Kratos Defense & Security Solutions
Annual Report 2008

Plain-text annual report

KRATOS DEFENSE & SECURITY SOLUTIONS, INC. FORM 10-K (Annual Report) Filed 03/10/09 for the Period Ending 12/28/08 Address Telephone CIK Symbol SIC Code 4810 EASTGATE MALL . SAN DIEGO, CA 92121 858-812-7300 0001069258 KTOS 4899 - Communications Services, Not Elsewhere Classified Industry Communications Services Sector Fiscal Year Services 12/28 http://www.edgar-online.com © Copyright 2009, EDGAR Online, Inc. All Rights Reserved. Distribution and use of this document restricted under EDGAR Online, Inc. Terms of Use.  Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K Commission file number 0-27231 KRATOS DEFENSE & SECURITY SOLUTIONS, INC. (Exact name of Registrant as specified in its charter) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes (cid:1) No (cid:3) Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes (cid:1) No (cid:3) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (cid:3) No (cid:1) 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 (Mark One) (cid:3) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 28, 2008 (cid:1) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 Delaware (State or other jurisdiction of incorporation or organization) 13-3818604 (I.R.S. Employer Identification) 4810 Eastgate Mall San Diego, CA 92121 (858) 812-7300 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) Title of Each Class Name of each exchange on which registered Common Stock, par value $0.001 The NASDAQ Global Select Market Right to Purchase Shares of Series C Preferred Stock contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. (cid:1) Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act); Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes (cid:1) No (cid:3) The aggregate market value of the voting and non-voting stock (Common Stock) held by non-affiliates as of the last business day of most recently completed second fiscal quarter (June 27, 2008) was approximately $207.2 million, based on the closing sale price on the NASDAQ Global Select Market on that date.* The number of shares outstanding of the Registrant's Common Stock was 128,169,634 as of December 28, 2008. * Large Accelerated Filer (cid:1) Non Accelerated Filer (cid:1) (Do not check if a smaller reporting company) Accelerated Filer (cid:3) Smaller Reporting Company (cid:1) Excludes the common stock held by executive officers, directors and stockholders whose individual ownership exceeds 10% of the Common Stock outstanding on June 27, 2008. This calculation does not reflect a determination that such persons are affiliates for any other purpose. Table of Contents Documents Incorporated by Reference Portions of the registrant's definitive proxy statement to be filed with the Commission pursuant to Regulation 14A in connection with the registrant's 2009 Annual Meeting of Stockholders (the "Proxy Statement") or portions of the registrant's Form 10-K/A, to be filed subsequent to the date here of, are incorporated by reference into Part III of this report. Such Proxy Statement or Form-10K/A will be filed with the Commission not later than 120 days after the conclusion of the registrant's fiscal year ended December 28, 2008. 2 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 28, 2008 TABLE OF CONTENTS 3 Page PART I Item 1. Business 4 Item 1A. Risk Factors 12 Item 1B. Unresolved Staff Comments 27 Item 2. Properties 27 Item 3. Legal Proceedings 28 Item 4. Submission of Matters to a Vote of Security Holders 33 PART II Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 34 Item 6. Selected Financial Data 36 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 36 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 62 Item 8. Financial Statements and Supplementary Data 63 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 63 Item 9A. Controls and Procedures 63 Item 9B. Other Information 66 PART III Item 10. Directors, Executive Officers and Corporate Governance 67 Item 11. Executive Compensation 67 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 67 Item 13. Certain Relationships and Related Transactions, and Director Independence 67 Item 14. Principal Accountant Fees and Services 67 PART IV Item 15. Exhibits, Financial Statement Schedules 67 Table of Contents All references to us, we, our, the Company and Kratos refer to Kratos Defense & Security Solutions, Inc., a Delaware Corporation, and its subsidiaries. PART I Item 1. Business This Annual Report (including the section regarding Management's Discussion and Analysis of Financial Condition and Results of Operations) contains forward-looking statements regarding our business, financial condition, results of operations and prospects. Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," "estimates" and similar expressions or variations of such words are intended to identify forward-looking statements, but are not deemed to represent an all-inclusive means of identifying forward-looking statements as denoted in this Annual Report. Additionally, statements concerning future matters are forward-looking statements. Although forward-looking statements in our Annual Report reflect our good faith judgment, such statements can only be based on facts and factors currently known by us. Consequently, forward-looking statements are inherently subject to risks and uncertainties and actual results and outcomes may differ materially from the results and outcomes discussed in or anticipated by the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, without limitation, those specifically addressed in Item 1A—"Risk Factors" below, as well as those discussed elsewhere in this Annual Report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of our Annual Report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Annual Report. Readers are urged to carefully review and consider the various disclosures made throughout the entirety of this Annual Report, which attempt to advise interested parties of the risks and factors that may affect our business, financial condition, results of operations and prospects. We were incorporated in the state of New York on December 19, 1994 and began operations in March 1995. We reincorporated in the state of Delaware in 1998. On September 12, 2007, we changed our name from Wireless Facilities, Inc. to Kratos Defense & Security Solutions, Inc. Overview We are an innovative provider of mission critical engineering, information technology (IT) services and warfighter solutions. We work primarily for the U.S. government and federal government agencies, but we also perform work for state and local agencies and commercial customers. Our principal services are related to, but are not limited to, Command, Control, Communications, Computing, Intelligence, Surveillance and Reconnaissance (C4ISR); weapons systems lifecycle support and sustainment; military weapon range operations and technical services; missile, rocket and weapons system test and evaluation; missile and rocket mission launch services; public safety, security and surveillance systems; modeling and simulation; unmanned aerial vehicle (UAV) products and technology; advanced network engineering and information technology services; and advanced information technology services. We offer our customers solutions and expertise to support their mission-critical needs by leveraging our skills across our core service areas. We derive a substantial portion of our revenue from contracts performed for federal government agencies, including the U.S. Department of Defense (DOD), with the majority of our revenue currently generated from the delivery of mission-critical warfighter solutions, advanced engineering services, system integration and system sustainment services to defense and other non-DOD and civilian government agencies. We believe our diversified and stable client base, strong client relationships, broad array of contract vehicles, considerable employee base possessing government security clearances, 4 Table of Contents extensive list of past performance qualifications, and significant management and operational capabilities position us for continued growth. Prior to 2008 we were also an independent provider of outsourced engineering and network deployment services, security systems engineering and integration services and other technical services for the wireless communications industry, the U.S. government and enterprise customers. In 2006 and 2007, we undertook a transformation strategy whereby we divested our commercial wireless-related businesses and chose to pursue business with the federal government, primarily the DOD, through strategic acquisitions. On September 12, 2007, we changed our name from Wireless Facilities, Inc. (WFI) to Kratos Defense & Security Solutions, Inc. (Kratos). Our new name reflects our revised focus as a defense contractor and security systems integrator for the federal government and for state and local agencies. In connection with our name change, we changed our NASDAQ Global Market trading symbol to "KTOS". Current Reporting Segments Prior to the divestiture of our wireless-related business, we had three operating segments: our Wireless Network Services (WNS) segment, our Enterprise Network Services (ENS) segment, and our Government Network Services (GNS) segment. Following the divestiture of the WNS segment and corporate name change, we reorganized into two operating segments, Kratos Government Solutions (KGS) (formerly GNS) and Public Safety and Security (PSS) (formerly ENS). The financial statements in this Annual Report are presented in a manner consistent with our new operating structure. For additional information regarding our operating segments, see Note 14 of Notes to Consolidated Financial Statements. From a customer and solutions perspective, we view our business as an integrated whole, leveraging skills and assets wherever possible. Kratos Government Solutions (KGS) Segment The Kratos Government Solutions segment provides engineering, information technology and weapons systems to federal, state, and local government agencies, but primarily the DOD. Our work includes weapon systems sustainment, lifecycle support and extension; command, control, communications, computing, intelligence, surveillance and reconnaissance (C4ISR) services; military range operations and technical services; missile, rocket, and weapons systems test and evaluation; mission launch services; public safety and security services; modeling and simulation, unmanned aerial vehicle (UAV) products and technology, and advanced network engineering and information technology services; public safety, security and surveillance systems integration. Our KGS segment also provides public safety, security and surveillance systems products and services to the homeland security market with products and services aimed at supporting first responders. Public Safety and Security (PSS) Segment The Kratos Public Safety and Security segment provides system design, deployment, integration, monitoring and support services for public safety, security and surveillance networks for state and local governments and commercial customers. Public safety and security networks have been traditionally segregated into systems such as voice, data, access control, video surveillance, temperature control and fire and life safety. We provide services that combine such systems and offer integrated solutions on an Ethernet-based platform. We also offer solutions that combine voice, data, electronic security and building automation systems with fixed or wireless connectivity solutions. Our target markets are retail, healthcare, education, sports and entertainment, municipal government, correctional facilities and other public facilities. Our commitments to these markets and our ability to provide feature-rich, cost-effective solutions have allowed us to become one of the larger independent integrators for these types of systems. We maintain regional office locations, comprised of Kratos Mid Atlantic, Kratos Southeast, and Kratos Southwest. 5 Table of Contents Industry Background U.S. Department of Defense Drives Strategic Priorities for the Company The delivery and execution of our mission-critical engineering and support services are driven by the priorities of the U.S. federal government and primarily the Department of Defense. The strategic priorities of the DOD are based in large part on the Quadrennial Defense Review, the first conducted in an era of global terrorism, which continues the shift in emphasis by identifying key strategic priorities. These priorities are currently focused on mission critical capabilities of the U.S. armed forces and providing the support infrastructure necessary to sustain these forces in a time of heightened warfare readiness and deployment. The 2009 Fiscal Year DOD approved budget is $515.4 billion, an increase of $35.9 billion over Fiscal Year 2008. The total budgetary increase of approximately 7.5% represents a significant opportunity to key federal government contractors in support of the DOD's war fighter, information technology, and other operational priorities. The approved DOD budget for 2009 includes a request for supplemental funding of $70.0 billion to fight the Global War on Terror. We believe there will be significant market opportunities for providers of system sustainment, IT and engineering services and solutions to federal government agencies over the next several years, particularly those in the defense and homeland security communities. Focus on Federal Government Transformation The federal government, and the DOD in particular, is in the midst of a significant transformation that is driven by the federal government's need to address the changing nature of global threats. A significant aspect of this transformation is the use of Command, Control, Communications, Computing, Intelligence, Surveillance and Reconnaissance (C4ISR), and information technology to increase the federal government's effectiveness and efficiency. The result is increased federal government spending on information technology to upgrade networks and transform the federal government from separate, isolated organizations into larger, enterprise level, network-centric organizations capable of sharing information broadly and quickly. While the transformation initiative is driven by the need to prepare for new world threats, adopting these IT transformation initiatives will also improve efficiency and reduce infrastructure costs across all federal government agencies. An additional aspect of the military transformation includes significantly enhancing military readiness in areas such as missile defense, weapons system sustainment and extension, and the overall strengthening of intelligence and security. For example, the objective of the DOD as it relates to missile defense is to continue to develop, test, and field missile defense systems to protect America, its allies and deployed forces. Competitive Strengths We believe we are well positioned to meet the rapidly evolving needs of federal government agencies for high-end engineering services, IT solutions and other technical operations because we possess the following key business strengths and performance qualifications: Significant and Highly Specialized Experience Through the existing customer engagements and with the government focused acquisitions we have completed over the past several years, we have amassed significant and highly specialized experience in areas directly related to weapon system life cycle extension and sustainment; missile, rocket and weapons system test and evaluation; C4ISR; military range operations and technical services and other highly differentiated services and solutions. This collective experience, or past performance qualifications, is a requirement on the majority of contract vehicles and customer engagements we are 6 Table of Contents involved in. We believe this presents a significant barrier to entry and positions us for long-term success. In-Depth Understanding of Client Missions We have a history of providing mission-critical services and solutions to our clients, enabling us to develop an in-depth understanding of their missions and technical needs. In addition, a significant number of our employees are located at client sites, giving us valuable strategic insights into clients' ongoing and future program requirements. Our in-depth understanding of our client missions, in conjunction with the strategic location of our employees, enables us to offer technical solutions tailored to our clients' specific requirements and consistent with their evolving mission objectives. Diverse Base of Key Contract Vehicles As a result of our business development focus on securing key contracts, we are a preferred contractor on numerous multi-year government-wide acquisition contracts and multiple award contracts that provide us with the opportunity to bid on hundreds of millions of dollars of business against a discrete number of other pre-qualified companies each year. These contracts include Seaport-e, GSA, Passive RFID EPC-1, PES, IT, LOG World, Mobis Millennia Lite, AMCOM Express, Consolidated Acquisition of Professional Services (CAPS), Support Services for Aviation, Air Defense and Missile Systems, Systems Engineering and Technical Assistance Contract, and Specialized Engineering, Development and Test Articles/Models. While the federal government is not obligated to make any awards under these vehicles, we believe that holding preferred positions on these contract vehicles provides us an advantage as we seek to expand the level of services we provide to our clients. Strategic Geographic Locations and BRAC The federal government's Base Realignment and Closure (BRAC) Act of 2005 is the congressionally authorized process the Department of Defense has implemented to reorganize its base structure to more efficiently and effectively support U.S. armed forces, increase operational readiness and facilitate new ways of doing business. As a result of the DOD's BRAC transformation, we have concentrated part of our business strategy on building a significant presence in key BRAC receiving locations where the federal government is relocating its personnel as well as related technical and professional services. As we continue to entrench in these key locations, we expect this to be a significant competitive advantage. Highly Skilled Employees and an Experienced Management Team We deliver our services through a highly skilled workforce of approximately 2,000 full-time, part-time and on-call employees in our on-going business. Our senior managers have over several hundred years of collective experience with federal government agencies, the U.S. military, and federal government contractors. Members of our management team have experience growing businesses organically, as well as through acquisitions. The cumulative experience and differentiated expertise of our personnel in our core focus areas of C4ISR, weapons systems lifecycle extension and maintenance, missile and rocket test and evaluation, along with our sizable employee base with government security clearances, allow us to qualify for and bid on larger projects in the prime contracting role. Services and Solutions We provide a range of integrated engineering, war fighter, security and information technology services and solutions by leveraging our core service offerings: weapons systems lifecycle support and 7 Table of Contents extension; C4ISR; military range operations and technical services; missile and rocket test and evaluation; security systems integration; and advanced network engineering; and IT services. Weapon Systems Lifecycle Sustainment, Support and Extension We provide weapons systems life cycle support and extension services for the DOD and foreign governments. These services focus on maintaining, testing and repairing certain weapons systems for the war fighter. C4ISR (Command, Control, Communications, Computing, Intelligence, Surveillance and Reconnaissance) In the area of C4ISR, Kratos is involved in a wide range of services, including installation, upgrade and maintenance of command, control, computing and surveillance systems for customers such as Joint Inter Agency Task Force-south (JIATF), the Naval Undersea Warfare Center (NUWC) and the Space and Naval Warfare Systems Center (SPAWAR). Missile Ranger Operations and Technical Services A key area of differentiation for us is within the range and technical service areas we offer. We have resources stationed at many major weapons and targets range locations throughout the United States, including Naval Air Warfare Center Pt. Mugu, Hawaii Pacific Missile Range, Fort Bliss, Texas, and White Sands Missile Range, New Mexico. Our services include aerial targets operations and maintenance, surface targets operations and maintenance, missile systems operations and maintenance, range operations planning and support, hazardous materials management, supply and logistics support, and manufacturing. Missile and Rocket Test and Evaluation Through the acquisitions of Haverstick Consulting, Inc. and DFI, we acquired expertise in the area of missile and rocket test and evaluation services. This includes exclusive rights to the design and manufacture of the motor on the Oriole Rocket System and ancillary hardware for sounding rockets, suborbital research and target services together with both intellectual property and subject matter expertise in sensors and modeling and simulation associated with a wide range of missile technologies. Additionally, this area of our business develops and produces low-cost ballistic missile defense targets. Security Systems Integration We have broad experience integrating security services and solutions across a number of network and communications platforms. In particular, our non-federal business has long-standing experience and has developed significant customer relationships by providing best-in-class systems integration services on a variety of platforms including digital (IP) surveillance and security, building automation systems and controls, fire and life safety systems, access control and perimeter protection, and service and maintenance of the aforementioned systems. We have comprehensive experience providing engineering services at any phase of a project lifecycle including program management, engineering design, system engineering, C5I System INCO, operations and maintenance, integrated telecommunications, and warfare systems training. Learning, Performance and Training Solutions Our learning, performance and training solutions consist of a broad range of products and services capabilities to deliver training solutions and web-enabled or satellite based interactive distance learning for customers in the DoD, other government agencies, universities and commercial organizations. Our training solutions include services, product development, and tools addressing a breadth of related 8 Table of Contents disciplines that include human performance factors, job & task analysis, competencies definition, skills & knowledge building via multiple delivery mediums, tracking, assessment, evaluation, and trend analysis. In addition, we develop and provide classroom based and e-learning training and education programs and Net-Centric Human Systems Integration (HIS) solutions. We also offer a range of IT services and solutions from conceptual network planning to system service and maintenance. We also offer our proprietary software based network management products via software license and maintenance sales which also serve as a platform for incremental network based services work. We have extensive experience building complex and secure networks for the federal government, and we possess in-depth experience with network operations centers. Our services include network operations centers, help desks, system maintenance, system upgrades, configuration management, data warehousing, COTS selection and integration, and high performance computing. Our Strategy Our strategy is to aggressively grow our business as a leading provider of highly-differentiated services in our core areas of focus as noted above by delivering comprehensive, high-end engineering services, technical solutions and information technology solutions to federal government agencies while improving our profitability. To achieve our objective, we intend to: Accelerate Internal Growth We are focused on accelerating our internal growth rate by capitalizing on our current contract base and customer relationships, expanding services provided to our existing clients, expanding our client base and offering new, complementary services. Capitalize on Current Contract Base. We are aggressively pursuing task orders under existing contract vehicles to maximize our revenue and strengthen our client relationships, though there is no assurance that the federal government will make awards up to the ceiling amounts or that we will be awarded any task orders under these vehicles. We have developed several internal tools that facilitate our ability to track, prioritize and win task orders under these vehicles. Combining these tools with our technical expertise, our strong past performance record and our knowledge of our clients' needs, should position us to win additional task orders. Expand Services Provided to Existing Clients. We are focused on expanding the services we provide to our current clients by leveraging our strong relationships, technical capabilities and past performance record, and by offering a wider range of solutions as we continue to acquire companies with new areas of specialization. We believe our understanding of client missions, processes and needs, in conjunction with our full lifecycle IT offerings, positions us to capture new work from existing clients as the federal government continues to increase the volume of IT services contracted to professional services providers. Moreover, we believe our strong past performance record positions us to expand the level of services we provide to our clients as the federal government places greater emphasis on past performance as a criterion for awarding contracts. Expand Client Base. We are also focused on expanding our client base into areas with significant growth opportunities by leveraging our capabilities, industry reputation, long-term client relationships and diverse contract base. We anticipate that this expansion will enable us both to pursue additional higher value work and to further diversify our revenue base across the federal government. Our long-term relationships with federal government agencies, together with our GWAC vehicles, give us opportunities to win contracts with new clients within these agencies. 9 Table of Contents Improve Operating Margins. We believe that we have significant opportunities to increase our operating margins and improve profitability by capitalizing on our corporate infrastructure investments and internally developed tools, and concentrating on high value-added prime contracts. Capitalize on Corporate Infrastructure Investments. In recent periods, we have made significant investments in our senior management and corporate infrastructure in anticipation of future revenue growth. These investments included hiring senior executives with significant experience with federal IT services companies, strengthening our internal controls over financial reporting and accounting staff in support of public company reporting requirements and expanding our Sensitive Compartmented Information Facilities and other corporate facilities. We believe our management experience and corporate infrastructure are more typical of a company with a much larger revenue base than ours. We therefore anticipate that, to the extent our revenue grows, we will be able to leverage this infrastructure base and increase our operating margins. Concentrate on High Value-Added Prime Contracts. We expect to improve our operating margins as we strive to increase the percentage of revenue we derive from our work as a prime contractor and from engagements where contracts are awarded on a best value, rather than on a low cost, basis. The federal government's move toward performance-based contract awards to realize greater return on its investment has resulted in a shift to greater utilization of best value awards. We believe this shift will enable us to expand our operating margins as we are awarded more contracts of this nature. Pursue Strategic Acquisitions We intend to supplement our organic growth by identifying, acquiring and integrating businesses that meet our primary objective of providing us with enhanced capabilities in order to pursue a broader cross section of the DoD, DHS and other government markets, complement and broaden our existing client base and expand our primary service offerings. Our senior management team brings significant acquisition experience. On December 31, 2007 we completed the acquisition of Haverstick Consulting, Inc., an Indianapolis, Indiana based privately-held provider of rocket and missile test and evaluation, weapons systems support, and professional services to the U.S. Army, U.S. Air Force, U.S. Navy, NASA, and other federal, state and local agencies. On June 28, 2008 we acquired San Diego-based C4ISR and net-centric warfare solutions provider SYS (AMEX:SYS) in a stock-for-stock transaction. In addition, on December 24, 2008 we acquired Huntsville, Alabama based Digital Fusion, Inc. (DFI) in a stock-for-stock transaction. They provide technical engineering services and Unmanned Aerial Vehicle (UAV) products and technology. We continue to evaluate potential acquisition targets. To the extent any future acquisition involves cash consideration, we will need to obtain additional financing through the sale of equity or debt securities to fund any such acquisitions. Customers A representative list of our customers in our KGS segment during 2008 included the U.S. Air Force, U.S. Army, U.S. Navy, Missile Defense Agency, the Department of Homeland Security, NASA, FMS and the U.S. Southern Command. In our PSS segment, our customers in 2008 included British Petroleum, Atlanta's Hartsfield-Jackson Airport, Lockheed Martin, City of Philadelphia, DuPont Fabros Technologies, Anadarko, Houston Community College, Shire Pharmaceuticals and Memorial Hermann Hospital System. 10 Table of Contents The following table presents our customers from whom we receive more than 10% of our revenue: Backlog As of December 28, 2008, our backlog was approximately $750 million, of which $160 million was funded. Backlog is our estimate of the amount of revenue we expect to realize over the remaining life of awarded contracts and task orders that we have in hand as of the measurement date. Our total backlog consists of funded and unfunded backlog. We define funded backlog as estimated future revenue under government contracts and task orders for which funding has been appropriated by Congress and authorized for expenditure by the applicable agency, plus our estimate of the future revenue we expect to realize from our commercial contracts that are under firm orders. Our funded backlog does not include the full potential value of our contracts, because Congress often appropriates funds to be used by an agency for a particular program of a contract on a yearly or quarterly basis, even though the contract may call for performance over a number of years. As a result, contracts typically are only partially funded at any point during their term, and all or some of the work to be performed under the contracts may remain unfunded unless and until Congress makes subsequent appropriation and the procuring agency allocates funding to the contract. Employees As of December 28, 2008, including the employees from the Haverstick, SYS, and DFI acquisitions, we employed approximately 2,000 full-time, part-time and on-call employees. We have one collective bargaining unit of approximately 22 employees which is represented by the International Association of Machinists & Aerospace Workers, AFL-CIO, White Sands Local Lodge 2515, Alamogordo, New Mexico. Competition Our market is competitive, and includes the full range of federal and non-federal engineering and IT service providers. Many of the companies that we compete against have significantly greater financial, technical and marketing resources, and generate greater revenues than we do. Competition in the federal business segment includes tier one, large federal government contractors, such as Northrop Grumman, SAIC, ITT Industries, Inc., Computer Sciences Corporation, ARINC, Raytheon Corporation, BAE, and CACI. While we view government contractors as competitors, we often team with these companies in joint proposals or in the delivery of our services for customers. Tier two competitors include smaller and mid-tier government contractors such as NCI, Inc., Stanley, Inc., and Dynamics Research Corp. Competition in the PSS segment includes Siemens Building Technology, Johnson Controls, Ingersoll Rand and Convergent. We believe that the principal competitive factors in our ability to win new business include past performance, qualifications, domain and technology expertise, the ability to replace contract vehicles, the ability to deliver results within budget (time and cost), reputation, accountability, staffing flexibility 11 Key Customer Revenue % of Total Revenue 2006 U.S. Navy $ 34.2 22 % 2007 U.S. Army $ 46.7 24 % U.S. Navy $ 38.7 20 % 2008 U.S. Army $ 49.0 16 % U.S. Navy $ 106.9 36 % Table of Contents including the large number of personnel with government security clearances, and project management expertise. We believe our ability to compete also depends on a number of additional factors including the ability of our customers to perform the services themselves, and competitive pricing for similar services. Available Information We file reports with the SEC. We make available on our website under "Investor Relations/SEC Filings," free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file such materials with or furnish them to the SEC. Our website address is www.kratosdefense.com . Item 1A. Risk Factors You should carefully consider the following risk factors and all other information contained herein as well as the information included in this Annual Report, and other reports and filings made with the SEC in evaluating our business and prospects. Risks and uncertainties, in addition to those we describe below, that are not presently known to us or that we currently believe are immaterial may also impair our business operations. If any of the following risks occur, our business and financial results could be harmed and the price of our common stock could decline. You should also refer to the other information contained in this report, including our consolidated financial statements and related notes. Our business could be adversely affected by changes in the contracting or fiscal policies of the federal government and governmental entities. We derive a significant portion of our revenue from contracts with the U.S. federal government and government agencies and subcontracts under federal government prime contracts, and the success of our business and growth of our business will continue to depend on our successful procurement of government contracts either directly or through prime contractors. Accordingly, changes in government contracting policies or government budgetary constraints could directly affect our financial performance. Among the factors that could adversely affect our business are: • changes in fiscal policies or decreases in available government funding, including budgetary constraints affecting federal government spending generally, or specific departments or agencies in particular; • the adoption of new laws or regulations or changes to existing laws or regulations; • changes in political or social attitudes with respect to security and defense issues; • changes in federal government programs or requirements, including the increased use of small business providers; • changes in or delays related to government restrictions on the export of defense articles and services; • potential delays or changes in the government appropriations process; and • delays in the payment of our invoices by government payment offices. These and other factors could cause governments and government agencies, or prime contractors that use us as a subcontractor, to reduce their purchases under existing contracts, to exercise their rights to terminate contracts at-will or to abstain from exercising options to renew contracts, any of which could have an adverse effect on our business, financial condition and results of operations. Many of our government customers are subject to stringent budgetary constraints. The award of additional 12 Table of Contents contracts from government agencies could be adversely affected by spending reductions or budget cutbacks at these agencies. Recent deterioration in the credit markets and the financial services industry may negatively impact our business, results of operations, financial condition or liquidity. Recently the credit markets and the financial services industry have been experiencing a period of unprecedented turmoil and upheaval characterized by the bankruptcy, failure, collapse or sale of various financial institutions and an unprecedented level of intervention from the United States federal government. While the outcome of these events cannot be predicted, they may have an adverse effect on our liquidity, financial condition and results of operations if it became necessary for us to acquire additional debt financing. Given our highly leveraged liquidity position, any down-turn in our operating earnings or cash flows could impair our ability to comply with the financial covenants of our existing credit facility. If additional debt financing were required, it may be at interest rates far greater than our current outstanding debt or may not be available at all. Although we maintain allowances for doubtful accounts for estimated losses from the inability of our customers to make required payments and such losses have historically been within our expectations and the allowances we have established, we cannot guarantee that we will continue to experience the same loss rates we have in the past, especially given the recent deterioration of the credit markets. A significant change in the liquidity or financial condition of our customers could cause unfavorable trends in our revenue and receivable collections and additional allowances may be required. These additional allowances could materially affect our financial results. We have incurred and may continue to incur goodwill impairment charges in our reporting entities which could harm our profitability. A significant portion of our net assets come from goodwill and other intangible assets. In accordance with Statement of Financial Accounting Standards, or SFAS 142, "Goodwill and Other Intangible Assets," (SFAS 142) we periodically review the carrying values of our goodwill to determine whether such carrying values exceed the fair market value. Our acquired companies are subject to annual review for goodwill impairment. If impairment testing indicates that the carrying value of a reporting unit exceeds its fair value, the goodwill of the reporting unit is deemed impaired. Accordingly, an impairment charge would be recognized for that reporting unit in the period identified, which could reduce our profitability. In 2008 as a result of our annual review, we recorded a goodwill impairment charge of $105.8 million related to our KGS segment, to reflect the declining market and economic conditions through December 28, 2008. Given continued significant decline in the stock market in general and specifically our stock price in 2009, we believe it is more likely than not that this could be an indication of additional goodwill impairment and could potentially result in a triggering event under SFAS 142 and an additional goodwill impairment charge in the first quarter of 2009. We derive a substantial amount of our revenues from the sale of our solutions either directly or indirectly to U.S. government entities pursuant to government contracts, which differ materially from standard commercial contracts, involve competitive bidding and may be subject to cancellation or delay without penalty, any of which may produce volatility in our revenues and earnings. Government contracts frequently include provisions that are not standard in private commercial transactions, and are subject to laws and regulations that give the federal government rights and remedies not typically found in commercial contracts, including provisions permitting the federal government to: • terminate our existing contracts; • reduce potential future income from our existing contracts; 13 Table of Contents • modify some of the terms and conditions in our existing contracts; • suspend or permanently prohibit us from doing business with the federal government or with any specific government agency; • impose fines and penalties; • subject us to criminal prosecution; • suspend work under existing multiple year contracts and related task orders if the necessary funds are not appropriated by Congress; • decline to exercise an option to extend an existing multiple year contract; and • claim rights in technologies and systems invented, developed or produced by us. In addition, government contracts are frequently awarded only after formal competitive bidding processes, which have been and may continue to be protracted and typically impose provisions that permit cancellation in the event that necessary funds are unavailable to the public agency. Competitive procurements impose substantial costs and managerial time and effort in order to prepare bids and proposals for contracts that may not be awarded to us. In many cases, unsuccessful bidders for government agency contracts are provided the opportunity to formally protest certain contract awards through various agency, administrative and judicial channels. The protest process may substantially delay a successful bidder's contract performance, result in cancellation of the contract award entirely and distract management. We may not be awarded contracts for which we bid, and substantial delays or cancellation of purchases may follow our successful bids as a result of such protests. Certain of our government contracts also contain "organizational conflict of interest" clauses that could limit our ability to compete for certain related follow-on contracts. For example, when we work on the design of a particular solution, we may be precluded from competing for the contract to install that solution. While we actively monitor our contracts to avoid these conflicts, we cannot guarantee that we will be able to avoid all organizational conflict of interest issues. We face intense competition from many competitors that have greater resources than we do, which could result in price reductions, reduced profitability or loss of market share. We operate in highly competitive markets and generally encounter intense competition to win contracts from many other firms, including mid-tier federal contractors with specialized capabilities and large defense and IT services providers. Competition in our markets may increase as a result of a number of factors, such as the entrance of new or larger competitors, including those formed through alliances or consolidation. These competitors may have greater financial, technical, marketing and public relations resources, larger client bases and greater brand or name recognition than we do. These competitors could, among other things: • divert sales from us by winning very large-scale government contracts, a risk that is enhanced by the recent trend in government procurement practices to bundle services into larger contracts; • force us to charge lower prices; or • adversely affect our relationships with current clients, including our ability to continue to win competitively awarded engagements in which we are the incumbent. If we lose business to our competitors or are forced to lower our prices, our revenue and our operating profits could decline. In addition, we may face competition from our subcontractors who, from time-to-time, seek to obtain prime contractor status on contracts for which they currently serve as a subcontractor to us. If one or more of our current subcontractors are awarded prime contractor 14 Table of Contents status on such contracts in the future, it could divert sales from us or could force us to charge lower prices, which could cause our margins to suffer. Recent acquisitions and potential future acquisitions could prove difficult to integrate, disrupt our business, dilute stockholder value and strain our resources. We have completed several acquisitions of complementary businesses in recent years, including our December 2007 acquisition of Haverstick Consulting, Inc., our June 2008 acquisition of SYS, and our December 2008 acquisition of DFI. The success of the acquisitions will depend in part on the success of integrating the operations, technologies and personnel of SYS and DFI. The failure to successfully integrate the operations of the two companies or otherwise to realize any of the anticipated benefits of the acquisitions could seriously harm our results of operations. We continually evaluate opportunities to acquire new businesses as part of our ongoing strategy and we may in the future acquire additional companies that we believe could complement or expand our business or increase our customer base. Acquisitions involve numerous risks, including: • difficulties in integrating operations, technologies, accounting and personnel; • difficulties in supporting and transitioning customers of acquired companies; • difficulties or delays in transitioning federal government contracts pursuant to federal acquisition regulations; • diversion of financial and management resources from existing operations; • potential loss of key employees; • federal acquisition regulations may require us to enter into government novation agreements, a potentially time-consuming process; and • inability to generate sufficient revenue to offset acquisition costs. Acquired companies may have liabilities or adverse operating issues that we fail to discover through due diligence prior to the acquisition. In particular, to the extent that prior owners of any acquired businesses or properties failed to comply with or otherwise violated applicable laws or regulations, or failed to fulfill their contractual obligations to the federal government or other clients, we, as the successor owner, may be financially responsible for these violations and failures and may suffer reputational harm or otherwise be adversely affected. Acquisitions also frequently result in the recording of goodwill and other intangible assets which are subject to potential impairments in the future that could harm our financial results. In addition, if we finance acquisitions by issuing convertible debt or equity securities, our existing stockholders may be diluted, which could affect the market price of our stock. As a result, if we fail to properly evaluate acquisitions or investments, we may not achieve the anticipated benefits of any such acquisitions, and we may incur costs in excess of what we anticipate. Our financial results may vary significantly from quarter to quarter. We expect our revenue and operating results to vary from quarter to quarter. Reductions in revenue in a particular quarter could lead to lower profitability in that quarter because a relatively large amount of our expenses are fixed in the short-term. We may incur significant operating expenses during the start-up and early stages of large contracts and may not be able to recognize corresponding revenue in that same quarter. We may also incur additional expenses when contracts expire, are terminated or are not renewed. In addition, payments due to us from federal government agencies may be delayed due to billing cycles or as a result of failures of government budgets to gain congressional and administration 15 Table of Contents approval in a timely manner. The federal government's fiscal year ends September 30. If a federal budget for the next federal fiscal year has not been approved by that date in each year, our clients may have to suspend engagements that we are working on until a budget has been approved. Any such suspensions may reduce our revenue in the fourth quarter of that year or the first quarter of the subsequent year. The federal government's fiscal year end can also trigger increased purchase requests from clients for equipment and materials. Any increased purchase requests we receive as a result of the federal government's fiscal year end would serve to increase our third or fourth quarter revenue, but will generally decrease profit margins for that quarter, as these activities generally are not as profitable as our typical offerings. Additional factors that may cause our financial results to fluctuate from quarter to quarter include those addressed elsewhere in these Risk Factors and the following, among others: • the terms of customer contracts that affect the timing of revenue recognition; • variability in demand for our services and solutions; • commencement, completion or termination of contracts during any particular quarter; • timing of award or performance incentive fee notices; • timing of significant bid and proposal costs; • variable purchasing patterns under GSA Schedule 70 contracts, government wide acquisition contracts (GWACs), blanket purchase agreements and other indefinite delivery/indefinite quantity contracts; • restrictions on and delays related to the export of defense articles and services; • costs related to ongoing government inquiries; • strategic decisions by us or our competitors, such as acquisitions, divestitures, spin-offs and joint ventures; • strategic investments or changes in business strategy; • changes in the extent to which we use subcontractors; • seasonal fluctuations in our staff utilization rates; • changes in our effective tax rate including changes in our judgment as to the necessity of the valuation allowance recorded against our deferred tax assets; and • the length of sales cycles. Significant fluctuations in our operating results for a particular quarter could cause us to fall out of compliance with the financial covenants contained in our credit facility, which if not waived by the lender, could restrict our access to capital and cause us to take extreme measures to pay down our debt under the credit facility. In addition, fluctuations in our financial results could cause our stock price to decline. If we fail to establish and maintain important relationships with government entities and agencies and other government contractors, our ability to bid successfully for new business may be adversely affected. To develop new business opportunities, we primarily rely on establishing and maintaining relationships with various government entities and agencies. We may be unable to successfully maintain our relationships with government entities and agencies, and any failure to do so could materially adversely affect our ability to compete successfully for new business. In addition, we often act as a subcontractor or in "teaming" arrangements in which we and other contractors bid together on 16 Table of Contents particular contracts or programs for the federal government or government agencies. As a subcontractor or team member, we often lack control over fulfillment of a contract, and poor performance on the contract could tarnish our reputation, even when we perform as required. We expect to continue to depend on relationships with other contractors for a portion of our revenue in the foreseeable future. Moreover, our revenue and operating results could be materially adversely affected if any prime contractor or teammate chooses to offer a client services of the type that we provide or if any prime contractor or teammate teams with other companies to independently provide those services. We derive a significant portion of our revenues from a limited number of customers. We have derived, and believe that we will continue to derive, a significant portion of our revenues from a limited number of customers. To the extent that any significant customer uses less of our services or terminates its relationship with us, our revenues could decline significantly. As a result, the loss of any significant client could seriously harm our business. For the fiscal year ended December 28, 2008, two customers comprised approximately 68.6% and 52.5% of our federal business revenues and total revenues, respectively, and our five largest customers accounted for approximately 82.4% and 63% of our total federal business revenues and total revenues, respectively. None of our customers are obligated to purchase additional services from us. As a result, the volume of work that we perform for a specific customer is likely to vary from period to period, and a significant client in one period may not use our services in a subsequent period. Our margins and operating results may suffer if we experience unfavorable changes in the proportion of cost-plus-fee or fixed-price contracts in our total contract mix. Although fixed-price contracts entail a greater risk of a reduced profit or financial loss on a contract compared to other types of contracts we enter into, fixed-price contracts typically provide higher profit opportunities because we may be able to benefit from cost savings. In contrast, cost-plus-fee contracts are subject to statutory limits on profit margins, and generally are the least profitable of our contract types. Our federal government customers typically determine what type of contract we enter into. Cost-plus-fee and fixed-price contracts in our federal business accounted for approximately 39.1% and 35.8%, respectively, of our federal business revenues for the fiscal year ended December 28, 2008. To the extent that we enter into more cost-plus-fee or less fixed-price contracts in proportion to our total contract mix in the future, our margins and operating results may suffer. Our cash flow and profitability could be reduced if expenditures are incurred prior to the final receipt of a contract. We provide various professional services and sometimes procure equipment and materials on behalf of our federal government customers under various contractual arrangements. From time to time, in order to ensure that we satisfy our customers' delivery requirements and schedules, we may elect to initiate procurement in advance of receiving final authorization from the government customer or a prime contractor. If our government or prime contractor customers' requirements should change or if the government or the prime contractor should direct the anticipated procurement to a contractor other than us or if the equipment or materials become obsolete or require modification before we are under contract for the procurement, our investment in the equipment or materials might be at risk if we cannot efficiently resell them. This could reduce anticipated earnings or result in a loss, negatively affecting our cash flow and profitability. Loss of our GSA contracts or GWACs would impair our ability to attract new business. We are a prime contractor under several GSA contracts and GWAC schedule contracts. We believe that our ability to provide services under these contracts will continue to be important to our business 17 Table of Contents because of the multiple opportunities for new engagements each contract provides. If we were to lose our position as prime contractor on one or more of these contracts, we could lose substantial revenues and our operating results could suffer. GSA contracts and other GWACs typically have a one or two-year initial term with multiple options exercisable at the government client's discretion to extend the contract for one or more years. We cannot be assured that our government clients will continue to exercise the options remaining on our current contracts, nor can we be assured that our future clients will exercise options on any contracts we may receive in the future. Failure to properly manage projects may result in additional costs or claims. Our engagements often involve large scale, highly complex projects. The quality of our performance on such projects depends in large part upon our ability to manage the relationship with our customers, and to effectively manage the project and deploy appropriate resources, including third-party contractors, and our own personnel, in a timely manner. Any defects or errors or failure to meet clients' expectations could result in claims for substantial damages against us. Our contracts generally limit our liability for damages that arise from negligent acts, error, mistakes or omissions in rendering services to our clients. However, we cannot be sure that these contractual provisions will protect us from liability for damages in the event we are sued. In addition, in certain instances, we guarantee customers that we will complete a project by a scheduled date. If the project experiences a performance problem, we may not be able to recover the additional costs we will incur, which could exceed revenues realized from a project. Finally, if we underestimate the resources or time we need to complete a project with capped or fixed fees, our operating results could be seriously harmed. The loss of any member of our senior management could impair our relationships with federal government clients and disrupt the management of our business. We believe that the success of our business and our ability to operate profitably depends on the continued contributions of the members of our senior management. We rely on our senior management to generate business and execute programs successfully. In addition, the relationships and reputation that many members of our senior management team have established and maintain with federal government personnel contribute to our ability to maintain strong client relationships and to identify new business opportunities. We do not have any employment agreements providing for a specific term of employment with any member of our senior management. The loss of any member of our senior management could impair our ability to identify and secure new contracts, to maintain good client relations and to otherwise manage our business. If we fail to attract and retain skilled employees or employees with the necessary security clearances, we might not be able to perform under our contracts or win new business. The growth of our business and revenue depends in large part upon our ability to attract and retain sufficient numbers of highly qualified individuals who have advanced information technology and/or engineering skills. These employees are in great demand and are likely to remain a limited resource in the foreseeable future. Certain federal government contracts require us, and some of our employees, to maintain security clearances. Obtaining and maintaining security clearances for employees involves a lengthy process, and it is difficult to identify, recruit and retain employees who already hold security clearances. In addition, some of our contracts contain provisions requiring us to staff an engagement with personnel that the client considers key to our successful performance under the contract. In the event we are unable to provide these key personnel or acceptable substitutions, the client may terminate the contract and we may lose revenue. If we are unable to recruit and retain a sufficient number of qualified employees, our ability to maintain and grow our business could be limited. In a tight labor market, our direct labor costs could increase or we may be required to engage large numbers of subcontractor personnel, which could cause 18 Table of Contents our profit margins to suffer. Conversely, if we maintain or increase our staffing levels in anticipation of one or more projects and the projects are delayed, reduced or terminated, we may underutilize the additional personnel, which would increase our general and administrative expenses, reduce our earnings and possibly harm our results of operations. If our subcontractors fail to perform their contractual obligations, our performance and reputation as a prime contractor and our ability to obtain future business could suffer. As a prime contractor, we often rely upon other companies to perform work we are obligated to perform for our clients as subcontractors. As we secure more work under our GWAC vehicles, we expect to require an increasing level of support from subcontractors that provide complementary and supplementary services to our offerings. Depending on labor market conditions, we may not be able to identify, hire and retain sufficient numbers of qualified employees to perform the task orders we expect to win. In such cases, we will need to rely on subcontracts with unrelated companies. Moreover, even in favorable labor market conditions, we anticipate entering into more subcontracts in the future as we expand our work under our GWACs. We are responsible for the work performed by our subcontractors, even though in some cases we have limited involvement in that work. If one or more of our subcontractors fail to satisfactorily perform the agreed-upon services on a timely basis or violate federal government contracting policies, laws or regulations, our ability to perform our obligations as a prime contractor or meet our clients' expectations may be compromised. In extreme cases, performance or other deficiencies on the part of our subcontractors could result in a client terminating our contract for default. A termination for default could expose us to liability, including liability for the agency's costs of reprocurement, could damage our reputation and could hurt our ability to compete for future contracts. Our failure to comply with complex procurement laws and regulations could cause us to lose business and subject us to a variety of penalties. We must comply with laws and regulations relating to the formation, administration and performance of federal government contracts, which affect how we do business with our clients and may impose added costs on us. In addition, the federal government, including the Defense Contract Audit Agency (DCAA), audits and reviews our performance on contracts, pricing practices, cost structure and compliance with applicable laws, regulations and standards. The DCAA reviews a contractor's internal control systems and policies, including the contractor's purchasing, property, estimating, compensation and management information systems, and the contractor's compliance with such policies. Any costs found to be improperly allocated to a specific contract will not be reimbursed, while such costs already reimbursed must be refunded. Adverse findings in a DCAA audit could materially affect our competitive position and result in a substantial adjustment to our revenue and profit. If a federal government audit uncovers improper or illegal activities, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with federal government agencies. In addition, we could suffer serious harm to our reputation and competitive position if allegations of impropriety were made against us, whether or not true. If our reputation or relationship with federal government agencies were impaired, or if the federal government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our revenue and operating profit would decline. 19 Table of Contents The commercial business arena in which we operate has relatively low barriers to entry and increased competition could result in margin erosion, which would make profitability even more difficult to sustain. Other than the technical skills required in our commercial business, the barriers to entry in this area are relatively low. We do not have any intellectual property rights in this segment of our business to protect our methods, and business start-up costs do not pose a significant barrier to entry. The success of our commercial business is dependent on our employees, customer relations and the successful performance of our services. If we face increased competition as a result of new entrants in our markets, we could experience reduced operating margins and loss of market share and brand recognition. If our commercial customers do not invest in security systems and other new in-building technologies such as wireless local area networks and/or IP-based networks, our business will suffer. We intend to devote significant resources to developing our enterprise-based wireless local area networks (WLAN), but we cannot predict that we will achieve widespread market acceptance amongst the enterprises we identify as potential customers. It is possible that some enterprises will determine that capital constraints and other factors outweigh their need for WLAN systems. As a result, we may be affected by a significant delay in the adoption of WLAN by enterprises, which would harm our business. If we experience systems or service failure, our reputation could be harmed and our clients could assert claims against us for damages or refunds. We create, implement and maintain IT solutions that are often critical to our clients' operations. We have experienced, and may in the future experience, some systems and service failures, schedule or delivery delays and other problems in connection with our work. If we experience these problems, we may: • lose revenue due to adverse client reaction; • be required to provide additional services to a client at no charge; • receive negative publicity, which could damage our reputation and adversely affect our ability to attract or retain clients; and • suffer claims for substantial damages. In addition to any costs resulting from product or service warranties, contract performance or required corrective action, these failures may result in increased costs or loss of revenue if clients postpone subsequently scheduled work or cancel, or fail to renew, contracts. While many of our contracts limit our liability for consequential damages that may arise from negligence in rendering services to our clients, we cannot assure you that these contractual provisions will be legally sufficient to protect us if we are sued. In addition, our errors and omissions and product liability insurance coverage may not be adequate, may not continue to be available on reasonable terms or in sufficient amounts to cover one or more large claims, or the insurer may disclaim coverage as to some types of future claims. The successful assertion of any large claim against us could seriously harm our business. Even if not successful, these claims could result in significant legal and other costs, may be a distraction to our management and may harm our reputation. Security breaches in sensitive federal government systems could result in the loss of clients and negative publicity. Many of the systems we develop, install and maintain involve managing and protecting information involved in intelligence, national security and other sensitive or classified federal government functions. 20 Table of Contents A security breach in one of these systems could cause serious harm to our business, damage our reputation and prevent us from being eligible for further work on sensitive or classified systems for federal government clients. We could incur losses from such a security breach that could exceed the policy limits under our errors and omissions and product liability insurance. Damage to our reputation or limitations on our eligibility for additional work resulting from a security breach in one of the systems we develop, install and maintain could materially reduce our revenue. Our employees may engage in misconduct or other improper activities, which could cause us to lose contracts. We are exposed to the risk that employee fraud or other misconduct could occur. Misconduct by employees could include intentional failures to comply with federal government procurement regulations, engaging in unauthorized activities or falsifying time records. Employee misconduct could also involve the improper use of our clients' sensitive or classified information, which could result in regulatory sanctions against us and serious harm to our reputation and could result in a loss of contracts and a reduction in revenues. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in controlling unknown or unmanaged risks or losses, which could cause us to lose contracts or cause a reduction in revenues. Our business is dependent upon our ability to keep pace with the latest technological changes. The market for our services is characterized by rapid change and technological improvements. Failure to respond in a timely and cost effective way to these technological developments would result in serious harm to our business and operating results. We have derived, and we expect to continue to derive, a substantial portion of our revenues from providing innovative engineering services and technical solutions that are based upon today's leading technologies and that are capable of adapting to future technologies. As a result, our success will depend, in part, on our ability to develop and market service offerings that respond in a timely manner to the technological advances of our customers, evolving industry standards and changing client preferences. If we are unable to manage our growth, our business could be adversely affected. Sustaining our growth has placed significant demands on our management, as well as on our administrative, operational and financial resources. For us to continue to manage our growth, we must continue to improve our operational, financial and management information systems and expand, motivate and manage our workforce. If we are unable to manage our growth while maintaining our quality of service and profit margins, or if new systems that we implement to assist in managing our growth do not produce the expected benefits, our business, prospects, financial condition or operating results could be adversely affected. We may be harmed by intellectual property infringement claims and our failure to protect our intellectual property could enable competitors to market products and services with similar features. We may become subject to claims from our employees or third parties who assert that software and other forms of intellectual property that we use in delivering services and solutions to our clients infringe upon intellectual property rights of such employees or third parties. Our employees develop some of the software and other forms of intellectual property that we use to provide our services and solutions to our clients, but we also license technology from other vendors. If our employees, vendors, or other third parties assert claims that we or our clients are infringing on their intellectual property rights, we could incur substantial costs to defend those claims. If any of these infringement claims are ultimately successful, we could be required to cease selling or using products or services that incorporate the challenged software or technology, obtain a license or additional licenses from our 21 Table of Contents employees, vendors, or other third parties, or redesign our products and services that rely on the challenged software or technology. We attempt to protect our trade secrets by entering into confidentiality and intellectual property assignment agreements with third parties, our employees and consultants. However, these agreements can be breached and, if they are, there may not be an adequate remedy available to us. In addition, others may independently discover our trade secrets and proprietary information and in such cases we could not assert any trade secret rights against such party. Enforcing a claim that a party illegally obtained and is using our trade secret is difficult, expensive and time consuming, and the outcome is unpredictable. If we are unable to protect our intellectual property, our competitors could market services or products similar to our services and products, which could reduce demand for our offerings. Any litigation to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others could result in substantial costs and diversion of resources, with no assurance of success. The matters relating to our internal review of our stock option granting practices and the restatement of our financial statements have exposed us to civil litigation claims, regulatory proceedings and government proceedings, which could have a material adverse effect on us. In the summer of 2006, our current executive management team, which has been in place since 2004, initiated an investigation of our past stock option granting practices (the "Equity Award Review") in reaction to media reports regarding stock option granting practices of public companies. The Equity Award Review was conducted with oversight from the Board and assistance from our outside counsel. In February 2007, the Board appointed a Special Committee of the Board to review the adequacy of the Equity Award Review and the recommendations of management regarding historical option granting practices, and to make recommendations and findings regarding those practices and individual conduct. The Special Committee was not charged with making, and did not make, any evaluation of the accounting determinations or tax adjustments. The Special Committee was comprised of a non-employee director who had not served on our Compensation Committee before 2005. The Equity Award Review encompassed all grants of options to purchase shares of our common stock and other equity awards made since two months prior to our IPO in November 1999 through December 2006. We also reviewed all option grants that were entered into our stock option database (Equity Edge) after our IPO with a grant date before November 1999, as well as other substantial grants issued prior to our IPO, consisting of more than 14,000 grants. We further reviewed all option grants with a grant date that preceded an employee's date of hire. As part of the review, interviews of 18 current and former officers, directors, employees and attorneys were conducted, and more than 40 million pages of electronic and hard copy documents were searched for relevant information. The Special Committee also conducted its own separate review of the option granting practices during the tenure of current executive management team through additional interviews and document collection and review with the assistance of its own separate counsel and FTI Consulting. The Equity Award Review established the absence of contemporaneous evidence supporting a substantial number of the previously-recorded option grants, substantially all of which were made in the period from 1998 through late 2003. During this period of time, in some instances, documents, data and interviews suggest that option grants were prepared or finalized days or, in some cases, weeks or months after the option grant date recorded in our books. The affected grants include options issued to certain newly-hired employees but dated prior to their employment start dates and options issued to non-employees, including advisors to the Board erroneously designated as employees. The Special Committee also concluded that certain former employees and former officers participated in making improper option grants, including the selection of grant dates with the benefit of hindsight and in the deferral of the recording of otherwise approved option grants. 22 Table of Contents In light of the Equity Award Review, the Audit Committee of our Board concluded that our prior financial statements for periods from 1998 through our filing of interim financial statements for the period ended September 30, 2006, could no longer be relied upon and must be restated. Our management determined that, from fiscal year 1998 through fiscal year 2005, we had unrecorded non-cash equity-based compensation charges associated with our equity incentive plans. These charges are material to our financial statements for the years ended December 31, 1998 through 2005, the periods to which such charges would have related. Previously filed annual reports on Form 10-K and quarterly reports on Form 10-Q affected by the restatements have not been and will not be amended and should not be relied upon. Our Annual Report on Form 10-K filed on September 11, 2007 superseded and replaced in their entirety all of our previously issued financial statements and related reports filed with the Securities and Exchange Commission. Our past stock option granting practices and the restatement of our prior financial statements have exposed and may continue to expose us to greater risks associated with litigation, regulatory proceedings and government inquiries and enforcement actions. As described in Part I, Item 3, "Legal Proceedings," several derivative complaints have been filed in state and federal courts against our current directors, some of our former directors and some of our current and former executive officers pertaining to allegations relating to stock option grants. The SEC initiated an inquiry into our historical stock option granting practices, and we received a subpoena from the United States Attorney's Office for the Southern District of California for the production of documents relating to our historical stock option granting practices. In April 2008, the SEC notified us that it had completed its investigation and that it did not intend to recommend any enforcement action by the SEC against us. We have cooperated and expect to continue to cooperate with the U.S. Attorney's Office. The period of time necessary to resolve the U.S. Attorney's Office inquiry is uncertain, and we cannot predict the outcome of this inquiry or whether we will face additional government inquiries, investigations or other actions related to our historical stock option grant practices. Subject to certain limitations, we are obligated to indemnify our current and former directors, officers and employees in connection with the investigation of our historical stock option practices, the completed SEC and pending U.S. Attorney's Office inquiries and any future government inquiries, investigations or actions. These inquiries could require us to expend significant management time and incur significant legal and other expenses, and could result in civil and criminal actions seeking, among other things, injunctions against us and the payment of significant fines and penalties by us, which could have a material adverse effect on our financial condition, business, results of operations and cash flow. If a federal government investigation uncovers improper or illegal activities, including any potential improper or illegal activities related to our stock option review or related matters, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or debarment from doing business with federal government agencies. The aggregate and ongoing legal fees associated with the investigation and defense of the matters related to the Equity Award Review are significant, but the impact has been partially mitigated by funds available under insurance policies purchased in prior years. We cannot assure you that the insurers will continue to reimburse us for ongoing fees. Moreover, the insurance policies contain a number of provisions that the insurers could assert either to discontinue payments or even to seek the return of previously made payments. For instance, if it were determined by final adjudication in the underlying action or in a separate action or proceeding that former officers or directors committed deliberate fraudulent or criminal acts, then insurers could assert that coverage under our directors and officer's liability insurance policies for those periods could be rescinded. In the event of such a determination and an assertion by an insurer, the insurance carriers could pursue a claim against the former officers and directors and/or us for amounts previously advanced under the underlying policies. If insurance coverage is withheld or rescinded by our insurance carriers, we could 23 Table of Contents be exposed to potentially significant financial burdens arising from continuing to fund ongoing costs and costs associated with potential claims for return of prior payments, which could cause us significant harm. In addition, we could suffer serious harm to our reputation and competitive position if allegations of impropriety were made against us, whether or not true. If our reputation or relationship with federal government agencies were impaired, or if the federal government otherwise ceased doing business with us or significantly decreased the amount of business it does with us, our revenue and operating profit would decline. If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results or prevent fraud. Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our operating results could be misstated, our reputation may be harmed and the trading price of our stock could be negatively affected. Our management has concluded that there are no material weaknesses in our internal controls over financial reporting as of December 28, 2008. However, there can be no assurance that our controls over financial processes and reporting will be effective in the future or that additional material weaknesses or significant deficiencies in our internal controls will not be discovered in the future. Any failure to remediate any future material weaknesses or implement required new or improved controls, or difficulties encountered in their implementation, could harm our operating results, cause us to fail to meet our reporting obligations or result in material misstatements in our financial statements or other public disclosures. Inferior internal controls could also cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock. In addition, from time to time we acquire businesses which could have limited infrastructure and systems of internal controls. On June 28, 2008, we completed the acquisition of SYS Technologies (SYS) and on December 24, 2008, we completed the acquisition of Digital Fusion, Inc. (DFI) and, as permitted by SEC guidance, we excluded from our assessment of the effectiveness of our internal control over financial reporting as of December 28, 2008, the internal control over financial reporting of these two entities. Performing assessments of internal controls, implementing necessary changes, and maintaining an effective internal controls process is costly and requires considerable management attention, particularly in the case of newly acquired entities. We may need additional capital in the future to fund the growth of our business, and financing may not be available. We currently anticipate that our available capital resources, including our credit facility and operating cash flows, will be sufficient to meet our expected working capital and capital expenditure requirements for at least the next 12 months. However, such resources may not be sufficient to fund the long-term growth of our business or the expenses associated with the ongoing litigation, litigation settlements and government inquiries. In particular, we may experience a negative operating cash flow due to billing milestones and project timelines in certain of our contracts. We may raise additional funds through public or private debt or equity financings if such financings become available on favorable terms or we may expand our credit facility to fund future acquisitions and for general corporate purposes. However, due to the current challenges in the lending markets, we can provide no assurance that the lender would agree to extend additional or continuing credit under that facility. We could fall out of compliance with financial and other covenants contained in our credit facility which, if not waived, would restrict our access to capital and could require us to pay down our existing debt under the credit facility. Any new financing or offerings would likely dilute our stockholders' equity ownership. In addition, additional financing may not be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, 24 Table of Contents we may not be able to take advantage of available opportunities, develop new products or otherwise respond to competitive pressures. In any such case, our business, operating results or financial condition could be materially adversely affected. Our ability to make payments on our debt will be contingent on our future operating performance, which will depend on a number of factors that are outside our control. Our debt service obligations are estimated to be approximately $11.0 million to $13.0 million in 2009, including approximately $5.9 million of principal repayments. This debt service may have an adverse impact on our earnings and cash flow, which could in turn negatively impact our stock price. Our ability to make principal and interest payments on our debt is contingent on our future operating performance, which will depend on a number of factors, many of which are outside of our control. The degree to which we are leveraged could have other important negative consequences, including the following: • we must dedicate a substantial portion of our cash flows from operations to the payment of our indebtedness, reducing the funds available for future working capital requirements, capital expenditures, acquisitions or other general corporate requirements; • a significant portion of our borrowings are, and will continue to be, at variable rates of interest, which may result in higher interest expense in the event of increases in interest rates; • we may be more vulnerable to a downturn in the industries in which we operate or a downturn in the economy; • we may be limited in our flexibility to plan for, or react to, changes in our business and the industries in which we operate; • we may be placed at a competitive disadvantage compared to our competitors that have less debt; • we may determine it to be necessary to dispose of certain assets or one or more of our businesses to reduce our debt; and • our ability to borrow additional funds in excess of our current financing may be limited. Our business may not generate sufficient cash flow from operations and future borrowings may not be available in amounts sufficient to enable us to pay our indebtedness or fund our other liquidity needs. Moreover, we may need to refinance all or a portion of our indebtedness on or before maturity. In such a case, we may not be able to refinance any of our indebtedness on commercially reasonable terms or at all. If we are unable to make scheduled debt payments or comply with the other provisions of our debt instruments, our lenders may be permitted under certain circumstances to accelerate the maturity of the indebtedness owed to them and exercise other remedies provided for in those instruments and under applicable law. We are subject to restrictive debt covenants pursuant to our indebtedness. These covenants may restrict our ability to finance our business and, if we do not comply with the covenants or otherwise default under them, we may not have the funds necessary to pay all amounts that could become due and the lenders could foreclose on substantially all of our assets. Our indebtedness contains covenants that, among other things, significantly restricts and, in some cases, effectively eliminates our ability and the ability of our subsidiaries to: • incur additional debt; • create or incur liens; 25 Table of Contents • bid on or perform work due to limits on the amount of performance bonds that may be secured by letters of credit; • pay dividends or make other equity distributions to our stockholders; • make investments; • sell assets; • issue or become liable on a guarantee; • create or acquire new subsidiaries; • effect a merger or consolidation of, or sell all or substantially all of our assets; and • raise capital using our equity. In addition, we must comply with certain financial covenants. In the event we were to fail to meet any of such covenants and were unable to cure such breach or otherwise renegotiate such covenants, our lenders would have significant rights to deny future access to liquidity and/or seize control of substantially all of our assets. The material financial covenants with which we must comply include a maximum first lien leverage ratio, a maximum total leverage ratio, a minimum liquidity ratio, a minimum fixed charge coverage ratio, and a minimum consolidated EBITDA. The covenants contained in our indebtedness and any credit agreement governing future debt may significantly restrict our future operations. Furthermore, upon the occurrence of any event of default, our lenders could elect to declare all amounts outstanding under such agreements, together with accrued interest, to be immediately due and payable. If those lenders were to accelerate the payment of those amounts, we may not have sufficient assets to repay those amounts in full. We are also subject to interest rate risk due to our indebtedness at variable interest rates, based on a base rate or LIBOR floor rate plus an applicable margin. Shifts in interest rates could have a material adverse effect on us. We may be required to prepay our indebtedness prior to its stated maturity, which may limit our ability to pursue business opportunities. Pursuant to the terms of certain of our indebtedness, in certain instances we are required to prepay outstanding indebtedness prior to its stated maturity date. Specifically, certain non-recurring cash inflows such as proceeds from asset sales, insurance recoveries, and equity offerings may have to be used to pay down indebtedness and may not be reborrowed. These prepayment provisions may limit our ability to utilize this cash flow to pursue business opportunities. Our stock price may be volatile, which may result in lawsuits against us and our officers and directors. The stock market in general and the stock prices of government services companies in particular, have experienced volatility that has often been unrelated to or disproportionate to the operating performance of those companies. The market price of our common stock has fluctuated in the past and is likely to fluctuate in the future. Factors which could have a significant impact on the market price of our common stock include, but are not limited to, the following: • quarterly variations in operating results; • announcements of new services by us or our competitors; • the gain or loss of significant customers; • changes in analysts' earnings estimates; 26 Table of Contents • rumors or dissemination of false information; • pricing pressures; • short selling of our common stock; • impact of litigation and ongoing government inquiries; • general conditions in the market; • political and/or military events associated with current worldwide conflicts; and • events affecting other companies that investors deem comparable to us. Companies that have experienced volatility in the market price of their stock have frequently been the subject of securities class action litigation. We and certain of our current and former officers and directors have been named defendants in class action and derivative lawsuits. These matters and any other securities class action litigation and derivative lawsuits in which we may be involved could result in substantial costs to us and a diversion of our management's attention and resources, which could materially harm our financial condition and results of operations. Our charter documents and Delaware law may deter potential acquirers and may depress our stock price. Certain provisions of our charter documents and Delaware law, as well as certain agreements we have with our executives, could make it substantially more difficult for a third party to acquire control of us. These provisions include: • authorizing the board of directors to issue preferred stock; • prohibiting cumulative voting in the election of directors; • prohibiting stockholder action by written consent; • establishing advance notice requirements for nominations for election to our board of directors or for proposing matters that can be acted on by stockholders at meetings of our stockholders; • Section 203 of the Delaware General Corporation Law, which prohibits us from engaging in a business combination with an interested stockholder unless specific conditions are met; and • a number of our executives have agreements with us that entitle them to payments in certain circumstances following a change in control. We have a stockholder rights plan which may discourage certain types of transactions involving an actual or potential change in control and may limit our stockholders' ability to approve transactions that they deem to be in their best interests. As a result, these provisions may depress our stock price. Item 1B. Unresolved Staff Comments None. Item 2. Properties Our principal executive offices for all business segments are located in approximately 93,000 square feet of office space in San Diego, California. The lease for such space expires in April 2010. Other corporate resource offices are located in the following locations: Washington, D.C.; Marietta, Georgia; Newport, Delaware; Houston, Texas; Dayton, Ohio; Huntsville, Alabama; Alexandria, Virginia; and Indianapolis, Indiana. We also lease office space to provide local support services to our customers in various regions throughout the United States. The leases on these spaces expire at various times through February 2016. We continually evaluate our current and future space capacity in relation to 27 Table of Contents current and projected future staffing levels. We believe that our existing facilities are suitable and adequate to meet our current business requirements. Item 3. Legal Proceedings Contingencies IPO Securities Litigation Beginning in June 2001, the Company and certain of its officers and directors were named as defendants in several parallel class action shareholder complaints filed in the United States District Court for the Southern District of New York, now consolidated under the caption, In re Wireless Facilities, Inc. Initial Public Offering Securities Litigation, Case 01-CV-4779. In the amended complaint, the plaintiffs allege that the Company, certain of its officers and directors, and the underwriters of the Company's initial public offering ("IPO") violated section 11 of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934 based on allegations that the Company's registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The plaintiffs seek unspecified monetary damages and other relief. Similar complaints were filed in the same court against hundreds of other public companies ("Issuers") that conducted IPOs of their common stock in the late 1990s and 2000. These complaints have been consolidated into an action captioned In re Initial Public Offering Securities Litigation, 21 MC 92 (the "IPO Cases"). In June 2004, the Issuers (including the Company) executed a partial settlement agreement with the plaintiffs that would have, among other things, resulted in the dismissal with prejudice of all claims against the Issuers and their officers and directors and the assignment of certain potential Issuer claims to the plaintiffs. On February 15, 2005, the district court issued a decision certifying a class action for settlement purposes and granting preliminary approval of the settlement subject to modification of certain bar orders contemplated by the settlement. On August 31, 2005, the court reaffirmed class certification of the settlement class and preliminary approval of the modified settlement in a comprehensive Order. On February 24, 2006, the court dismissed litigation filed against certain underwriters in connection with certain claims to be assigned under the settlement. On April 24, 2006, the district court held a Final Fairness Hearing to determine whether to grant final approval of the settlement, and the court reserved decision at that time. While the partial settlement was pending approval, the plaintiffs continued to litigate against the underwriter defendants. The district court directed that the litigation proceed within a number of "focus cases" rather than all of the 310 cases that had been consolidated. The Company's case is not one of these focus cases. On October 13, 2004, the district court certified the focus cases as class actions. The underwriter defendants appealed that ruling and on December 5, 2006, the Second Circuit Court of Appeals reversed the district court's class certification decision. On April 6, 2007, the Second Circuit denied plaintiffs' rehearing petition, but clarified that the plaintiffs could seek to certify a more limited class in the district court. In light of the Second Circuit opinion, liaison counsel for all issuer defendants, including the Company, informed the district court that the settlement could not be approved because the defined settlement class, like the litigation class, could not be certified. On June 24, 2007, the district court entered an order terminating the proposed settlement. Plaintiffs filed second consolidated amended complaints in the six focus cases on August 14, 2007, 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. On March 26, 2008, the district court denied 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. Briefing on the class certification motion was completed in May 2008. That motion was withdrawn without prejudice on 28 Table of Contents October 10, 2008. On February 25, 2009, liaison counsel for the plaintiffs informed the district court that a settlement had been agreed to in principle, subject to formal approval by the parties and preliminary and final approval by the court. Due to the inherent uncertainties of litigation, the ultimate outcome of this matter cannot be predicted. In accordance with FASB 5, "Accounting for Contingencies," the Company believes any contingent liability related to this claim is not probable or estimable and therefore no amounts have been accrued in regards to this matter. 2004 Securities Litigation In August 2004, following the Company's announcement on August 4, 2004 that it intended to restate its financial statements for the fiscal years ended December 31, 2000, 2001, 2002 and 2003, the Company and certain of its current and former officers and directors were named as defendants ("Defendants") in several securities class action lawsuits filed in the United States District Court for the Southern District of California. These actions were filed on behalf of those who purchased, or otherwise acquired, the Company's common stock between April 26, 2000 and August 4, 2004. The lawsuits generally alleged that, during that time period, Defendants made false and misleading statements to the investing public about the Company's business and financial results, causing its stock to trade at artificially inflated levels. Based on these allegations, the lawsuits alleged that Defendants violated the Securities Exchange Act of 1934, and the plaintiffs sought unspecified damages. These actions were consolidated into a single action—In re Wireless Facilities, Inc. Securities Litigation, Master File 04CV1589-JAH. Plaintiffs filed a First Amended Consolidated Class Action Complaint on April 1, 2005. Defendants filed their motion to dismiss this first amended complaint on April 14, 2005. The plaintiffs then requested leave to amend their first amended complaint. The plaintiffs filed their Second Amended Complaint on June 9, 2005, this time on behalf of those who purchased, or otherwise acquired, the Company's common stock between May 5, 2003 and August 4, 2004. Defendants filed their motion to dismiss this Second Amended Complaint on July 14, 2005. The motion to dismiss was taken under submission on October 20, 2005 and on March 8, 2006, the Court granted the Defendants' motion. However, plaintiffs were granted the right to amend their complaint within 45 days and subsequently filed their Third Amended Consolidated Class Action Complaint on April 24, 2006. Defendants filed a motion to dismiss this complaint on June 8, 2006. On May 7, 2007, the Court denied the Defendants' motion to dismiss. Defendants' filed their answer to the plaintiffs' complaint on July 13, 2007. In February 2008, following a voluntary mediation of the matter, the parties reached a tentative agreement to settle the class action. In June 2008, the parties executed a Memorandum of Understanding documenting the essential terms of the proposed settlement and on August 8, 2008, the parties filed their joint motions for preliminary approval of the proposed settlement with the Court. The Court granted preliminary approval of the proposed settlement on September 3, 2008. On January 13, 2009, following a motion by the parties, the Court granted final approval of the proposed settlement terms, issued its final judgment on the matter, and entered an order dismissing the case with prejudice. Pursuant to the settlement agreement and final order of the Court, plaintiffs and the class dismissed all claims, with prejudice, in exchange for a cash payment in the total amount of $12 million. The Company's directors' and officers' liability insurers paid the settlement amount in accordance with the Company's insurance policies, less the applicable retention or co-insurance obligations that were paid directly by the Company. The Company's amount of payment toward the settlement was approximately $2.4 million. In the fourth quarter of 2008, the Company paid $3.0 million related to this matter, of which $1.0 million was from its restricted cash account. The Company expects to receive $0.6 million from the insurance carriers for this payment in the first half of 2009. Despite the settlement reached in this action, the Company believes that the allegations lacked merit. 29 Table of Contents In 2004, two derivative lawsuits were filed in the United States District Court for the Southern District of California against certain of the Company's current and former officers and directors: Pedicini v. Wireless Facilities, Inc., Case 04CV1663; and Roth v. Wireless Facilities, Inc., Case 04CV1810. These actions were consolidated into a single action in In re Wireless Facilities, Inc. Derivative Litigation, Lead Case No 04CV1663-JAH. These lawsuits contain factual allegations that are substantially similar to those made in the class action lawsuits, but the plaintiffs in these lawsuits assert claims for breach of fiduciary duty, gross mismanagement, abuse of control, waste of corporate assets, violation of Sarbanes Oxley Act section 304, unjust enrichment and insider trading. The plaintiffs in these lawsuits seek unspecified damages and equitable and/or injunctive relief. The lead plaintiff filed a consolidated complaint on March 21, 2005. On May 3, 2005, the defendants filed motions to dismiss this action, to stay this action pending the resolution of the consolidated non-derivative securities case pending in the Southern District of California, and to dismiss the complaint against certain non-California resident defendants. Pursuant to a request by the Court, Defendants' motions were withdrawn without prejudice pending a decision on defendants' motion to dismiss the complaint against the non-California resident defendants. On March 20, 2007, the Court ruled that it lacked personal jurisdiction over five of the six non-California defendants and dismissed them from the federal derivative complaint. On March 27, 2007, plaintiffs filed an amended derivative complaint setting forth all of the same allegations from the original complaint and adding allegations regarding the Company's stock option granting practices. Basically, plaintiffs allege that the Company "backdated" or "springloaded" employee stock option grants so that the options were granted at less than fair market value. The amended complaint names all of the original defendants (including those dismissed for lack of jurisdiction) as well as nine new defendants. On July 2, 2007, the non-California resident defendants moved to dismiss the complaint for lack of personal jurisdiction. On October 17, 2007, the Court took the motion under submission without oral argument. On February 26, 2008, the Court again ruled that it lacked personal jurisdiction over five of the six non-California defendants and dismissed them from the amended federal derivative complaint. Plaintiffs subsequently moved the Court for certification and entry of final judgment of the Court's order dismissing the non-residents for lack of personal jurisdiction so that the plaintiffs may seek immediate appellate review of the matter. On July 10, 2008, the court granted plaintiffs' motion for certification, which was not opposed by defendants. On August 12, 2008, Plaintiffs filed a notice of appeal of the personal jurisdictional order. Neither a briefing schedule nor a hearing date on the matter is presently set. The parties have conferred and discussed the Court's personal jurisdictional order and notice of appeal and have stipulated to a briefing schedule for any remaining motions to dismiss that the Company, along with the individual defendants subject to the court's jurisdiction, may bring in an effort to dismiss the complaint as to them. Pursuant to the parties' stipulation, such motions must be brought on or before March 26, 2009. The Company believes that the allegations lack merit and intends to vigorously defend all claims asserted. It is impossible at this time to assess whether or not the outcome of these proceedings will have a material adverse effect on the Company. In April 2007, another derivative complaint was filed in the United States District Court for the Southern District of California, Hameed v. Tayebi, Case 07-CV-0680 BTM(RBB) (the "Hameed Action"), against several of the Company's current and former officers and directors. The allegations in this derivative complaint mirrored the amended allegations in the 2004 federal derivative action. Pursuant to a Court order and agreement of the parties, the defendants' responses to the complaint in the Hameed Action were stayed until the Court ruled on the motion to dismiss for lack of personal jurisdiction in the 2004 derivative litigation. As noted above, on February 26, 2008, the Court ruled that it lacked personal jurisdiction over five of the non-California defendants named in the 2004 derivative action, including three that were also named in the Hameed Action. In August 2008, and before defendants had responded to the complaint, Plaintiff voluntarily dismissed the Hameed Action pursuant to Federal Rule of Civil Procedure 41(a). The Company believes that the allegations lacked merit and intended to vigorously defend all claims asserted. 30 Table of Contents In August and September 2004, two virtually identical derivative lawsuits were filed in California Superior Court for San Diego County against certain of the Company's current and former officers and directors. These actions contain factual allegations similar to those of the federal lawsuits, but the plaintiffs in these cases assert claims for violations of California's insider trading laws, breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust enrichment. The plaintiffs in these actions seek unspecified damages, equitable and/or injunctive relief and disgorgement of all profits, benefits and other compensation obtained by defendants. These lawsuits have been consolidated into one action—In re Wireless Facilities, Inc. Derivative Litigation, California Superior Court, San Diego County, Lead Case GIC 834253. The plaintiffs filed a Consolidated Shareholder Derivative Complaint on October 14, 2004. This action has been stayed pending a decision in federal court on a motion to dismiss the federal derivative lawsuit. In October 2008, the parties notified the Court of the status of the federal action and the court continued the stay for an additional six months. The Court also ordered the parties to file an updated status report in April 2009. The Company believes that the allegations lack merit and intends to vigorously defend all claims asserted. It is impossible at this time to assess whether or not the outcome of these proceedings will have a material adverse effect on the Company. The Company has recorded an accrual for a contingent liability associated with the legal proceedings related to the derivative actions of $0.7 million based on the Company's estimate of the potential amount it would have to pay in relation to these lawsuits. 2007 Securities Litigation In March and April 2007, there were three federal class actions filed in the United States District Court for the Southern District of California against the Company and several of its current and former officers and directors. These class action lawsuits followed the Company's March 12, 2007 public announcement that it was conducting a voluntary internal review of its stock option granting processes. These actions were consolidated into a single action, In re Wireless Facilities, Inc. Securities Litigation II, Master File 07-CV-0482-BTM-NLS. The consolidated class action complaint was filed on November 19, 2007. In March 2008, following a voluntary mediation of the matter, the parties reached a tentative agreement to settle the class action. In May 2008, the parties executed a Memorandum of Understanding documenting the essential terms of the proposed settlement and on August 8, 2008, the parties filed their joint motions for preliminary approval of the proposed settlement with the Court. The Court granted preliminary approval of the proposed settlement on September 3, 2008. On December 19, 2008, following a motion by the parties, the Court granted final approval of the proposed settlement terms, issued its final judgment on the matter, and entered an order dismissing the case with prejudice. Pursuant to the settlement agreement and final order of the Court, plaintiffs and the class dismissed all claims, with prejudice, in exchange for a cash payment in the amount of $4.5 million. The Company's directors' and officers' liability insurers paid the settlement amount, less the applicable retention or co-insurance obligations and contributions that were paid directly by the Company. In July 2008, the Company paid $1.8 million related to the settlement of this litigation. Despite the settlement reached in this action, the Company believes that the allegations lacked merit. Other Litigation and Government Investigations In January 2005, a former independent contractor of the Company filed a lawsuit in Brazil against the Company's subsidiary, WFI de Brazil, to which he had been assigned for a period of time. He sought to be designated an employee of WFI de Brazil and entitled to severance and related compensation pursuant to Brazilian labor law. The individual sought back wages, vacation pay, stock option compensation and related benefits in excess of $0.5 million. This matter was argued before the appropriate labor court in July 2005 and in July, 2006, the labor court awarded the individual the 31 Table of Contents Brazilian currency equivalent of approximately $0.4 million for his back wages, vacation pay and certain other benefits. The Company filed an appeal in the matter on July 20, 2006 and is challenging the basis for the award on several theories. The Company has accrued approximately $0.4 million as of December 28, 2008 related to this matter. On August 22, 2007, the appeals court partially upheld the Company's appeal, although it upheld the individual's designation as an employee. The court is reviewing possible damage calculations before publishing a final decision. The Company's counsel is preparing a motion for clarification of the judgment due to omissions in the decision. On March 28, 2007, three plaintiffs, on behalf of a purported class of similarly situated employees and contractors, filed a lawsuit against the Company in the Superior Court of the State of California, Alameda County. The suit alleges various violations of the California Labor Code and seeks payments for allegedly unpaid straight time and overtime, meal period pay and associated penalties. The Company and the plaintiffs agreed to venue for the suit in San Diego County. Although the Company believes that the allegations lack merit, it has agreed with the plaintiffs to settle their claims for an aggregate amount in the range of $0.3 million to $0.5 million, to include individual and incentive awards, attorneys' fees and administrative costs, subject to court approval. The actual amount paid by the Company will depend upon the number of responses received from members of the purported class of plaintiffs. The Company has recorded an accrual for a contingent liability associated with this legal proceeding in the amount of $0.3 million. On May 3, 2007, Kratos announced that it had a filed a lawsuit against a former employee who previously served as its stock option administrator and left Kratos in mid-2004, and his spouse. The lawsuit sought to recover damages resulting from the theft by a former employee of Kratos stock options and common stock valued in excess of $6.3 million. The thefts, which appear to have taken place during 2002 and 2003, were discovered through the Kratos review of its past practices related to the granting and pricing of employee stock options with the assistance of its outside counsel and forensic computer consultants. The complaint also alleged that the former employee attempted to cover up the scheme by, among other things, deleting entries from the records of Kratos. Kratos promptly reported to the SEC the discovery of the theft. The SEC initiated an inquiry and commenced an enforcement action against the former employee. The U.S. Attorney's Office also forwarded a grand jury subpoena to Kratos seeking records related to the former employee and Kratos' historical option granting practices. The SEC filed a federal lawsuit and obtained a temporary restraining order and asset freeze against the former employee and his spouse. The U.S. Attorney's Office indicted him for the theft and he pled guilty to federal criminal charges and has been sentenced to 46 months in prison and currently is incarcerated. On April 1, 2008, the SEC notified Kratos that it had completed its investigation and that it did not intend to recommend any enforcement action by the SEC against the Company. Kratos has cooperated with, and continues to cooperate with the U.S. Attorney's Office on this matter and otherwise. The former employee and his wife entered into a settlement agreement with Kratos on October 5, 2007, turning over substantially all of their assets to Kratos in settlement of the damages incurred in the theft. On February 15, 2008, the SEC approved the settlement. On February 19, 2008, the court entered a final judgment approving the settlement. Kratos has obtained the assets, which aggregate approximately $3.4 million and recovered $0.6 million from its insurance carrier related to the theft of options, and is in the process of liquidating the remaining assets which approximate $0.1 million in value. Kratos' directors' and officers' liability insurers have agreed to reimburse it for $4.1 million related to fees previously incurred on the ongoing investigation by the U.S. Attorney's Office as well as fees previously incurred on the SEC investigation. As a result, a benefit for this amount has been recorded in the recovery of unauthorized issuance of stock options and stock option investigation and related fees line item in the accompanying Consolidated Statements of Operations. In addition to the foregoing matters, from time to time, the Company may become involved in various claims, lawsuits and legal proceedings that arise in the ordinary course of business. However, 32 Table of Contents litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company's business. The Company is currently not aware of any such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse affect on our business, financial condition, operating results or cash flows. Item 4. Submission of Matters to a Vote of Security Holders On December 22, 2008 we held a special stockholders' meeting at which our stockholders approved the issuance of 32,900,534 shares of our common stock pursuant to the Agreement and Plan of Merger, dated as of November 21, 2008, by and among Kratos Defense & Security Solutions, Inc., Dakota Merger Sub, Inc., and Digital Fusion, Inc. The vote on the matter was as follows: 33 For Against Abstain 72,398,419 591,664 82,288 Table of Contents PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Market Information Our Common Stock is listed on the NASDAQ Global Select Market and has traded under the symbol "KTOS" since September 17, 2007. Our common stock traded under the symbol "WFII" from November 5, 1999 through September 14, 2007. The following table sets forth the high and low sales prices for our Common Stock for the periods indicated, as reported by NASDAQ. Such quotation represents inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. On March 6, 2009 the last sale price of our Common Stock as reported by NASDAQ was $0.65 per share. On March 6, 2009, there were 509 shareholders of record of our Common Stock. We have not declared any cash dividends since becoming a public company. We currently intend to retain any future earnings to finance the growth and development of the business and, therefore, do not anticipate paying any cash dividends in the foreseeable future. In addition, our credit facility restricts our ability to pay dividends. Any future determination to pay cash dividends will be at the discretion of our Board and will be dependent upon the future financial condition, results of operations, capital requirements, general business conditions and other relevant factors as determined by our Board. Securities Authorized for Issuance Under Equity Compensation Plans Information about our equity compensation plans as of December 28, 2008 is as follows (shares in thousands): (1) High Low Year Ended December 28, 2008: Fourth Quarter $ 2.04 $ 1.11 Third Quarter $ 2.14 $ 1.51 Second Quarter $ 2.04 $ 1.61 First Quarter $ 2.35 $ 1.54 Year Ended December 31, 2007: Fourth Quarter $ 3.04 $ 1.91 Third Quarter $ 2.75 $ 1.73 Second Quarter $ 1.74 $ 1.07 First Quarter $ 2.85 $ 1.24 Plan Category Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights Weighted Average Exercise Price of Outstanding Options, Warrants and Rights Number of Securities Remaining Available for Future Issuance Equity Compensation Plans Approved by Shareholders(1) 7,280 $ 4.17 11,479 Equity Compensation Plans Not Approved by Shareholders(2) 11,202 $ 1.57 2,225 Total 18,482 13,704 Includes 1997 Stock Option Plan, 1999 and 2005 Equity Incentive Plan and 1999 Employee Stock Purchase Plan (2) Includes 2000 Non-Statutory Stock Option Plan For more detailed information regarding our equity compensation plans, see Note 11 to our consolidated financial statements. 34 Table of Contents Performance Graph The following performance graph is a comparison of the five year cumulative stockholder return on our common stock against the cumulative total return of the NASDAQ Composite Index, the NASDAQ Telecommunications Index and a peer group composed of the Russell 2000 Stock Index and SYS Technologies, NCI, Inc., Stanley, Inc., SI International, Inc., MTC Technologies, Inc., and Dynamic Research Corporation for the period commencing December 31, 2003 and ending December 28, 2008. SYS, SI International, Inc. and MTC Technologies, Inc. were included for the periods prior to the time they were acquired. We consider the fiscal year ended December 28, 2008 to be the last year in the transformation of the Company from a provider of services to the Wireless Communications Industry to a company primarily engaged in defense contracting. As such, we have continued to include performance data against the NASDAQ Composite Index and the NASDAQ Telecommunication Index. In subsequent years, we will discontinue those two comparisons. The performance graph assumes an initial investment of $100 in our common stock and in each of the indices and peer group. The comparison also assumes that all dividends are reinvested and all returns are market-cap weighted. The historical information set forth below is not necessarily indicative of future performance. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Kratos Defense & Security Solutions, Inc. *$100 invested on 12/31/03 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright© 2009 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. The performance graph above and related text are being furnished solely to accompany this Annual Report on Form 10-K pursuant to Item 201(e) of Regulation S-K, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and are not to be incorporated by reference into any filing of ours, whether made before or after the date hereof, regardless of any general incorporation language in such filing. 35 Table of Contents Item 6. Selected Financial Data The selected consolidated financial data has been restated as a result of the discontinued businesses. The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations" which are incorporated in Item 7 or included elsewhere in this Report on Form 10-K. Our historical results are not necessarily indicative of operating results to be expected in the future. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") This report contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by 36 Year Ended December 31, 2004 2005 2006 2007 2008 (All amounts except per share data in millions) Consolidated Statements of Operations Financial Data: Revenues $ 116.9 $ 152.3 $ 153.1 $ 193.6 $ 297.3 Gross profit 29.0 36.6 28.9 31.6 59.5 Operating income (loss) (13.8 ) 3.2 (31.5 ) (24.6 ) (94.8 ) Provision (benefit) for income taxes (8.4 ) (0.1 ) 13.8 1.3 (0.7 ) Income (loss) from continuing operations (8.2 ) 3.6 (46.2 ) (28.2 ) (105.6 ) Income (loss) from discontinued operations 23.2 (2.0 ) (11.7 ) (12.6 ) (5.5 ) Net income (loss) $ 15.0 $ 1.6 $ (57.9 ) $ (40.8 ) $ (111.1 ) Income (loss) from continuing operations per common share Basic $ (0.12 ) $ 0.05 $ (0.63 ) $ (0.38 ) $ (1.14 ) Diluted $ (0.12 ) $ 0.05 $ (0.63 ) $ (0.38 ) $ (1.14 ) Income (loss) from discontinued operations per common share Basic $ 0.34 $ (0.03 ) $ (0.16 ) $ (0.17 ) $ (0.06 ) Diluted $ 0.34 $ (0.03 ) $ (0.16 ) $ (0.17 ) $ (0.06 ) Net income (loss) per common share Basic $ 0.22 $ 0.02 $ (0.79 ) $ (0.55 ) $ (1.20 ) Diluted $ 0.22 $ 0.02 $ (0.79 ) $ (0.55 ) $ (1.20 ) Weighted average shares: Basic 67.7 74.0 73.5 74.0 92.6 Diluted 67.7 75.0 73.5 74.0 92.6 As of December 31, 2004 2005 2006 2007 2008 (All amounts in millions) Consolidated Balance Sheet Data: Cash and cash equivalents $ 50.4 $ 7.7 $ 5.4 $ 8.6 $ 3.2 Short-term investments 7.6 — — — — Working capital 98.6 67.4 (3.8 ) 23.4 35.0 Total assets 330.7 342.0 337.7 335.3 312.4 Short-term debt 1.9 0.7 51.4 2.7 5.9 Long-term debt — — — 74.0 76.0 Total stockholders' equity $ 219.6 $ 229.7 $ 187.1 $ 167.2 $ 146.9 Table of Contents terminology such as "may," "will," "should," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential" or "continue," the negative of such terms or other comparable terminology. These statements are only predictions. Actual events or results may differ materially. Factors that may cause our results to differ include, but are not limited to: changes in the scope or timing of our projects; changes or cutbacks in spending by the U.S. Department of Defense which could cause delays or cancellations of key government contracts; the timing, rescheduling or cancellation of significant customer contracts and agreements, or consolidation by or the loss of key customers; failure to successfully consummate acquisitions or integrate acquired operations; failure to establish and maintain important relationships with government entities and agencies and other government contractors could limit our ability to bid successfully for new business; and competition in the marketplace which could reduce revenues and profit margins. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements. Moreover, neither we, nor any other person, assume responsibility for the accuracy and completeness of the forward-looking statements. We are under no obligation to update any of the forward-looking statements after the filing of our Annual Report on Form 10-K to conform such statements to actual results or to changes in our expectations. Certain of the information set forth herein, including costs and expenses that exclude the impact of stock compensation expense, amortization expense of purchased intangibles for 2006, 2007 and 2008, and the stock option investigation and related costs in 2007 and recovery of a portion of these costs in 2008, may be considered non-GAAP financial measures. We believe this information is useful to investors because it provides a basis for measuring the operating performance of our business and our cash flow, excluding the effect of stock compensation expense that would normally be included in the most directly comparable measures calculated and presented in accordance with Generally Accepted Accounting Principles. Our management uses these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating our operating performance, capital resources and cash flow. Non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information presented in compliance with GAAP, and non-financial measures we report may not be comparable to similarly titled amounts reported by other companies. The following discussion should be read in conjunction with our audited consolidated financial statements and the related notes and other financial information appearing elsewhere in this Report and other reports and filings made with the Securities and Exchange Commission. Readers are also urged to carefully review and consider the various disclosures made by us which attempt to advise interested parties of the factors which affect our business, including without limitation the disclosures made under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," and Item 1A—Risk Factors. Overview We are an innovative provider of mission critical engineering, information technology (IT) services and warfighter solutions. We work primarily for the U.S. government and federal government agencies, but we also perform work for state and local agencies and commercial customers. Our principal services are related to, but are not limited to, Command, Control, Communications, Computing, Intelligence, Surveillance and Reconnaissance (C4ISR), weapons systems lifecycle support and sustainment; military weapon range operations and technical services; missile, rocket and weapons system test and evaluation; missile and rocket mission launch services; public safety, security and surveillance systems; modeling and simulation; unmanned aerial vehicle (UAV) products and technology; advanced network engineering and information technology services; and advanced information technology services. We offer our customers solutions and expertise to support their mission-critical needs by leveraging our skills across our core service areas. 37 Table of Contents We derive a substantial portion of our revenue from contracts performed for federal government agencies, including the U.S. Department of Defense (DOD), with the majority of our revenue currently generated from the delivery of mission-critical warfighter solutions, advanced engineering services, system integration and system sustainment services to defense and other non-DOD and civilian government agencies. We believe our diversified and stable client base, strong client relationships, broad array of contract vehicles, considerable employee base possessing government security clearances, extensive list of past performance qualifications, and significant management and operational capabilities position us for continued growth. Historically, the majority of our business was concentrated in the area of wireless network services, and our business operated in three reportable segments: Wireless Network Services, Government Network Services, and Enterprise Network Services. In 2006, we were an independent provider of outsourced engineering and network deployment services, security systems engineering and integration services and other technical services for the wireless communications industry, the U.S. government, and enterprise customers. In 2006 and 2007, we undertook a transformation strategy whereby we divested our wireless-related businesses and chose to pursue business with the federal government, primarily the U.S. Department of Defense (DOD), through strategic acquisitions and organic growth. We divested assets in our Wireless Network Services segment and renamed our Enterprise Network Services segment "Public Safety and Security". Today, under the new corporate name of Kratos Defense & Security Solutions, Inc., we are organized into two primary operating segments: Kratos Government Solutions (KGS) and Public Safety & Security (PSS). The financial statements in this Annual Report are presented in a manner consistent with our new operating structure. For additional information regarding our operating segments, see Note 14 of Notes to Consolidated Financial Statements. From a customer and solutions perspective, we view our business as an integrated whole, leveraging skills and assets wherever possible. Kratos Government Solutions Segment (KGS) Our Kratos Government Solutions segment provides engineering, information technology and technical services to federal, state, and local government agencies, but primarily the DOD. Our work includes weapon systems lifecycle support and extension; C4ISR; military range operations and technical services; missile, rocket, and weapon systems test and evaluation; mission launch services; public safety and security services; advanced network engineering and information technology services; and public safety, security and surveillance systems integration. Our KGS segment also focuses on the homeland security market with products and services aimed at supporting first responders. Public Safety and Security Segment (PSS) Our Public Safety and Security segment provides system design, deployment, integration, monitoring and support services for public safety, security and surveillance networks for state and local governments and commercial customers. Public safety and security networks have been traditionally segregated into systems such as voice, data, access control, video surveillance, and temperature control and fire and life safety. We provide services that combine such systems and offer integrated solutions on an Ethernet-based platform. We also offer solutions that combine voice, data, electronic security and building automation systems with fixed or wireless connectivity solutions. Our target markets are retail, healthcare, education, sports and entertainment, municipal government, correctional facilities and other public facilities. Our commitments to these markets and our ability to provide feature-rich, cost-effective solutions have allowed us to become one of the larger independent integrators for these types of systems. We maintain regional office locations, comprised of Kratos Mid-Atlantic, Kratos Southeast, and Kratos Southwest. 38 Table of Contents Divestiture of Wireless Network Business On December 28, 2006, our Board approved a plan to divest portions of our business where critical mass had not been achieved. This plan involved the divestiture of our EMEA operations and our remaining South American operations. The EMEA operations were sold to LCC International, Inc. (LCC) on March 9, 2007 for $4.0 million in cash, $3.3 million of which was received on that date. We also received approximately $1.8 million from our EMEA operations prior and subsequent to the closing date as payment on outstanding intercompany debt. The balance of the $0.7 million sales price was withheld as security for the satisfaction of certain indemnification obligations and was payable on March 31, 2008. Based upon our review of the most recently available financial statements of the buyer, as of December 31, 2007, we had concern about their ability to pay this holdback, due to their available liquidity. We recorded a reserve of $0.7 million for this receivable. In May 2008, we reached an agreement with LCC for the payment of the $0.7 million holdback amount, under which LCC agreed to pay the outstanding balance in $0.1 million increments each month commencing June 30, 2008. We have not yet received any payments due according to the agreement. While we intend to vigorously pursue collection of the amounts, there is a substantial likelihood that we will not receive payment of the amount due, in light of LCC's apparent available liquidity amounts. On April 20, 2007, we entered into an Equity Purchase Agreement to sell our wholly-owned subsidiary WFI de Brazil Techlogia en Telecommunications LTDA to Strategic Project Services, LLC (SPS). The consideration included the assumption of substantially all outstanding liabilities of WFI Brazil, nominal cash consideration, and additional earn-out consideration based on 25% of net receivables collected subsequent to the closing date. With respect to the additional earn-out consideration, we have not received and do not anticipate receiving any payments. On May 29, 2007, we entered into an Asset Purchase Agreement with LCC International, Inc. for the sale of all of the assets used in the conduct of the operation of our engineering services business of our Wireless Network Services segment that provided engineering services to the non-government wireless communications industry in the United States, for aggregate consideration of $46 million. LCC delivered a subordinated promissory note for the principal amount of $21.6 million (the "Subordinated Promissory Note"), paid $17 million at closing and paid final working capital adjustments of $2.4 million through an amendment to the Subordinated Promissory Note. We retained an estimated $5.0 million in net working capital. The transaction was completed on June 4, 2007. On July 5, 2007, we sold the $21.6 million Subordinated Promissory Note to Silver Point Capital, L.P. ("Silver Point") in a transaction arranged by KeyBanc Capital Markets ("KeyBanc"). We received approximately $19.6 million in net cash proceeds, reflecting a discount from par value of less than five percent and aggregate transaction fees of approximately $1 million, which includes a $0.75 million fee to KeyBanc, an affiliate of our lender. On January 30, 2008, we received net proceeds of approximately $2.3 million on the working capital adjustment from Silver Point, net of a $0.1 million discount from par value. We did not provide any guaranty for LCC's payment obligations under the note. On July 7, 2007, we entered into a definitive agreement with an affiliate of Platinum Equity to sell our deployment services business of our Wireless Network Services segment for total consideration payable of $24 million, including $18 million in cash at closing (subject to typical post closing working capital adjustments) and an aggregate $6 million in a three-year earn-out arrangement. We also agreed to provide certain transition services for a period of six months. The assets sold to Platinum Equity included all of our wireless deployment business and the Wireless Facilities name. The transaction closed on July 24, 2007. As a result of these engineering and deployment services divestitures in 2007, the Wireless Network Services segment has been classified as a discontinued operation in this Annual Report and all prior year results presented herein have been reclassified to reflect these businesses as discontinued operations in accordance with SFAS 144, " Accounting for the Impairment or Disposal of Long-Lived Assets ". 39 Table of Contents On September 25, 2007, we provided the working capital calculation to Platinum Equity, which indicated a working capital adjustment was due to Platinum Equity primarily due to cash collected on accounts receivables by us prior to the close of the transaction that exceeded our previous estimate of working capital to be delivered to Platinum Equity. On July 16, 2008, we came to an agreement with Platinum Equity on a working capital adjustment of $5.0 million. In connection with that agreement, the earn-out arrangement was terminated. The adjustment was to be paid in installments. We made payments of $1.0 million in August and September 2008 and an additional payment of $0.5 million in December 2008. As of December 28, 2008, the balance of $2.5 million plus accrued interest has been reflected in other current liabilities. Recent Acquisitions On October 2, 2006 we acquired Huntsville, Alabama based Madison Research Corporation ("MRC") for $69 million in cash. MRC offers a broad range of technical, engineering and IT solutions, and has developed core competencies in weapons system lifecycle support, integrated logistics, test and evaluation, commercial-off-the-shelf software and hardware selection and implementation, software development and systems lifecycle maintenance. We have one holdback payment remaining related to this acquisition of approximately $2.5 million which we expect to pay in the first half of 2009. On December 31, 2007, we completed our acquisition of Indianapolis, Indiana headquartered Haverstick Consulting, Inc. ("Haverstick") as part of our KGS segment. Haverstick provides rocket and missile test and evaluation, weapons systems support, and professional services to the U.S. Army, U.S. Air Force, U.S. Navy, NASA, and other federal, state and local agencies. Through the Haverstick acquisition, we expanded our customer relationship within the DOD and enhanced our presence with the U.S. Air Force, a key growth area for Haverstick. The total purchase price for the Haverstick acquisition was $92.0 million, including transaction costs incurred by us of $0.8 million. The purchase price paid to Haverstick of $91.2 million was paid in a combination of $70.3 million of cash and common stock valued at $19.4 million based on 7.48 million shares at a price of $2.60 per share, the average closing price of Kratos shares of common stock for the two days prior to, including, and the two days subsequent to the public announcement of the acquisition on November 5, 2007, and a working capital adjustment of $1.5 million. We held back $8.6 million, $1.2 million in cash and $7.4 million in stock, to secure any negative working capital adjustments required by the merger agreement and our indemnity rights. The holdback consideration, which accrues interest in accordance with the terms of the agreement until paid, was to be released on the 12 th month and 21 st month after the date of the acquisition As a result of a claims notice we filed in relation to an indemnity claim which could exceed the amount of the holdback consideration payable due to Haverstick, we did not make the December 2008 holdback payment. Haverstick is disputing the claims notice. In addition to the indemnity holdback, the agreement also calls for a post closing working capital adjustment. In February 2008, we and Haverstick agreed on the working capital calculation called for in the agreement. The calculation resulted in a working capital adjustment due to Haverstick in an amount of $1.5 million. The working capital adjustment was paid in April 2008 with 697,315 shares of common stock valued at $1.3 million and cash of $0.2 million. To fund the acquisition, we secured a new credit facility of $85.0 million arranged by KeyBanc Capital Markets. The credit facility, which includes a $25.0 million line of credit and $60.0 million in term notes, replaced our previous credit facility, which had an outstanding principal balance of $6.0 million on December 31, 2007. Until the date on which the shares of stock issued to Haverstick became salable interest accrued on the value of the closing stock at a floating rate of one-month LIBOR plus four percent (4%) per annum. The shares became saleable on June 30, 2008 and 167,692 additional shares were issued in satisfaction of the accrued interest. On June 28, 2008, we completed our merger with SYS, a San Diego-based company. The merger enhances our position as a premier mid-tier federal, state and local government contractor in the 40 Table of Contents United States in the areas of C4ISR, IT services and public safety and homeland security solutions. The merger creates a broad, complementary set of business offerings, and positions the company to deliver capabilities to a wider spectrum of customers. We issued 25.3 million shares to SYS shareholders in the merger, for a total purchase price of $55.9 million including direct transaction costs of $2.4 million. Each share of SYS common stock was converted into the right to receive 1.2582 shares of Kratos common stock. The value of the Kratos common stock issued in the merger was derived from the number of shares of Kratos common stock issued, or 25.3 million, at a price of $2.022 per share, the average closing price of Kratos shares of common stock for the two days prior to, including, and the two days subsequent to the public announcement of the merger on February 21, 2008. Since signing the definitive merger agreement in February 2008, senior management of Kratos and SYS have been developing a plan to restructure and/or exit certain business activities of SYS. The plan includes a comprehensive assessment of personnel, relocation of personnel, facility consolidation and exit strategies for certain lines of business. As of December 28, 2008, the plan tentatively estimates approximately $2.0 million of restructuring costs associated with personnel, and additional costs of $0.5 million for facilities consolidation. Personnel, facilities consolidation and exit costs are still being developed therefore, the estimated restructuring liabilities are subject to change as plans become finalized. The Company expects to finalize the restructuring plan as soon as possible, but no later than June 28, 2009. We identified three business units of SYS that were not core to our business strategy and/or have been dilutive to profitability. The divestiture of these businesses will slightly reduce revenues going forward, and will immediately increase profitability and cash flow. We have recently completed the sale of two of these businesses in the first quarter of 2009 for an aggregate cash consideration of approximately $0.3 million, and expect the sale of the other business by the end of the first half of 2009. These businesses have been classified as discontinued operations in our Consolidated Financial Statements as of December 28, 2008 and we have recorded an impairment charge of $4.5 million, resulting from allocated goodwill, purchased intangibles and other assets associated with these businesses, and incurred net operating losses of $1.4 million since the acquisition of SYS. On December 24, 2008 we acquired Huntsville, Alabama based Digital Fusion Inc. (DFI). DFI provides C4ISR and technical engineering services, Unmanned Aerial Vehicle (UAV) products and technology and has significant engineering, exotic sensor and modeling and simulation capabilities. The acquisition of DFI provides us with new customers and an expanded contract vehicle portfolio, in addition to expanding the range of service offerings to our existing customers. Principal customers of DFI include the Army Aviation and Missile Research, Development and Engineering Center (AMRDEC), Army Space and Missile Defense Command/Army Forces Strategic Command ARSTRAT), NASA Marshall Space Flight Center, and certain classified customers. The total stock for stock transaction was valued at approximately $37.0 million, including Kratos transaction costs of $0.9 million. We issued 22.9 million shares to DFI shareholders and assumed outstanding DFI options, which resulted in the issuance of options to acquire approximately 10.0 million Kratos shares. The value of the purchase price related to the common stock issued was derived from the number of shares of Kratos common stock issued of 22.9 million, based on 12.8 million shares of DFI common stock outstanding and the exchange ratio of 1.7933 for each DFI share, at a price of $1.27 per share, the average closing price of Kratos shares of common stock for the two days prior to, including, and the two days subsequent to the public announcement of the merger on November 24, 2008. The fair value of the options issued allocated to goodwill based upon the Black-Scholes pricing model was $7.0 million. The fair value of unvested options which are related to future service will be expensed as the service is performed. 41 Table of Contents Key Financial Statement Concepts As of December 28, 2008, we consider the following factors to be important in understanding our financial statements. Kratos Government Solutions' business with the U.S. government and prime contractors is generally performed under cost reimbursable, fixed-price or time and materials contracts. Cost reimbursable contracts for the government provide for reimbursement of costs plus the payment of a fee. Some cost reimbursable contracts include incentive fees that are awarded based on performance on the contract. Under fixed-price contracts, we agree to perform certain work for a fixed price. Under time and materials contracts, we are reimbursed for labor hours at negotiated hourly billing rates and reimbursed for travel and other direct expenses at actual costs plus applied general and administrative expenses. Our Public Security and Safety contracts are primarily fixed-price contracts whereby revenue is recognized using the percentage-of-completion method of accounting under the provisions of Statement of Position (SOP) 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts." For contracts offered on a time and material basis, we recognize revenues as services are performed. Cost of revenues includes direct compensation, living, travel and benefit expenses for project-related personnel, payments to third-party subcontractors, cost of materials, project-related incentive compensation based upon the successful achievement of certain project performance goals, allocation of overhead costs and other direct project-related expenses. Selling, general and administrative expenses include compensation and benefits for corporate service employees and similar costs for billable employees whose time and expenses cannot be assigned to a project (underutilization costs), expendable computer software and equipment, facilities expenses and other operating expenses not directly related and/or allocated to projects. General and administrative costs include all corporate and administrative functions that support existing operations and provide infrastructure to facilitate our future growth. Additionally, our sales personnel and senior corporate executives have, as part of their compensation packages, periodic and annual bonus/commission incentives based on the attainment of specified performance goals. We consider the following factors when determining if collection of a receivable is reasonably assured: comprehensive collection history; results of our communications with customers; the current financial position of the customer; and the relevant economic conditions in the customer's country. If we have had no prior experience with the customer, we review reports from various credit organizations to ensure that the customer has a history of paying its creditors in a reliable and effective manner. If the financial condition of our customers were to deteriorate, and adversely affect their financial ability to make payments, additional allowances would be required. Additionally, on certain contracts whereby we perform services for a prime/general contractor, a specified percentage of the invoiced trade accounts receivable may be retained by the customer until we complete the project. We periodically review all retainages for collectibility and record allowances for doubtful accounts when deemed appropriate, based on our assessment of the associated risks. We believe that our Kratos Government Solutions segment will build and expand our customer relationships within the DOD, Department of Homeland Security and other non-DoD state and local agencies by taking advantage of the significant opportunities for companies with substantial expertise in advanced engineering and information technology. We believe we will experience continued growth in revenues and operating income from this operating segment. The acquisitions of Haverstick on December 31, 2007, SYS on June 28, 2008, and DFI on December 24, 2008 resulted in the addition of over 1,000 highly skilled technical professionals and engineers with expertise in the areas of military weapons and target range support as well as targets and missile operations and maintenance. 42 Table of Contents Results of Operations Comparison of Results for the Year Ended December 31, 2007 to the Year Ended December 28, 2008 Revenues. Revenues by operating segment for the years ended December 31, 2007 and December 28, 2008 are as follows (in millions): Revenues increased $103.7 million from $193.6 million in 2007 to $297.3 million in 2008, reflecting an increase of $104.2 million in our Kratos Government Solutions segment, primarily due to the acquisitions of Haverstick on December 31, 2007 and SYS on June 28, 2008. Haverstick revenue in 2008 was $85.5 million and SYS revenue was $33.2 million. This combined increase of $118.7 million from the acquired companies was partially offset by decreases in revenues in the KGS segment of approximately $14.5 million. This decrease was a result of the impact of the conversion of our work as prime to subcontractor on one of our target range projects, which was recompeted earlier in the year and awarded to a small business as well as the timing of deliverables and completion on one of our Foreign Military Sales programs. The reduction in revenues in our PSS segment was primarily the result of a reduction in revenue on municipal wireless programs and the completion of certain projects. As described in the section "Critical Accounting Principles and Estimates" and in the notes to Consolidated Financial Statements, a portion of our revenue is derived from fixed-price contracts whereby revenue is calculated using the percentage-of-completion method based on the ratio of total costs incurred to date compared to estimated total costs to complete the contract. These estimates are reviewed monthly on a contract-by-contract basis, and are revised periodically throughout the life of the contract such that adjustments to profit resulting from revisions are made cumulative to the date of the revision. Significant management judgments and estimates, including the estimated costs to complete projects, which determine the project's percent complete, must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates. During the reporting periods contained herein, we did experience revenue and margin adjustments of certain projects based on the aforementioned factors, but the effect of such adjustments, both positive and negative, when evaluated in total were determined to be immaterial to the consolidated financial statements. Cost of Revenues. Cost of revenues increased $75.8 million or 46.8% from $162.0 million for the year ended December 31, 2007 to $237.8 million for the year ended December 28, 2008 primarily due to the increase in total revenues. The increase was primarily attributable to cost of revenues of approximately $90.6 million related to the Haverstick and SYS acquisitions, partially offset by decreases in cost of revenues as a result of the reduced revenues in the two programs as discussed above. Gross margin during the year ended December 28, 2008 of 20.0% increased from a 2007 gross margin of 16.3%. The increase in gross margin primarily resulted from higher gross margins in our KGS segment as a result of our Haverstick and SYS acquisitions due to the types of program mix as well as classification of costs between cost of sales and selling, general and administrative expenses (SG&A) in accordance with government accounting standards. In addition there was improved operational performance in our PSS segment, for which margins increased from 21.5% to 25.1% for the year ended December 31, 2007 and December 28, 2008, respectively. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased 30.9% from $39.5 million to $51.7 million for the years ended December 31, 2007 and 43 2007 2008 $ change % change Public Safety & Security Segment $ 51.1 $ 50.6 $ (0.5 ) (1.0 )% Kratos Government Solutions Segment 142.5 246.7 104.2 73.1 % Total revenues $ 193.6 $ 297.3 $ 103.7 53.6 % Table of Contents December 28, 2008, respectively. The increase of $12.2 million is primarily due to an increase in costs reflecting the acquisitions of Haverstick and SYS, offset by a reduction in corporate expenses. Included in the selling, general and administrative expenses for 2007 and 2008 are amortization of purchased intangibles of $2.8 million and $5.0 million, respectively. The increase in amortization year over year is also a result of the Haverstick and SYS acquisitions. As a percentage of revenues, selling, general and administrative expenses decreased from 20.4% in 2007 to 17.4% in 2008. Excluding the impact of the amortization of purchased intangibles, SG&A decreased from 19.0% to 15.7% of revenues for 2007 and 2008, respectively, reflecting the leverage on increased revenues. Stock Option Investigation, Related Fees and Recoveries. In 2008, we recovered $4.5 million, through insurance reimbursements, of costs and losses related to the stock option investigation in 2007. Our 2007 costs of $10.6 million included $14.0 million in legal, accounting and other professional fees related to our Equity Award Review which was completed in September 2007 and the ongoing government inquiries by the Department of Justice and the now completed SEC investigation. This amount was partially offset by $3.4 million related to the recovery of assets from our settlement with our former stock option administrator related to damages for the theft of our stock options and common stock which occurred in 2002 and 2003 and was discovered during our internal review of our option granting practices. See Item 3. Legal Proceedings for a further discussion of these items. Litigation Settlement Charge. In February 2008, following a voluntary mediation of the 2004 and 2007 securities litigation, the parties reached a tentative agreement to settle the various class action lawsuits. In 2007, we accrued an estimated $4.9 million related to its costs for the settlement of these matters of which we have paid approximately $4.2 million in settlements in 2008. See Item 3. Legal Proceedings for a further discussion of these items. Impairment and Restructuring Charges. In December 2008, we concluded that the decision to exit three businesses obtained with the SYS acquisition and included with our KGS reporting segment met the criteria to be classified as held for sale and was a triggering event under SFAS 142 " Goodwill and Other Intangible Assets" ("SFAS 142") that required a review of goodwill and intangibles assets with indefinite lives. Because the three business units were never integrated into the KGS reporting unit, and the benefits of the acquired goodwill were never realized by the rest of the reporting unit, the goodwill of the disposed businesses was not adjusted based upon the relative fair values of the businesses disposed and businesses retained. Because of the timing of the disposals mentioned above, the required impairment test of the KGS goodwill and intangible assets with indefinite lives was included with our required annual impairment test of goodwill. The annual impairment test for goodwill was performed using a discounted cash flow analysis supported by comparative market multiples to determine the fair values of our segments versus their book values. The test as of December 28, 2008, indicated that the book values for the KGS segment, excluding DFI (which was purchased on December 24, 2008), exceeded the fair values of these businesses and resulted in our recording a non-cash charge totaling $105.8 million in our KGS segment for the impairment of goodwill. The impairment charge is primarily driven by adverse equity market conditions that caused a decrease in current market multiples and our stock price as of December 28, 2008, compared with the test performed as of December 31, 2007. The charge does not impact our normal business operations. Given continued significant decline in the stock market in general and specifically our stock price in 2009, we believe it is more likely than not that this could be an indication of additional goodwill impairment and could potentially result in a triggering event under SFAS 142 and an additional goodwill impairment charge in the first quarter of 2009. The impairment and restructuring charges also included costs of $0.3 million for the year ended December 28, 2008 which are primarily a result of a change in estimate of our excess facility accrual for obligations under facility leases and a write-off of fees related to our withdrawal of our previously 44 Table of Contents filed S-3 and S-4 registration statements, which will no longer be able to be used as a result of the change in regulations. Other Expense, Net. For the year ended December 28, 2008, net other expense was $11.5 million compared to net other expