologies and services.

 

A portion of L-1 revenue comes from sales to partners including OEMs, systems integrators, distributors and resellers. Some of these relationships have not been formalized in a detailed contract, and may be subject to termination at any time. Even where these relationships are formalized in a detailed contract, the agreements can often be terminated with little or no notice and subject to periodic amendment.

 

L-1 intends to continue to seek strategic relationships to distribute, license and sell certain of L-1 products. However the Company may not be able to negotiate acceptable relationships in the future and cannot predict whether current or future relationships will be successful.

 

If solutions, systems and products are not delivered in a timely fashion or do not perform as promised, L-1 could experience increased costs, lower margins, liquidated damage payment obligations and reputational harm.

 

L-1 often provides complex systems that are required to operate in difficult or sensitive circumstances. The development of such complex systems may be subject to delays or failure to meet performance requirements to customer specifications. The negative effects of any delay or failure to deliver to meet performance requirements could be exacerbated if the delay or failure occurs in systems that provide personal

security, secure sensitive computer data, authorize significant financial transactions or perform other functions where a security breach could have significant consequences.

 

If a product launch is delayed or is the subject of an availability shortage because of problems with the Company’s ability to manufacture or assemble the product successfully on a timely basis, or if a product or service otherwise fails to meet performance criteria, L-1 may lose revenue opportunities entirely and/or experience delays in revenue recognition associated with a product or service in addition to incurring higher operating expenses during the period required to correct the defects.

 

There is a risk that for unforeseen reasons L-1 may be required to repair or replace a substantial number of systems in use or to reimburse customers for systems that fail to work or meet strict performance criteria. From time to time, in certain critical or complex sale or licensing transactions, L-1 may be compelled to accept liability provisions that vary from the Company’s preferred contracting model. There is a risk that in certain contracts and circumstances L-1 may not be successful in adequately minimizing product and related liabilities or that the protections negotiated will not ultimately be deemed enforceable. L-1 carries product liability insurance, but existing coverage may not be adequate to cover potential claims. Although the Company will deploy back-up systems, the failure of products to perform as promised could result in increased costs, lower margins, liquidated damage payment obligations and harm to reputation. This could result in contract terminations and have a material adverse effect on business and financial results.

 

Failure to maintain the proprietary nature of L-1 technology, intellectual property and manufacturing processes could have a material adverse affect on the business and the Company’s ability to effectively compete.

 

L-1 principally relies upon patent, trademark, copyright, trade secret and contract law to establish and protect proprietary rights. There is a risk that claims allowed on any patents or trademarks held by L-1 may not be broad enough to protect the Company’s technology. In addition, patents or trademarks may be challenged, invalidated or circumvented and L-1 cannot be certain that the rights granted there under will provide competitive advantages.

 

Moreover, any current or future issued or licensed patents, or trademarks, or currently existing or future developed trade secrets or know-how may not afford sufficient protection against competitors with similar technologies or processes, and the possibility exists that certain of already issued patents or trademarks may infringe upon third party patents or trademarks or be designed around by others.

 

In addition, there is a risk that others may independently develop proprietary technologies and processes, which are the same as, substantially equivalent or superior to L-1, or become available in the market at a lower price.

 

L-1 may be required to expend significant resources to monitor and protect intellectual property rights. The Company may have to litigate to enforce patents or trademarks or to determine the scope and validity of other parties’ proprietary rights. Litigation could be very costly and divert management’s attention. An adverse outcome in any litigation may have a severe negative effect on financial results and stock price.

 

To determine the priority of inventions, L-1 may participate in interference proceedings declared by the United States Patent and Trademark Office or oppositions in foreign patent and trademark offices, which could result in substantial cost and limitations on the scope or validity of patents or trademarks.

 

In addition, foreign laws treat the protection of proprietary rights differently from laws in the United States and may not protect proprietary rights to the same extent as U.S. laws. The failure of foreign laws or judicial systems to adequately protect L-1’s proprietary rights or intellectual property, including intellectual property developed on the Company’s behalf by foreign contractors or subcontractors may have a material adverse effect on the L-1 business, operations, financial results and stock price.

Legal claims regarding infringement by L-1 or suppliers of third party intellectual property rights could result in substantial costs, diversion of managerial resources and reputational harm.

 

Although L-1 believes that its solutions, products and services do not infringe currently existing and validly issued intellectual property rights of others, the Company might not be able to defend successfully against a third-party infringement claim. A successful infringement claim against L-1, its customers or suppliers could subject the Company to:

 

 

Failure to prevail against any third party infringement claim could have a material adverse effect on the business and financial results. Even if L-1 is not found liable in a claim for intellectual property infringement, such a claim could result in substantial costs, diversion of resources and management attention, termination of customer contracts and harm to the Company’s reputation.

 

L-1 faces inherent product liability or other liability risks that could result in large claims against the Company.

 

L-1 has inherent risk of exposure to product liability and other liability claims resulting from the use of its products, especially to the extent customers may depend on L-1 products in public safety situations that may involve physical harm or even death to individuals, as well as exposure to potential loss or damage to property. Despite quality control systems and inspection, there remains an ever-present risk of an accident resulting from a faulty manufacture or maintenance of products, or an act of an agent outside of the Company’s or supplier’s control. Even if L-1 products perform properly, the Company may become subject to claims and costly litigation due to the catastrophic nature of the potential injury and loss. A product liability claim, or other legal claims based on theories including personal injury or wrongful death, made against L-1 could adversely affect operations and financial condition. Although L-1 may have insurance to cover product liability claims, the amount of coverage may not be sufficient.

 

L-1 is dependent on a small number of individuals and if the Company loses key personnel, the business will be adversely affected.

 

If the Safran transaction is not completed, much of L-1’s future success depends on the continued service and availability of senior management, including the Chairman of the Board, President and Chief Executive Officer, Robert V. LaPenta, and other members of the executive team. These individuals have acquired specialized knowledge and skills with regards to advanced technology identity solutions. The loss of any of these individuals could severely harm the business. L-1 also is highly dependent on the ability to retain, hire and motivate talented highly skilled personnel. Experienced personnel in the advanced technology identity solutions industry are in high demand and competition for their talents is intense. If L-1 is unable to successfully attract, retain and motivate key personnel, the business may be severely harmed.

 

If L-1 fails to recruit and retain skilled employees or employees with the necessary security clearances, the Company may not be able to perform under government services contracts or win new business.

 

To be competitive, L-1 must have employees with advanced information technology and technical services skills that work well with customers in a government or defense-related environment. Often, these employees require some of the highest security clearances in the United States. These employees are in great demand and are likely to remain a limited resource in the foreseeable future. If L-1 is unable to recruit and

retain a sufficient number of these employees, the ability to maintain and grow the business could be negatively impacted.

 

Certain L-1 shareholders have significant relationships with the Company that could result in actions taken that are not supported by unaffiliated shareholders.

 

In connection with the Aston investment in the Company, Aston became the largest shareholder of L-1, currently owning approximately 8.1 percent of L-1’s outstanding common stock. As a result, Aston (together with its affiliate, L-1 Investment Partners LLC) has an influence on matters requiring approval by shareholders, including the election of directors and most corporate actions, such as mergers and acquisitions. In addition, L-1 has significant relationships within L-1 Investment Partners LLC and Aston including Mr. Robert V. LaPenta, founder and Chief Executive Officer of L-1 Investments Partners LLC who is Chairman of the Board and Chief Executive Officer and President of L-1.

 

Mr. James DePalma, Mr. Joseph Paresi and Ms. Doni Fordyce are affiliates of L-1 Investment Partners LLC and Aston, serve as the Executive Vice President and Chief Financial Officer, Executive Vice President and Chief Marketing and Sales Officer, and Executive Vice President of Corporate Communications, respectively.

 

L-1 has entered into certain transactions with Aston, L-1 Investment Partners and Mr. LaPenta, including a sublease of office space from L-1 Investment Partners, an agreement in principle to purchase a portfolio Company of Aston at fair market value (if and as approved by the Board of Directors), and a private placement issuance of securities to Mr. LaPenta in connection with his participation in L-1’s $120 million private placement to fund in part the acquisition of the ID Systems business of Digimarc. See Note 4 to the Consolidated Financial Statements, “Related Party Transactions” for a more detailed description of these transactions.

 

Mr. LaPenta also has a significant personal investment in L-1 common stock through his controlling interest in Aston and his direct ownership which, at December 31, 2010 considered in the aggregate, represented beneficial ownership of approximately 14.6 percent of the outstanding L-1 common stock. The concentration of large percentages of ownership in any single shareholder, or in any series of single shareholders, may influence the likelihood or timing of any change in control of the Company. Additionally, the sale of a significant number of shares in the open market by single shareholders or otherwise could adversely affect the Company’s stock price. In connection with the Safran transaction, Mr. LaPenta and Aston entered into a voting agreement under which they agreed to vote all shares beneficially owned by them in favor of the Safran transaction and not to transfer their shares other than pursuant to the Safran transaction, in each case subject to limited exceptions.

 

Acquisition Related Risks

 

Integration of acquired businesses may be difficult to achieve and will consume significant financial and managerial resources, which may adversely affect operations.

 

The L-1 operating philosophy is to let acquired businesses operate in an autonomous manner subject to corporate oversight but integrating and rationalizing duplicative functions to achieve revenue and cost synergies. The Company may encounter substantial difficulties, costs and delays in integrating the operations recently acquired and future acquisitions such as:

 

 

 

The geographic distance between acquired businesses and their respective offices and operations increases the risk that the integration will not be completed successfully or in a timely and cost-effective manner. L-1 may not be successful in overcoming these risks or any other problems encountered in connection with the integration of the companies. The simultaneous integration of these acquisitions may place additional strain on L-1 resources and increase the risk that business may be adversely affected by the disruption caused by the acquisitions. The strategy contemplates acquiring additional businesses, the integration of which may consume significant financial and managerial resources, and could have a severe negative impact on the business, financial condition and results of operations.

 

Acquisitions could result in future impairment and other charges, which could adversely affect operational results.

 

L-1 recorded impairment charges aggregating $3.1 million in 2010 and $528.6 million in 2008 for goodwill and long-lived assets, primarily related to the biometric businesses. At December 31, 2010, goodwill, intangible assets and property and equipment related to continuing operations amounted to $700.3 million, $61.3 million and $126.2 million, respectively. Because goodwill represents a residual after the purchase price is allocated to the fair value of acquired assets and liabilities, it is difficult to quantify the factors that contribute to the recorded amounts and subsequent impairments, if any. Nevertheless, management believes that the following factors have contributed to the amount recorded:

 

 

The recorded amounts at the purchase date for goodwill and other intangible assets are estimates at a point in time and are based on valuations and other analyses of fair value that require significant estimates and assumptions about future events, including but not limited to projections of revenues, market growth, demand, technological developments, political developments, government policies, among other factors, which are derived from information obtained from independent sources, as well as the management of the acquired businesses and business plans for the acquired businesses or intellectual property.

 

If estimates and assumptions used to initially record goodwill and intangible assets do not materialize, or unanticipated adverse developments or events occur, ongoing reviews of the carrying amounts of such goodwill and intangible assets may result in impairments which will require L-1 to record a charge in the period in which such an impairment is identified, and could have a severe negative impact on its business and financial statements.

 

If the L-1 stock price were to decrease materially from current levels and remain depressed for a sustained period of time, the Company may be required to assess the carrying amount of goodwill and long-lived assets of reporting units before the next scheduled annual impairment test. If at that time the estimated fair values of the reporting units are less than their respective carrying amounts, L-1 would need to determine whether goodwill and long-lived assets would be impaired. Moreover, if economic conditions deteriorate and capital markets conditions negatively impact the valuation of enterprises, the estimated fair values of L-1 reporting units could be adversely impacted, which could result in future impairments.

If L-1 does not achieve expected benefits from completed acquisitions, the price of L-1 common stock could decline.

 

L-1 expects that its consummated acquisitions will enhance leadership in the identity solutions industry through the combination of respective technologies. However, the combination of such technologies might not meet the demands of the customers.

 

If L-1 technologies fail to meet such demand, customer acceptance of L-1 biometric products could decline, which would have an adverse effect on results of operations and financial conditions. Further, L-1 expects that the additions to solutions offerings will extend current market reach and provide a critical component to the Company’s comprehensive offering for new markets in need of identity solutions. However, there can be no assurance that current customers or customers in new markets will be receptive to these additional offerings. Further, L-1 might not be able to market successfully its products and services to the customers of the businesses acquired. If L-1 solutions offerings and services fail to meet the demands of customers, results of operations and financial condition could be adversely affected.

 

There is also a risk that L-1 will not achieve the anticipated benefits of the acquisitions as rapidly as, or to the extent, anticipated by financial or industry analysts, or that such analysts will not perceive the same benefits to the acquisitions as does the Company. If these risks materialize, the L-1 stock price could be adversely affected.

 

There are no unresolved staff comments.

 

 

L-1 does not own any properties. Significant leasing arrangements are outlined below.

 

The Corporate headquarters comprises approximately 17,000 square feet of space in facilities located in Stamford, Connecticut. L-1 subleases space from L-1 Investment Partners LLC. The sublease terminates on the earlier of the date that the Company’s Chairman and Chief Executive Officer ceases employment with the Company or March 2015. L-1 uses this property for corporate, administrative and general business needs.

 

Information about the Company’s leased facilities related to continuing operations follows.

 

 

L-1 also leases sales and support offices in multiple locations throughout the United States and internationally.

 

While the Company believes that these facilities are adequate to meet immediate needs, it may become necessary to secure additional space in the future to accommodate any future growth. The Company believes that such additional space will be available as needed in the future on commercially reasonable terms.

 

 

Putative Shareholder Class Action Litigation

 

The Company was named as a defendant in five putative shareholder class actions filed in the Superior Court of Connecticut, Judicial District of Stamford-Norwalk at Stamford, arising out of the transactions with Safran and BAE pursuant to the Merger Agreement and BAE Purchase Agreement. The actions were captioned: Michael Palma v. Robert LaPenta et al., CV-10-6006781-S (Conn. Super. Ct.), Barry P. Kranz, Jr. v. L-1 Identity Solutions et al., CV-10-6006760-S (Conn. Super. Ct.), Michael Matteo v. L-1 Identity Solutions et al., CV-10-6006759-S (Conn. Super. Ct.), Dart Seasonal Products Retirement Plan v. L-1 Identity Solutions et al., CV-10-6006835-S (Conn. Super. Ct.), and George F. Chrisman v. Robert LaPenta et al., CV-10-6006886-S (Conn. Super. Ct.) (collectively, the “Shareholder Actions”).

 

The plaintiffs in the Shareholder Actions generally alleged the members of the L-1 Board of Directors and certain officers of the Company breached their fiduciary duties to shareholders by, among other things, allegedly

failing to receive maximum value for their shares, failing to conduct an appropriate sale process and agreeing to certain terms in the proposed merger agreement with Safran that allegedly discourage competing offers from other potential bidders and/or benefit defendants. The Shareholder Actions generally alleged that the Company aided and abetted these alleged breaches of fiduciary duty. Certain of the suits also alleged claims against Safran, Merger Sub, BAE and BAE Systems, Inc. (the parent entity to BAE and the U.S. affiliate of BAE Systems plc) for aiding and abetting the foregoing alleged breaches of fiduciary duty. The Shareholder Actions generally sought preliminary and permanent relief, including, among other things, permission to proceed as a class action, declaratory relief declaring that defendants have breached their fiduciary duties, an injunction enjoining the transactions contemplated by the Merger Agreement and BAE Purchase Agreement, rescissionary damages in the event that the Transactions are consummated, costs and attorneys’ and experts’ fees.

 

On December 1, 2010, the plaintiffs reported that they had agreed on a lead counsel and lead plaintiff structure whereby the Matteo, Kranz & Dart Seasonal Products Retirement Plan plaintiffs became co-lead plaintiffs and their counsel co-lead counsel. On December 3, 2010, the Court entered an order consolidating the actions and appointing a leadership structure consisting of Kranz and Dart Seasonal Products Retirement Plan as Lead Plaintiffs, the law firms of Robbins Umeda LLP and Robbins Geller Rudman & Dowd LLP as Co-Lead Counsel for Plaintiffs, and the law firms of Wofsey Rosen Kweskin Kuriansky, LLP and Diserio Martin O’Connor & Castiglioni LLP as Co-Liaison Counsel for Plaintiffs. The caption for the consolidated cases is: In re L-1 Identity Solutions, Inc. Shareholder Litigation, Lead Case No. X05-FST-CVIO-6006759-S.

 

On December 6, 2010, Lead Plaintiffs filed a Motion for Limited Expedited Discovery and for a Briefing and Hearing Schedule on Plaintiffs’ Anticipated Motion for Equitable Relief and Objection to Defendants’ Request for Extension of Time to Respond to Plaintiff’s Discovery Requests in the Court. On December 10 and 13, 2010, the Company and the other defendants (except the BAE defendants who had already filed motions to strike and to stay), respectively, filed motions to strike the Complaint and motions to stay discovery pending adjudication of the motions to strike and objections to Lead Plaintiffs’ motion to expedite discovery.

 

On December 15, 2010, after arm’s length negotiations, the parties entered into a memorandum of understanding (“MOU”) to settle the litigation, which will be memorialized in a final settlement agreement to be submitted to the Court for approval. Pursuant to the MOU, the Company agreed to make certain additional disclosures in the Final Proxy. Additionally, pursuant to the MOU, the plaintiffs will be afforded the opportunity to conduct confirmatory discovery sufficient to confirm the fairness and reasonableness of the terms of the final settlement agreement.

 

The Company continues to vigorously deny any and all liability with respect to the facts and claims alleged in the action.

 

Old Digimarc Litigation

 

In connection with the Company’s August 2008 acquisition of Old Digimarc, which consisted of its Secure ID Business following the spin-off of its digital watermarking business, the Company assumed certain legal proceedings of Old Digimarc as described below.

 

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the federal securities laws were filed in the United States District Court for the Southern District of New York naming approximately 300 companies, including Old Digimarc, certain officers and directors and certain underwriters of the companies’ initial public offerings as defendants. The complaints were subsequently consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters of Old Digimarc’s initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements in Old Digimarc’s initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of Old Digimarc’s stock in the aftermarket subsequent to the initial public offering. Old Digimarc and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters’ alleged compensation arrangements and manipulative practices. The complaint sought unspecified damages. In July 2002, the claims against Old Digimarc under Section 10(b) were dismissed. In October 2002, the individual officer and

director defendants were dismissed without prejudice pursuant to tolling agreements. Subsequent addenda to these tolling agreements extended the tolling period through August 27, 2010. In June 2004, a stipulation of partial settlement among the plaintiffs, the companies, and the officers and directors was submitted to the District Court. While the partial settlement was pending approval, the plaintiffs continued to litigate their claims against the underwriter defendants. The district court directed that the litigation proceed within a number of “focus cases” rather than in all of the 309 cases that had been consolidated. Old Digimarc was not one of these focus cases. In October 2004, the district court certified the focus cases as class actions. The underwriter defendants appealed that ruling and, on December 5, 2006, the Court of Appeals for the Second Circuit reversed the district court’s class certification decision for the six focus cases. In light of the Second Circuit opinion, in June 2007, the district court entered an order terminating the settlement. On August 14, 2007, the plaintiffs filed their second consolidated amended class action complaints against the focus cases and on September 27, 2007, again moved for class certification. On November 12, 2007, certain of the defendants in the focus cases moved to dismiss the second consolidated amended class action complaints. The court issued an opinion and order on March 26, 2008, denying the motions to dismiss except as to Section 11 claims raised by those plaintiffs who sold their securities for a price in excess of the initial offering price and those who purchased outside the previously certified class period. The class certification motion was withdrawn without prejudice on October 10, 2008. On April 2, 2009, a stipulation and agreement of settlement among the plaintiffs, issuer defendants (including Old Digimarc) and underwriter defendants was submitted to the Court for preliminary approval. Old Digimarc’s portion of the settlement, which is wholly immaterial, is covered entirely by insurance.

 

On June 10, 2009, the Judge granted preliminary approval of the settlement, and on October 5, 2009, the Judge granted final approval of the settlement. On August 26, 2010, based on the expiration of the tolling period stated in the tolling agreements with the individual officers and directors, the plaintiffs filed a Notice of Termination of Tolling Agreement and Recommencement of Litigation against the named officers and directors. The plaintiffs stated to the Court that they do not intend to take any further action against the named officers and directors at this time. Notices of appeal of the opinion granting final approval were filed by six groups of appellants. In October 2010, four of the groups of appellants withdrew their appeals with prejudice. Plaintiffs have moved to dismiss with prejudice one of the remaining appeals based on alleged violations of the Second Circuit’s rules, including failure to serve, falsifying proofs of service, and failure to include citations to the record, and moved to dismiss the other appeal based on alleged lack of standing. It is unclear when the Second Circuit will rule on these motions.

 

On October 10, 2007, an Old Digimarc shareholder filed a lawsuit in the United States District Court for the Western District of Washington against several companies that acted as lead underwriters for the Old Digimarc initial public offering. The complaint, which also named Old Digimarc as a nominal defendant but did not assert any claims against Old Digimarc, asserted claims against the underwriters under Section 16(b) of the Securities Exchange Act of 1934. On February 28, 2008, an amended complaint was filed, with Old Digimarc still named only as a nominal defendant. Similar complaints have been filed by this same plaintiff against a number of other issuers in connection with their initial public offerings, and the factual allegations are closely related to the allegations in the litigation pending in the United States District Court for the Southern District of New York which is described above.

 

On March 12, 2009, after considering motions to dismiss, one filed by thirty moving issuers and the other filed by the underwriters, the judge dismissed the plaintiff’s claims on a jurisdictional and statute of limitations basis. On April 10, 2009, the plaintiff filed a notice of appeal of the dismissal. The final appellate brief was filed on November 17, 2009; and oral argument was heard by the Ninth Circuit Court of Appeals on October 5, 2010.

 

On December 2, 2010, the Ninth Circuit Court of Appeals affirmed the District Court’s decision to dismiss the moving issuers’ cases (including the Company’s) on the grounds that plaintiff’s demand letters were insufficient to put the issuers on notice of the claims asserted against them and further ordered that the dismissals be made with prejudice. The Ninth Circuit, however, reversed and remanded the District Court’s decision on the underwriter’ motion to dismiss as to the claims arising from the non-moving issuers’ IPOs, finding plaintiff’s claims were not time-barred under the applicable statute of limitations. In remanding, the

Ninth Circuit advised the non-moving issuers and underwriters to file in the District Court the same challenges to plaintiff’s demand letters that moving issuers had filed.

 

On December 16, 2010, underwriters filed a petition for panel rehearing and petition for rehearing en banc. Appellant Vanessa Simmonds also filed a petition for rehearing en banc. On January 18, 2011, the Ninth Circuit denied the petition for rehearing and petitions for rehearing en banc. It further ordered that no further petitions for rehearing may be filed.

 

On January 24, 2011, the underwriters filed a motion to stay the issuance of the Ninth Circuit’s mandate in the cases involving the non-moving issuers. On January 25, 2011, the Ninth Circuit granted the underwriters’ motion and ordered that the mandate in the cases involving the non-moving issuers is stayed for ninety days pending the filing of a petition for writ of certiorari in the United States Supreme Court. On January 26, 2011, Appellant Vanessa Simmonds moved to join the underwriters’ motion and requested the Ninth Circuit stay the mandate in all cases. On January 26, 2011, the Ninth Circuit granted Appellant’s motion and ruled that the mandate in all cases (including the Company’s and other moving issuers) is stayed for ninety days pending Appellant’s filing of a petition for writ of certiorari in the United States Supreme Court. The Company currently believes that the outcome of this litigation will not have a material adverse impact on its condensed consolidated financial position and results of operations.

 

Patent Litigation

 

On May 12, 2010, the Company was served with a complaint in the U.S. District Court, District of Delaware, alleging patent infringement of US Patent No. 5,913,542 regarding the making, using, offering for sale and selling of ID cards, including drivers’ licenses. On August 19, 2010, the Company filed an amended answer to the complaint, which contained counterclaims for declaratory judgment against the plaintiff. The Court has set a trial date of June 11, 2012. Based on the preliminary nature of the proceedings, it is not possible at this stage to quantify the potential damages, exposure or liability to L-1, if any.

 

Other

 

The Company records a liability for any claim, demand, litigation and other contingency when management believes that it is both probable that a liability has been incurred and can reasonably estimate the amount of the potential loss. Based on current information and belief, the Company believes it has adequate provisions for any such matters. The Company reviews these provisions quarterly and adjusts these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular matter. However, because of the inherent uncertainties of litigation the ultimate outcome of certain litigation cannot be accurately predicted by the Company; it is therefore possible that the consolidated financial position, results of operations or cash flows of the Company could be materially adversely affected in any particular period by the unfavorable resolution of one or more of these matters and contingencies.

 

[Removed and Reserved]

 

 

Market for L-1 Common Stock

 

L-1 common stock is traded on the New York Stock Exchange under the symbol “ID.” As of February 24, 2011, there were 828 holders of record of L-1 common stock.

 

The quarterly high and low sales prices, as reported by the New York Stock Exchange or NASDAQ, as applicable, of L-1 common stock during 2010 and 2009 were as follows:

 

 

Dividend Policy

 

L-1 paid no dividends in 2010 or 2009.   L-1 presently intends to retain its cash for use in the operation and expansion of business and, therefore, does not anticipate paying any cash dividends in the foreseeable future. In addition, L-1 is prohibited from paying dividends pursuant to its credit agreement with Bank of America, N.A.

 

Recent Sales of Unregistered Securities

 

None.

 

Repurchases of Common Stock

 

There were no significant shares repurchased of common stock during 2010 and 2009. On January 26, 2011, JP Morgan Chase delivered 3,490,400 shares of common stock pursuant to the prepaid forward contract. The shares are being held in treasury.

 

Equity Compensation Plan Information⁽¹⁾

 

Information about our equity compensation plans as of December 31, 2010 is as follows:

 

 

 

Stock Performance Chart

 

The following performance chart assumes an investment of $100 on December 31, 2005 and compares the change through December 31, 2010 in the market price for L-1 common stock with the Russell 2000 Index, the NASDAQ Composite Index, and a peer group identified by the Company (the “Selected Peer Group Index”). The Selected Comparative Group Index was selected to include publicly-traded companies engaging in one or more of the Company’s lines of business.

 

The Selected Comparative Group Index is weighted according to the respective issuer’s stock market capitalization and is comprised of the following companies: CACI International, Inc., LaserCard Corporation, Bio-Key International and ImageWare Systems, Inc. The selected group data have been changed from that provided in prior periods to eliminate Cogent, Inc, and ActivIdentity Corporation which are no longer public companies.

 

The comparisons in the graphs below are based on historical data and are not intended to forecast the possible future performance of L-1’s common stock.

 

Stock Performance Chart

 

 

 

The financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and L-1’s audited consolidated financial statements as of December 31, 2010 and 2009 and for each of the three years in the period ended December 31, 2010 included in this annual report on Form 10-K, from which the data have been derived for the dates and periods indicated. The financial data set forth below has been revised to retroactively reflect the Company’s Intel Business as discontinued operations. The balance sheet data for all dates have been derived from the audited financial statements for the respective years. The income statement data for 2006 have been derived from

unaudited statement of operations reflecting the Intel Business as discontinued operations. The historical results of operations are not necessarily indicative of future results.

 

 

 

 

 

 

The following discussion and analysis should be read in conjunction with L-1’s consolidated financial statements and the accompanying notes thereto provided pursuant to “Item 8. Financial Statements and Supplementary Data” contained within this Annual Report on Form 10-K.

 

Overview

 

L-1 Identity Solutions, Inc. (“L-1” or the “Company”) is a provider of technology, products, systems and solutions, and services that protect and secure personal identities and assets. Together with its divisions, L-1 delivers the full range of offerings required for solving complex problems associated with managing identity. Depending upon customer needs, identity solutions can be bundled with services offerings to create an integrated solution.

 

The business is evaluated primarily through financial metrics including revenues, operating income (loss) and Adjusted EBITDA (earnings before, interest expense, net, depreciation and amortization, stock- based compensation expense, asset impairments and provision (benefit) for income taxes), and unlevered free cash flow.

 

The Company operates in two reportable segments: Solutions and Services.

 

The Solutions segment includes Secure Credentialing and Biometrics/Enterprise Access. Secure Credentialing solutions span the entire secure credentialing lifecycle, from testing through issuance and inspection. This includes driver’s licenses, national IDs, ePassports and other forms of government-issued proof of identity credentials. Biometric solutions capture, manage and move biometric data for positive, rapid ID and tracking of persons of interest. Biometrics solutions also encompass access control readers that enable businesses and governments to secure facilities and restricted areas by preventing unauthorized entry.

 

Prior to September 19, 2010, the Services segment included Enrollment Services, SpecTal/McClendon and Advanced Concepts. Enrollment Services performs fingerprint-based background checks necessary for federal and state licensed employment in the banking, finance, insurance, healthcare, legal, real estate, education and other industries. SpecTal/McClendon and Advanced Concepts provide services to the national security and intelligence community, including information technology, engineering and analytics, and intelligence. As a result of accounting for SpecTal/McClendon and Advanced Concepts as discontinued operations, subsequent to September 19, 2010, the Services segment consists of the Enrollment Services operating segment and all prior period segment data have been revised accordingly.

 

Recent Transactions

 

In January 2010, L-1 announced that one of its strategic goals and objectives for 2010 was to explore strategic alternatives to enhance shareholder value. Subsequently, on September 19, 2010, the Company entered into an agreement (the “Merger Agreement”) with Safran SA (“Safran”) and Laser Acquisition Sub Inc. (“Merger Sub”), a wholly owned subsidiary of Safran, pursuant to which, subject to the terms and conditions set forth in the Merger Agreement, the Company is to be acquired by Safran in a merger transaction providing for shareholders to receive $12.00 per share in cash, for an aggregate enterprise value of approximately $1.6 billion, inclusive of outstanding debt. Completion of the merger remains subject to certain conditions, including, among others, (i) termination or expiration of the Committee on Foreign Investment in

the United States (“CFIUS”) review period pursuant to the Exon-Florio Provision of the Defense Production Act of 1950; (ii) no Company Material Adverse Effect (as defined in the Merger Agreement) having occurred since the date of the Merger Agreement; (iii) subject to certain materiality exceptions, the accuracy of the representations and warranties made by the Company and Safran and compliance by the Company and Safran with their respective obligations under the Merger Agreement; (iv) no law or government order prohibiting the merger; and (v) other customary conditions.

 

In February 2011, the Company completed its previously announced sale of the Intel Business to BAE Systems Information Solutions, Inc. (“BAE”) (a subsidiary of BAE Systems, Inc., the U.S. affiliate of BAE Systems plc). Pursuant to the terms of the Purchase Agreement, dated as of September 19, 2010 (the “BAE Purchase Agreement”), by and between the Company and BAE, the Company sold the Intel Business to BAE for a purchase price of $295.8 million in cash (inclusive of acquired cash) and approximately $7.2 million in assumed obligations, the net proceeds of which were used to repay $289.3 million of outstanding debt under the Company’s credit agreement.

 

The accompanying financial data reflect the impact of the sale of the Intel Business, whose operating results have been reflected as discontinued operations for all periods presented, and the related assets have been presented as assets held for sale and liabilities related to assets held for sale as of December 31, 2010. However, the consolidated financial statements do not reflect the pro forma effect of the sale of the Intel Business or the repayment of the long-term debt in accordance with the terms of the Credit Agreement. Unless otherwise noted, revenues and expenses presented herein exclude amounts attributable to discontinued operations. See Notes 1 and 15 to the consolidated financial statements for additional information.

 

Business Trends

 

In the last two years management considered the following factors, among others in evaluating its financial condition and operating results:

 

 

 

The results of operations of the Company have been impacted by the considerations described above. Additional specific events that directly impacted the financial condition, results of operations and cash flows are discussed in the Consolidated Results of Operations and Liquidity and Capital Resources sections.

 

Revenues from continuing operations, increased to $450.1 million for the twelve months ended December 31, 2010, from $437.1 million for the year ended December 31, 2009. L-1’s net loss from continuing operations for the year ended December 31, 2010 was $10.0 million, compared $1.1 million loss for the year ended December 31, 2009. The net loss from continuing operations in 2010 includes a pre-tax impairment charge of $3.2 million primarily related to Registered Traveler program and pre-tax charges of $11.1 million of costs related to the strategic alternative process that resulted in executing definitive agreements to sell the Company. The 2009 loss includes a pre-tax provision of $1.2 million related to the suspension of the Registered Traveler program.

 

The net loss from discontinued operations for the year ended December 31, 2010 was $6.5 million, compared to a corresponding net loss of $2.9 million for the year ended December 31, 2009 and includes $4.7 million of strategic alternative costs. In the first quarter of 2011, the Company will recognize a pre-tax gain on the sale of the Intel Business to BAE of approximately $40.0 million.

 

Revenues

 

The Secure Credentialing business generates revenues from the sales of solutions consisting of bundled proprietary software with commercial off-the-shelf equipment and related maintenance and services, the sale of secure printing solutions and related consumables, and the design, customization and installation of secure credential issuance systems which generate revenues as the credentials are issued by the customer. The division also generates revenues from sales of solutions using biometric technologies of other divisions.

 

The Biometrics/Enterprise Access business generates revenues from the sale of biometric solutions incorporating fingerprint, facial, and iris biometrics and system components necessary for the biometric capture and knowledge discovery and the sale of biometrics solutions using proprietary multi-biometric capture devices bundled together with proprietary software and other biometric technologies, as well as sales of licenses and software. The division’s offerings include Live Scan and mobile systems and services for biometric capture and identification, systems and biometric solutions that include modules and software for biometric matching and verification, and related maintenance services. Revenues are generated by sales of hardware, software and maintenance and other services. In addition, the division provides solutions that include biometrics-based readers used to secure buildings and restricted areas.

 

The Enrollment Services business generates revenues through the sales of enrollment and background screening products and fingerprinting services principally under long term service contracts.

 

Government Consulting Services (now reported as discontinued operations) consists of the businesses of Advanced Concepts Inc., McClendon LLC, SpecTal, LLC, and generates revenue by providing consulting and information technology services to U.S. intelligence and military communities, principally under long term Federal contracts and subcontracts.

 

L-1 markets its solutions and services primarily to U.S. and foreign, Federal, State and Local government agencies and law enforcement agencies. L-1 also is working to expand the use of its solutions in commercial markets, particularly financial services, transportation and healthcare. In a typical contract with a government entity for an identity solution, L-1 designs the system, supplies and installs equipment and software and integrates the solution within the entity’s existing infrastructure and provides maintenance services. These contracts may be structured as fixed price contracts with payments made upon completion of agreed milestones or deliveries and with each milestone or delivery typically having a value specified in the contract. Alternatively, these contracts may provide for a fixed price per credential issued as is typical in the driver’s

license market. For services contracts, L-1 is compensated at a rate per fingerprint delivered in the case of fingerprinting services, or on a time and material, fixed price level of effort and cost reimbursable basis for Government Consulting Services contracts.

 

L-1’s aggregate revenues from continuing and discontinued operations have grown to $668.5 million in 2010 from $66.2 million in 2005. L-1 growth in revenues is due principally to acquisitions consummated, increased demand for identity solutions related to heightened emphasis on security, secure credentials, document authentication and biometrics, as well as increased demand for government security services. L-1 anticipates that the U.S. government agencies will continue to be major customers for the foreseeable future. L-1 also expects to experience increased demand from a number of other government entities as they deploy identity solutions, particularly document authentication, at points of entry and exit, including borders, seaports and airports and in connection with national identification programs. Notwithstanding expectations regarding demand for these solutions, the quantity and timing of orders from both U.S. and foreign government entities depends on a number of factors outside of the Company’s control, such as the level and timing of budget appropriations. Any funding delays or other changes in the rollout of government programs utilizing L-1 solutions, products and services could cause revenues to fall short of expectations.

 

Acquisitions

 

L-1 has pursued strategic acquisitions to complement and expand its existing solutions and services. Acquisitions since January 1, 2008 include:

 

 

The acquisitions have resulted in the consolidation of certain marketing resources, corporate functions of the separate entities and are expected to have a continuing material effect on operations resulting from, but not limited to:

 

 

Reportable Segments Results of Operations

 

L-1 operates in two reportable segments, the Solutions segment and the Services segment. Prior to September 19, 2010 the Services reportable segment consisted of the SpecTal/McClendon, Advanced Concepts and the Enrollment Services operating segments. As a result of presenting the SpecTal/McClendon and Advanced Concepts operating segments as discontinued operations, the Services reportable segment now consists of the Enrollment Services operating segment; accordingly, the segment data has been retroactively revised. L-1 measures segment performance primarily based on revenues, operating income (loss) and Adjusted

EBITDA and unlevered free cash flow. Operating results by segment for continuing operations, including allocation of corporate expenses, for the three years ended December 31, 2010 are as follows (in thousands):

 

 

In 2010 and 2009, the Solutions reportable segment includes a provision of $3.1 million and $1.2 million, respectively, primarily related to the suspension of the Registered Traveler program. In 2008, the Solutions and Services reportable segments include goodwill and long-lived asset impairments of $527.2 million and $1.4 million, respectively, and the Solutions segment includes merger related severance costs of $1.1 million. In 2010, the Solutions and Services segments includes allocated strategic alternative costs of $9.7 million and $1.4 million, respectively.

 

Excluding the above charges, the operating income (loss) for Solutions was $4.2 million in 2010, $13.7 million in 2009 and ($6.5) million in 2008 and operating income (loss) for Services was ($2.8) million in 2010 and $1.8 million in 2008. The 2010 period also reflects higher depreciation as a result of new credentialing systems coming on line. The 2008 period also reflects higher intangible amortization of intangible assets.

 

Revenue increases for the Solutions segment are primarily attributable to the acquisition of Digimarc in August 2008 and Bioscrypt in March 2008 as well as organic growth in the business as discussed below. Revenue increases for the Services segment reflects growth from higher volumes and new contracts.

 

Dependence on Significant Customers

 

For the year ended December 31, 2010, U.S. Federal government agencies, directly or indirectly, accounted for 36 percent of consolidated revenues from continuing operations. For the years ended December 31, 2009 and 2008, U.S. Federal Government agencies, directly or indirectly accounted for 39 percent and 44 percent of consolidated revenues from continuing operations, respectively. Accounts receivable from U.S. government agencies amounted to $8.6 million and $13.9 million at December 31, 2010 and 2009, respectively.

Discontinued Operations

 

Effective September 19, 2010, the Intel Business has been presented as discontinued operations. All prior period data have been revised accordingly. The following table summarizes operating data related to discontinued operations (in thousands):

 

 

Revenues from discontinued operations increased by $4.6 million in 2010 and $9.1 million in 2009 which reflects the impact of competitive pressures and the goal of certain agencies in the intelligence community to reduce reliance on subcontractors. The 2010 results include $4.7 million of strategic alternative costs. Operating margins before strategic alternative costs were 9.0 percent (6.8 percent after strategic alternative costs), 10.6 percent and 10.1 percent for 2010, 2009 and 2008, respectively.

 

Interest expense represents allocated costs incurred in connection with the debt required to be repaid from the proceeds from the sale of the discontinued operations.

 

Continuing Operations

 

Consolidated Results

 

Comparative results of operations have been affected by the March 2008 acquisition of Bioscrypt and the August 2008 acquisition of Old Digimarc (collectively the “Acquisitions”).

 

In addition to the impact of the Acquisitions, the following items impacted operating results, net of related tax effects, if applicable (in millions):

 

 

Specific information regarding the impact of the Acquisitions on the results of operations is provided below.

Comparison of 2010 to 2009

 

Revenues (in thousands)

 

 

Products and Services Revenues

 

The following represents details of the products and services revenues for the years ended December 31, 2010 and 2009 (in thousands):

 

 

Services revenues included in continuing operations represent revenues from enrollment services contracts for which the Company is compensated based on volume of enrollments performed. Solutions revenues comprise revenues from the delivery of consumables and equipment, as well as hardware, software and systems that include related services, primarily maintenance bundled with the related product deliverables. Because the product functionality is the primary deliverable for the customer, we have included the total revenues from these arrangements in solutions revenues. Solutions revenues also include revenues related to driver’s license production contracts for which we provide systems and maintenance, produce the licenses and are compensated in one all inclusive price per license as the licenses are produced.

 

Revenues increased by $13.0 million for the year ended December 31, 2010 or 3 percent from the year ended December 31, 2009. The increase from the prior year reflects revenue growth in L-1’s state drivers license contracts and hardware sales to India both of which are included in the Solutions segment. In addition, there were higher volumes in L-1’s enrollment services included in L-1’s Services segment.

 

Approximately 26 percent of L-1 revenues from continuing operations in 2010 and 2009 were derived from long-term service contracts with the U.S. Federal and State governments included in the L-1 Services reportable segment. These contracts are fixed unit price contracts for which L-1 is compensated as fingerprints are transmitted to the appropriate government agency.

 

Approximately 27 percent of L-1 revenues from continuing operations in 2010 and 2009 were derived from long-term contracts for the production of driver’s licenses and credentials for which L-1 is compensated on a fixed unit price per license or credential produced. The unit price for these contracts is fixed throughout the term of the contract. The prices are established in competitive bids in which price is one among many important criteria evaluated by the customer.

The remaining revenues, including other revenues from the driver’s licenses contracts which are not based on card production volumes, comprise 47 percent of revenues for the years ended December 31, 2010 and 2009 and were derived from contracts and purchase orders for consumables, hardware, software and custom solutions, including maintenance. These revenues are priced at prevailing prices at the time the order or contract is negotiated. These orders and contracts are often competitively bid, although some, particularly consumables sold pursuant to driver license and credential contracts, are sole source. Most of L-1 research, engineering and development and sales and marketing costs are related to generating these revenues.

 

Cost of Revenues and Gross Margin (in thousands)

 

 

Cost of revenues increased by $20.1 million or 6% for the year ended December 31, 2010 compared to the year ended December 31, 2009 which is consistent of the increase in revenues. Gross margin for 2010 was 27 percent compared to 29 percent in 2009. The decrease was due primarily to higher growth in revenues from lower margin enrollment services relative to the growth in L-1’s higher margin biometrics and credentialing solutions, which was also impacted by more competitive pricing in biometric products.

 

Included in the cost of revenues were $34.7 million and $29.2 million of non-cash charges for the years ended December 31, 2010 and 2009, respectively, which increased by $5.5 million, reflecting higher depreciation from our credentialing business. These non-cash charges reduced gross margins by 8 percent and 7 percent for the years ended December 31, 2010 and 2009, respectively.

 

Sales and Marketing Expenses (in thousands)

 

 

Sales and marketing expenses decreased by approximately $1.5 million for the year ended December 31, 2010 compared to the prior year. The decrease is attributable to cost reductions from synergies and rationalization in certain of L-1 businesses. Sales and marketing expenses consists primarily of salaries and costs including stock-based compensation, commissions, travel and entertainment expenses, promotions and other marketing and sales support expenses.

 

Research and Development Expenses (in thousands)

 

Research and development expenses increased by approximately $1.6 million for the year ended December 31, 2010 compared to the prior year. L-1 continues to focus on enhancing L-1 credentialing and biometric solutions offerings while maximizing L-1’s research costs to focus on those activities with the greatest technological and revenue potential. Gross research and development expenses were offset by lower utilization of research and development resources in the performance of contracts, the cost of which is included in cost of revenues and in capital projects. Gross research and development expenditures aggregated to $50.1 million for the year ended December 31, 2010 compared to $46.9 million in the prior year. Virtually all of L-1’s research and development costs are attributable to the Solutions segment. As a percentage of Solutions revenues, gross research and development costs were 15 percent for the years ended December 31, 2010 and 2009. Research and development expenses consist primarily of salaries and related personnel costs, including stock-based compensation and other costs related to the design, development, testing and enhancement of L-1 products.

 

General and Administrative Expenses (in thousands)

 

 

General and administrative expense increased approximately by $4.6 million for year ended December 31, 2010 compared to 2009. The increase relates to employee related expenses including stock-based compensation. As a percentage of revenues, general and administrative expenses remained flat at 13 percent for the years ended December 31, 2010 and 2009. General and administrative costs in 2009 also include a provision of $1.2 million related to suspension of the Registered Traveler program. General and administrative expenses consist primarily of salaries and related personnel costs, including stock-based compensation for L-1’s executive and administrative personnel, professional and Board of Directors’ fees, public and investor relations and insurance.

 

Asset Impairments and Acquisition Related Expenses (in thousands)

 

 

The asset impairment charge in 2010 primarily related to the Company’s decision not to participate in the restart of the Registered Traveler program. In 2009 the Company recorded $0.7 million related to potential acquisitions that were not consummated.

 

Strategic Alternative Transactions Costs and Other (in thousands)

 

 

Strategic alternative transactions costs were $11.1 million for the year ended December 31, 2010 and primarily represent legal and advisory costs incurred in connection with the exploration of strategic alternatives in 2010, and exclude costs attributable to the Intel Business.

Financing Costs (in thousands)

 

 

For the year ended December 31, 2010, financing costs increased by approximately $2.4 million compared to the prior year as a result of increased borrowings outstanding under the revolving credit facility. Financing costs are net of amounts attributed to discontinued operations of $23.7 million and $26.6 million in 2010 and 2009, respectively.

 

Other Expense, Net (in thousands)

 

 

Other expense, net includes interest income and realized and unrealized currency transaction gains and losses on foreign currency transactions, which are related primarily to changes in the value of the U.S. dollar relative to the Canadian Dollar and the Japanese Yen during the periods.

 

Income Taxes (in thousands)

 

 

The 2010 results reflect an income tax benefit of $20.2 million, primarily reflecting an increase in deferred tax assets as a result of current year temporary differences of $12.0 million, as well as a reduction of the valuation allowance related to the estimated utilization of net operating loss carryforwards of $9.0 million. At December 31, 2010, the Company had U.S. Federal net operating loss carryforwards of $477.2 million, which may be used to reduce future taxable income. In addition, the Company has $145.2 million of deductible goodwill, of which $46.4 million relates to continuing operations. Management evaluated the adequacy of the valuation allowance in light of the results for the year based on the cumulative results of operations for the three years ended December 31, 2010, after considering items that do not enter in the determination of taxable income, and the likely future operating results, including the expected tax gain from the sale of the Intel Business. Management will continue to evaluate the adequacy of the valuation allowance annually, and when its assessment of whether it is more likely than not that the related tax benefits will be realized changes, the valuation allowance will be increased or reduced with a corresponding benefit or charge included in income.

 

The 2009 results reflect an income tax benefit of $1.3 million, primarily reflecting an increase in deferred tax assets as a result of current year temporary differences, net of the utilization of net operating losses to offset estimated net taxable income. At December 31, 2009, the Company had U.S. Federal net operating loss carryforwards of $447.7 million, which may be used to reduce future taxable income. In addition, the Company has $159.5 million of deductible goodwill, of which $51.8 million relates to continuing operations. Management evaluated the adequacy of the valuation allowance in light of the results for the year based on the cumulative results of operations for the three years ended December 31, 2009, after considering items that do not enter in the determination of taxable income, and the likely future operating results. The review indicated that the recorded valuation allowance related to net operating losses was adequate as of December 31, 2009.

Comprehensive Loss (in thousands)

 

 

The change in comprehensive loss results from the net loss in 2010 of $16.5 million compared to $4.0 million in 2009, (the components of which are described above), changes in the fair value and amortization of derivatives accounted for as hedges which resulted in a net gain of $0.3 million in 2010 and $0.5 million in 2009. In addition, there were translation losses of $0.5 million and gains of $1.4 million in 2010 and 2009, respectively, resulting from the changes in the value of the U.S. dollar relative to foreign currencies, primarily the Euro and the Canadian Dollar.

 

Comparison of 2009 to 2008

 

Revenues (in thousands)

 

 

Products and Services Revenues

 

The following represents details of the products and services for revenues for the years ended December 31, 2009 and 2008 (in thousands):

 

 

Services revenues included in continuing operations represent revenues from enrollment services contracts for which the Company is compensated based on volume of enrollments performed. Solutions revenues comprise revenues from the delivery of consumables and equipment, as well as hardware, software and systems that include related services, primarily maintenance bundled with the related product deliverables. Because the product functionality is the primary deliverable for the customer, we have included the total revenues from these arrangements in solutions revenues. Solutions revenues also include revenues related to driver’s license production contracts for which we provide systems and maintenance, produce the licenses and are compensated in one all inclusive price per license as the licenses are produced.

Revenues increased by $79.0 million for the year ended December 31, 2009, of which $59.9 million related to the Acquisitions. Excluding the impact of the Acquisitions, revenues increased $19.1 million or 6 percent from the year ended December 31, 2008. The increase from the prior year is a result of increased revenue and new contracts in L-1’s enrollment services included in L-1’s Services segment.

 

Approximately 26 percent and 22 percent of L-1 revenues in 2009 and 2008 were derived from long-term service contracts with the U.S. Federal and State governments included in the L-1 Services reportable segment. These contracts are fixed unit price contracts for which L-1 is compensated as fingerprints are transmitted to the appropriate government agency for fingerprinting services.

 

Approximately 27 percent and 19 percent of L-1 revenues in 2009 and 2008, respectively, were derived from long-term contracts for the production of driver’s licenses and credentials for which L-1 is compensated on a fixed unit price per license or credential produced. The unit price for these contracts is fixed throughout the term of the contract. The prices are established in competitive bids in which price is one among many important criteria evaluated by the customer.

 

The remaining revenues, including other revenues from the driver’s licenses contracts which are not based on card production volumes, comprise 47 percent and 59 percent of revenues for the years ended December 31, 2009 and 2008, respectively, and were derived from contracts and purchase orders for consumables, hardware, software and custom solutions, including maintenance. These revenues are priced at prevailing prices at the time the order or contract is negotiated. These orders and contracts are often competitively bid, although some, particularly consumables sold pursuant to driver license and credential contracts, are sole source. Most of L-1 research and development and sales and marketing costs are related to generating these revenues.

 

Cost of Revenues and Gross Margin (in thousands)

 

 

Cost of revenues increased by $58.5 million for the year ended December 31, 2009 compared to the year ended December 31, 2008, of which $44.4 million is related to the Acquisitions. Excluding the Acquisitions, cost of revenues increased by $14.1 million or 6 percent in 2009 compared to the previous year, which is consistent with the increase in revenues. Gross margin for 2009 was 29 percent compared to 30 percent in 2008. The decrease was due primarily to increased revenue from lower margin enrollment services offset in part by the growth in L-1’s higher margin biometrics solutions.

 

Included in the cost of revenues were $29.2 million and $39.6 million of non-cash charges for the years ended December 31, 2009 and 2008, respectively, which decreased by $10.4 million, reflecting lower amortization in 2009 resulting from intangible asset impairments recorded in 2008, offset by additional amortization related to the Acquisitions. This decrease was offset by higher depreciation resulting from the acquisition of Digimarc. These non-cash charges reduced gross margins by 7 percent and 11 percent for the years ended December 31, 2009 and 2008, respectively.

Sales and Marketing Expenses (in thousands)

 

 

Sales and marketing expenses increased by approximately $2.2 million for the year ended December 31, 2009 compared to the prior year. Excluding the effects of the Acquisitions, sales and marketing expenses decreased by $2.6 million for the year ended December 31, 2009. These decreases are attributable to cost reductions from synergies and rationalization in certain of L-1 businesses, offset by continued investment in increasing sales and international marketing resources. Sales and marketing expenses consists primarily of salaries and costs including stock-based compensation, commissions, travel and entertainment expenses, promotions and other marketing and sales support expenses.

 

Research and Development Expenses (in thousands)

 

 

Research and development expenses decreased by approximately $4.5 million for the year ended December 31, 2009 compared to the prior year. Excluding the effects of the Acquisitions, research and development expenses in 2009 decreased by $1.7 million. L-1 continues to focus on enhancing L-1 credentialing and biometric solutions offerings while maximizing L-1’s research costs to focus on those activities with the greatest technological and revenue potential. Gross research and development expenses were offset by higher utilization of research and development resources in the performance of contracts, the cost of which is included in cost of revenues and in other projects. Gross research and development expenditures aggregated to $46.9 million for the year ended December 31, 2009 compared to $43.0 million in the prior year. Virtually all of L-1’s research and development costs are attributable to the Solutions segment. As a percentage of Solutions revenues, gross research and development costs were 15 percent for the years ended December 31, 2009 and 2008. Research and development expenses consist primarily of salaries and related personnel costs, including stock-based compensation and other costs related to the design, development, testing and enhancement of L-1 products.

 

General and Administrative Expenses (in thousands)

 

 

General and administrative expense increased approximately by $5.8 million for year ended December 31, 2009 compared to 2008, which is directly related to the Acquisitions. Excluding the effects of the Acquisitions, the general and administrative expenses remained flat as the Company continues to realize operating leverage by increasing revenue without corresponding increases in general and administrative expenses. As a percentage of revenues, general and administrative expenses decreased to 13 percent, as compared to 14 percent in the prior year and reflects the impact of improved leverage. General and administrative costs in 2009 also include a provision of $1.2 million related to suspension of the Registered Traveler program. General and administrative expenses consist primarily of salaries and related personnel costs, including stock-based compensation for L-1’s executive and administrative personnel, professional and Board of Directors’ fees, public and investor relations and insurance.

Asset Impairments and Acquisition Related Expenses (in thousands)

 

 

In 2008, assets impairments consist of goodwill of $430.0 million and long-lived assets of $98.6 million, principally intangible assets recorded in connection with acquisitions, and relate principally to the Company’s biometrics businesses included in the Solutions segment. The impairment charges resulted from the deteriorating economic conditions that manifested themselves in the fourth quarter of 2008 as well as capital market conditions that adversely impacted valuation of businesses L-1 acquired and the Company’s stock prices and market capitalization. The remaining $1.1 million related to merger related expense for the Old Digimarc acquisition. In 2009 the Company incurred transaction costs of $0.7 million related to potential acquisitions that were not consummated.

 

Strategic Alternative Transaction Costs and Other (in thousands)

 

 

In 2008, the Company recorded acquisition-related intangible amortization for assets that were impaired in 2008, for which no comparable amortization was recorded in 2009.

 

Financing Costs (in thousands)

 

 

For the year ended December 31, 2009, net financing costs increased by approximately $1.4 million compared to the prior year as a result of increased borrowings under L-1’s credit facility in August 2008, incurred primarily to fund the acquisitions, as well as higher interest rates. Interest expense is net of amounted attributed to discontinued operations of $26.6 million and $14.6 million in 2009 and 2008, respectively.

 

Other Income (Expense), Net (in thousands)

 

 

Other income (expense), net includes interest income and realized and unrealized currency transaction gains and losses on foreign currency transactions. The increases in other income (expense), net are related primarily to changes in the value of the U.S. dollar relative to the Canadian Dollar and the Japanese Yen during the periods.

 

Income Taxes (in thousands)

 

The 2009 results reflect an income tax benefit of $1.3 million, primarily reflecting an increase in deferred tax assets as a result of current year temporary differences, net of the utilization of net operating losses to offset estimated net taxable income. At December 31, 2009, the Company had U.S. Federal net operating loss carryforwards of $447.7 million, which may be used to reduce future taxable income. In addition, the Company has $159.5 million of deductible goodwill, of which $51.8 million relates to continuing operations. Management evaluated the adequacy of the valuation allowance in light of the results for the year based on the cumulative results of operations for the three years ended December 31, 2009, after considering items that do not enter in the determination of taxable income, and the likely future operating results. The review indicated that the recorded valuation allowance related to net operating losses is adequate as of December 31, 2009.

 

The 2008 results reflect an income tax expense of $7.6 million, primarily reflecting an increase in the deferred tax asset valuation allowance of approximately $48.0 million offset by the deferred benefit of $42.3 million primarily related to the impairment of long-lived assets recorded for the year (excluding the impact of the goodwill impairment which is not deductible for income tax purposes), and a current tax provision of $1.9 million. During the fourth quarter of 2008, management evaluated the adequacy of the valuation allowance in light of the results for the year and determined that, based on the cumulative results of operations for the three years ended December 31, 2008, after considering items that do not enter in the determination of taxable income, and the likely future operating results, it was more likely than not that the portion of the tax benefits of its net operating loss carryforwards that would not be realized would be higher than previously recorded. As a result, the Company increased the deferred tax asset valuation allowance to reflect the estimated tax benefits it expected to realize.

 

Comprehensive Loss (in thousands)

 

 

The change in comprehensive loss results from the net loss in 2009 of $4.0 million compared to $551.6 million in 2008, (the components of which are described above) changes in the fair value and amortization of derivatives accounted for as hedges which resulted in a net gain of $0.5 million in 2009 and $1.1 million loss in 2008. There were translation gains of $1.4 million and losses of $6.6 million in 2009 and 2008, respectively, resulting from the changes in the value of the U.S. dollar relative to foreign currencies, primarily the Euro and the Canadian Dollar.

 

Liquidity and Capital Resources

 

Capital Requirements

 

The Company’s most significant capital requirements are capital expenditures for new secure credentialing contracts, research and development and working capital needs. The most significant capital expenditures are related to L-1’s Solutions segment. Generally, new State driver’s license contracts provide for up front capital expenditures necessary to perform under the contract. As expected, with the acquisition of Old Digimarc, L-1’s capital requirements have increased as L-1 has bid on and was awarded new contracts or as contracts have been renewed. In 2010, L-1’s capital expenditures decreased to $45.0 million compared to $55.0 million in 2009. L-1 expects capital expenditures to approximate $40.0 million in 2011 as we complete the build out of systems from recently awarded contracts. L-1 expects to fund L-1’s capital requirements primarily with operating cash flows.

 

Liquidity

 

As of December 31, 2010, L-1 had $27.4 million of working capital including assets held for sale of $271.3 million, related liabilities of $42.1 million, including net deferred income tax liabilities of $15.7 million), current maturities of long term debt of $271.4 million, deferred income assets of $40.9 million and cash

and cash equivalents of $3.1 million. In addition, L-1 has financing arrangements, as further described below, available to support L-1’s ongoing liquidity needs, pursuant to which L-1 has available $68.9 million at December 31, 2010 under L-1’s revolving credit facility, subject to continuing compliance with debt covenants. As a result of the consummation of the sale of the Intel Business to BAE, the Company repaid approximately $289.3 million of its debt. L-1 believes that its existing cash and cash equivalent balances, existing financing arrangements and cash flows from operations will be sufficient to meet L-1’s operating and debt service requirements for the next 12 months. L-1 expects that the sale the Company to Safran will result in the repayment of substantially all existing debt of the Company including the Convertible Notes. However, if the Safran transaction is not consummated, it is likely that we will require additional financing to improve our liquidity and in that connection, we evaluate financing needs and the terms and conditions and availability under our credit facility on a regular basis and consider other financing options. L-1 may also pursue reduction of our current indebtedness if equity financing can be obtained on advantageous terms and may take other actions to improve liquidity. There can be no assurance that additional debt or equity financing will be available or that other actions can be taken on commercially reasonable terms, or at all. L-1’s ability to meet our business plan is dependent on a number of factors, including those described in the section of this report entitled “Risk Factors”.

 

Credit Agreement

 

On August 5, 2008, L-1 entered into a Second Amended and Restated Credit Agreement (the “Credit Agreement”), among L-1’s wholly owned subsidiary L-1 Identity Operating, L-1, Bank of America, N.A., Wachovia Bank, National Association, Banc of America Securities LLC and Wachovia Capital Markets LLC, to amend and restate the Amended and Restated Credit Agreement, by and among L-1, Bank of America, N.A. (“Administrative Agent”), Bear Stearns Corporate Lending, Inc., Bear Stearns & Co., Inc., Banc of America Securities LLC, Wachovia Bank, N.A. and Credit Suisse, Cayman Islands Branch. The Credit Agreement provided for a senior secured term loan facility in an aggregate principal amount of up to $300.0 million, with a term of five years, and a senior secured revolving credit facility in an aggregate principal amount of up to $135.0 million. The proceeds of the senior secured facilities were used to (i) fund, in part, the purchase price paid, and fees and expenses incurred, in connection with L-1’s acquisition of Digimarc Corporation after giving effect to the spin-off of its digital watermarking business (“Old Digimarc”), (ii) repay borrowings under L-1’s then existing revolving credit facility and (iii) provide ongoing working capital and fund other general corporate purposes of L-1. As of December 31, 2010, the Company has approximately $68.9 million available under its revolving credit facility, subject to continuing compliance with covenants under the credit agreement.

 

On July 9, 2009, L-1 entered into an amendment to the Credit Agreement pursuant to which the term loans under the Credit Agreement have been split into two tranches: the Tranche B-1 Term Loan and the Tranche B-2 Term Loan. The Tranche B-1 Term Loan, with an aggregate principal amount of approximately $128.1 million at December 31, 2010, requires annual principal payments (payable quarterly) of 10 percent of the original principal amount through September 30, 2010, 20 percent of the original principal amount through September 30, 2012, and thereafter, increasing over the duration of the Credit Agreement. The Tranche B-2 Term Loan, with an aggregate principal amount of approximately $131.8 million at December 31, 2010, requires annual principal payments (also payable quarterly) of 1 percent of the related original principal amounts over the remaining term of the Credit Agreement. After the consummation of the sale of the Intel Business to BAE, the borrowings outstanding under the term loans were fully repaid and the borrowings under the revolving credit facility were reduced to $56.2 million. At December 31, 2010, there were $57.9 million of borrowings that were outstanding under the revolving credit facility.

 

Under the terms of the amended senior secured credit facility, the Company has the option to borrow at LIBOR (subject to a floor of 3 percent) plus 2.75 percent to 5.0 percent per annum or at prime (subject to a floor of 2 percent) plus 1.75 percent to 4.0 percent per annum. L-1 is required to pay a fee of 0.5 percent on the unused portion of the revolving credit facility. All obligations of L-1 Operating under the Credit Agreement are guaranteed on a senior secured basis by L-1 and by each of L-1’s existing and subsequently acquired or organized direct or indirect wholly-owned subsidiaries (subject to certain exceptions). At

December 31, 2010, the interest rates were 6.75 percent for Tranche B-1 Term Loans, 7.25 percent for Tranche B-2 Term Loans and 6.0 percent for borrowings under the revolving credit facility.

 

L-1 is required to maintain the following financial covenants under the Credit Agreement:

 

 

On August 30, 2010, L-1 entered into an amendment and consent (the “Third Amendment”) to the Second Amended and Restated Credit Agreement dated as of August 5, 2008, among L-1 Identity Solutions Operating Company, the Company, Bank of America, N.A., the Lenders party thereto, Wachovia Bank, National Association, Banc of America Securities LLC and Wachovia Capital Markets LLC (as amended, the “Credit Agreement”). The Third Amendment extends the time period during which previously modified financial covenants will apply under the Credit Agreement, subject to the Company entering into definitive agreements providing for the sale of all or substantially all of the assets and operations of the Company and its subsidiaries in connection with its strategic alternatives review by September 30, 2010, which the Company executed on September 19, 2010. The Third Amendment provides that the minimum Consolidated Debt Service Coverage Ratio of 1.65 to 1.00 will remain in effect for the third fiscal quarter of 2010 and the period through and including March 30, 2011, after which the minimum Consolidated Debt Service Coverage Ratio shall return to 2.25 to 1.00 for each fiscal quarter thereafter, and the maximum Consolidated Leverage Ratio of 3.85 to 1.00 remain in effect for the third fiscal quarter of 2010 and the period through and including March 30, 2011, after which the maximum Consolidated Leverage Ratio shall return to 2.75 to 1.00 for each fiscal quarter thereafter. At December 31, 2010 the Company’s Consolidated Debt Service Coverage Ratio was 1.79:1.00 and the Consolidated Leverage Ratio was 3.50:1.00; accordingly the Company was in compliance with the modified financial covenants. On a pro forma basis giving effect to the BAE sale and the repayment of long term debt as if it had occurred on January 1, 2010, the pro forma debt service coverage ratio would have been 6.40: 1.00 and the pro forma leverage ratio would have been 0.55: 1.00.

 

Under the terms of the Credit Agreement, as amended, L-1 Operating may incur, assume or guarantee unsecured subordinated indebtedness in an amount up to $200.0 million, provided that no default or event of default shall have occurred or would occur as a result of the incurrence of such subordinated debt and the borrower and its subsidiaries are in pro forma compliance, after giving effect to the incurrence of such subordinated debt, with each of the covenants in the Credit Agreement, including, without limitation, the financial covenants described above.

 

Pursuant to the terms of the Credit Agreement, as amended, L-1 may incur, assume or guarantee any amount of unsecured subordinated indebtedness, provided, that no default or event of default shall have occurred or would occur as a result of the incurrence of such subordinated debt and the pro forma Consolidated Leverage Ratio (as defined in the Credit Agreement) of L-1 and its subsidiaries after giving effect to the incurrence of such subordinated debt shall be less than 4.75:1.00. The Credit Agreement limits

the ability of L-1 to (i) pay dividends or other distributions or repurchase capital stock, (ii) create, incur, assume or suffer to exist any indebtedness, (iii) create, incur, assume or suffer to exist liens upon any of its property, assets or revenues, (iv) sell, transfer, license, lease or otherwise dispose of any property, (v) make or become legally obligated to make capital expenditures above certain thresholds, subject to certain permitted adjustments, (vi) make investments, including acquisitions, and (vii) enter into transactions with affiliates. These covenants are subject to a number of exceptions and qualifications. The Credit Agreement provides for customary events of default which include (subject in certain cases to customary grace and cure periods), among others: nonpayment, breach of covenants or other agreements in the Credit Agreement or the other Loan Documents (as defined in the Credit Agreement), payment defaults or acceleration of other indebtedness, failure to pay certain judgments, inability to pay debts as they become due and certain events of bankruptcy, insolvency or reorganization.

 

If an event of default, including a change in control (as defined in the Credit Agreement) occurs, the Administrative Agent may, with the consent of the Required Lenders declare all outstanding indebtedness including accrued and unpaid interest under the Credit Agreement to be due and payable.

 

The Company has entered into interest rate protection agreements to reduce its exposure to the variable interest rate payments on its term loan. In October 2008, the Company entered into an interest rate protection agreement with a notional amount of $62.5 million, which expires in November, 2011. Under the term of the agreement, the Company pays the counter party a fixed rate of 4.1 percent and receives variable interest based on three-month LIBOR (subject to a floor of 3.0 percent). In May 2009, the Company entered into two additional interest rate protection agreements with notional amounts of $50.0 million each, pursuant to which the Company pays a fixed rate of 1.4 percent and receives three month LIBOR. The Company settled the agreements in February 2011.

 

Convertible Senior Notes

 

On May 17, 2007, the Company issued $175.0 million of Convertible Notes with a conversion feature which allows the Company the option to settle the debt either in shares of common stock or to settle the principal amount in cash and the conversion spread in cash or stock. The proceeds of the Convertible Notes offering, net of deferred financing costs amounted to $168.7 million. In connection with the issuance of the Convertible Notes, L-1 entered into an agreement with Bear Stearns (now JP Morgan Chase) to purchase approximately 3.5 million shares of L-1’s common stock for approximately $69.8 million for delivery in May 2012. However, L-1 settled its obligation at the date the prepaid forward agreement was executed for cash.

 

The Notes are governed by an indenture, dated May 17, 2007 (the “Indenture”), between the Company and the trustee. The Notes will be convertible only under certain circumstances, as described below. If, at the time of conversion, the daily volume-weighted average price per share for a 25 trading day period calculated in accordance with the Indenture (as defined in greater detail in the Indenture, “VWAP”) of the Company’s common stock is less than or equal to $32.00 per share, which is referred to as the base conversion price, the Notes will be convertible into 31.25 shares of common stock of the Company per $1,000 principal amount of the Notes, subject to adjustment upon the occurrence of certain events. If, at the time of conversion, the VWAP of the shares of common stock of the Company exceeds the base conversion price of $32.00 per share, the conversion rate will be determined pursuant to a formula resulting in holders’ receipt of up to an additional 14 shares of common stock per $1,000 principal amount of the Notes, subject to adjustment upon the occurrence of certain events and determined as set forth in the Indenture. As an example, if the volume-weighted price per share (VWAP) of the Company stock were to increase to $40.00 per share, the additional shares issuable upon conversion would be 2.8, and the shares issuable per $1,000 principal amount of the Notes would be 34.05.

 

The Notes are convertible until the close of business on the second business day immediately preceding May 15, 2027, in multiples of $1,000 in principal amount, at the option of the holder under the following circumstances: (1) during the five business-day period after any five consecutive trading day period (the “measurement period”) in which the trading price per Note, for each day of such measurement period was less than 98 percent of the product of the last reported sale price of shares of common stock of the Company and

the applicable conversion rate for such trading day; (2) during any fiscal quarter, if the last reported sale price of shares of common stock of the Company for 20 or more trading days in a period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130 percent of the base conversion price on the related trading day; (3) if the Company calls any or all of the Notes for redemption; and (4) upon the occurrence of specified corporate transactions described in the Indenture, including for a specified period of time prior to a change in control transaction. Upon conversion, the Company has the right to deliver shares of common stock based upon the applicable conversion rate, or a combination of cash and shares of common stock, if any, based on a daily conversion value as described above calculated on a proportionate basis for each trading day of a 25 trading-day observation period. In the event of a fundamental change as specified in the Indenture, which includes a change in control transaction, the Company will increase the conversion rate by a number of additional shares of common stock specified in the Indenture, or, in lieu thereof, the Company may in certain circumstances elect to adjust the conversion rate and related conversion obligation so that the Notes will become convertible into shares of the acquiring or surviving Company. In connection with the Safran merger, the Company delivered a conversion notice, and expects that the conversion price will be equal to the base conversion price. The Notes will not become convertible into shares of Safran in connection with the merger.

 

The Notes bear interest at a rate of 3.75 percent per year payable semiannually in arrears in cash on May 15 and November 15. The Notes will mature on May 15, 2027, unless earlier converted, redeemed or repurchased. The Company may redeem the Notes at its option, in whole or in part, on or after May 20, 2012, subject to prior notice as provided in the Indenture. The redemption price during that period will be equal to the principal amount of the notes to be redeemed, plus any accrued and unpaid interest. The holders may require the Company to repurchase the Notes for cash on May 15, 2012, May 15, 2017 and May 15, 2020.

 

Upon consummation of any share exchange, consolidation of merger of L-1 pursuant to which its common stock will be converted into cash, securities or other property or any sale, lease or other transfer in one transaction or a series of transactions of all or substantially all of L-1’s and L-1’s subsidiaries’ assets, taken as a whole, to any person other than one of its subsidiaries, the holders of the Convertible Notes can require the Company to convert or to repurchase all outstanding debt at a purchase price equal to 100 percent of the principal amount plus accrued and unpaid interest. It is expected that the holders of the Notes will exercise their rights to require the Company to purchase the Notes upon closing of the consummation of the merger of the Company with Safran.

 

Equity Securities

 

On August 5, 2008, pursuant to the terms and conditions of (i) the Securities Purchase Agreement, by and between L-1 and Robert V. LaPenta (the “LaPenta Agreement”), (ii) the Securities Purchase Agreement (the “Iridian Agreement”), by and between L-1 and Iridian Asset Management LLC (“Iridian”) and (iii) the LRSR Agreement (together with the LaPenta Agreement and Iridian Agreement, the “Investor Agreements”). L-1 issued an aggregate of 8,083,472 shares of L-1 common stock and 15,107 shares of Series A Convertible Preferred Stock (the “Series A Preferred Stock’) for aggregate proceeds to L-1 of $119.0 million, net of related issuance costs, which were used to fund a portion of L-1’s acquisition of Old Digimarc. In accordance with its terms, the Series A Preferred Stock was subsequently converted into 1,310,992 shares of common stock. See Note 4 for additional information.

Consolidated Cash Flows

 

 

Comparison of 2010 to 2009

 

Cash flows from operating activities including discontinued operations, decreased by approximately $39.1 million for the year ended December 31, 2010 as compared to the corresponding period of the prior year. Net loss for the year ended December 31, 2010 was $16.5 million and includes non-cash charges of $41.7 million for depreciation and amortization, $25.6 million for stock-based compensation and retirement contributions settled or to be settled in common stock, $11.8 million for amortization of deferred financing costs, debt discount and other, and $21.8 million for non-cash income tax benefit and asset impairments of $3.6 million. Operating cash flows reflect the impact of changes in operating assets and liabilities which had an adverse impact on cash flows of $22.9 million for the year ended December 31, 2010 and an adverse impact on cash flows of $5.4 million in the corresponding period in the prior year.

 

Cash used for investing activities in 2010, consisting principally of payments for capital expenditures of $45.0 million for the year ended December 31, 2010, which decreased from $55.0 million in the prior year and are primarily related to L-1’s driver’s license business.

 

Net cash provided by financing activities in 2010 was $31.8 million compared to $8.5 used by financing activities in 2009. L-1 had borrowings of $87.1 million related to the revolving credit facility and repaid $34.0 million and $22.1 million related to the revolving credit facility and the term loans, respectively, in 2010. During 2009, L-1 repaid $15.1 million of long-term debt and had net borrowings of $4.9 million under L-1’s revolving credit facility.

 

Comparison of 2009 to 2008

 

Cash flows from operating activities including discontinued operations, increased by approximately $7.8 million for the year ended December 31, 2009 as compared to the corresponding period of the prior year. Net loss for the year ended December 31, 2009 was $4.0 million and includes non-cash charges of $37.1 million for depreciation and amortization, $23.7 million for stock-based compensation and retirement contributions settled or to be settled in common stock, $12.1 million for amortization of deferred financing costs, debt discount and other, and $2.9 million for non-cash income tax benefit. Operating cash flows reflect the impact in accruals and deferrals related to operating assets and liabilities which had an adverse impact on cash flows of $5.4 million for the year ended December 31, 2009 and an adverse impact on cash flows of $7.7 million in the corresponding period in the prior year.

 

Cash used for acquisitions in 2009, consisting principally of payments of acquisition related costs, totaled $3.7 million for the year ended December 31, 2009, compared to $320.5 million for the same period in the prior year, which was primarily related to the acquisition of Old Digimarc in August 2008. Capital expenditures were approximately $55.0 million and $22.5 million for the years ended December 31, 2009 and 2008, respectively, and are primarily related to L-1’s driver’s license business.

 

Net cash used in financing activities in 2009 was $8.5 million compared to $310.8 million provided from financing activities in 2008. L-1 repaid $15.1 million of long-term debt during 2009 and had net borrowings of $4.9 million under L-1’s revolving credit facility. L-1 had net borrowings of $206.2 million in 2008 which was primarily used to fund the Acquisitions. L-1 paid debt issuance costs of $0.8 million for the year ended

December 31, 2009 compared to $14.0 million in the prior year. In 2008, L-1 repurchased 362,000 shares of L-1’s common stock for $6.2 million and L-1 issued common and preferred stock for net proceeds of $119.0 million.

 

Working Capital

 

December 31, 2010

 

As a result of the Company accounting for the Intel Business as discontinued operations, working capital includes assets held for sale of $271.3 million and related liabilities of $42.1 million, including net deferred income tax liabilities of $15.7 million. In addition, working capital includes current maturities of long-term debt with a carrying amount of $271.4 million, which was repaid from the proceeds of the sale of the Intel Business.

 

Accounts receivable, including $42.0 million classified as assets held for sale, increased by approximately $28.7 million as of December 31, 2010 from December 31, 2009, primarily due to increased revenues from sales of hardware to India. Days sales outstanding at December 31, 2010 was 74 days compared to 67 days at December 31, 2009. Accounts receivables is net of an allowance of $5.0 million and $4.9 million at December 31, 2010 and 2009, respectively. At December 31, 2009, the allowance reflects additions recorded in 2009 for the suspension of the Registered Traveler program of approximately $1.2 million as well as approximately $2.9 million for estimated unrecoverable amounts related to enrollment services programs that started in 2009. During 2010, the net receivable related to the Registered Traveler program was written off and the allowance was increased for additional exposures for bad debts primarily at the Enrollment Services segment.

 

Inventory increased by $3.3 million as of December 31, 2010, compared to December 31, 2009, primarily to meet expected deliveries of L-1’s credentialing and biometric solutions.

 

Accounts payable, accrued expenses and other current liabilities including $24.8 million included in liabilities related to discontinued operations, increased by $6.1 million as of December 31, 2010, compared to December 31, 2009, reflecting, liabilities and accruals of approximately $1.5 million related to strategic alternative transaction costs, additional benefit accruals which are settled in subsequent periods, as well as timing of invoice payments.

 

Total deferred revenue decreased by $2.5 million as of December 31, 2010, compared to December 31, 2009, primarily as a result of the impact of lower maintenance renewals in 2010 compared to 2009.

 

December 31, 2009

 

Accounts receivable increased by approximately $10.7 million as of December 31, 2009 from December 31, 2008, primarily due to increased revenues over the prior year. Days sales outstanding at December 31, 2009 was 67 days compared to 66 days at December 31, 2008 Accounts receivables is net of an allowance of $4.9 million and reflects additions recorded in 2009 related to the Registered Traveler program of $1.0 million, as well as $2.8 million of unrecoverable amounts related to enrollment services contracts started in 2009.

 

Inventory decreased by $5.1 million as of December 31, 2009, compared to December 31, 2008, primarily as a result of planned reductions of L-1’s biometrics and secure credentialing inventories. Inventory is maintained at the levels required to meet expected deliveries of L-1’s credentialing and biometric solutions.

 

Accounts payable, accrued expenses and other current liabilities decreased by $3.9 million as of December 31, 2009, compared to December 31, 2008, as a result of lower accruals for incentive compensation and benefits and professional fees.

 

Total deferred revenue decreased by $3.8 million as of December 31, 2009, compared to December 31, 2008, primarily as a result of recognition of revenues related to transactions for which the Company received customer prepayments in 2008.

 

Contractual obligations

 

The following table sets forth L-1’s contractual obligations as of December 31, 2010: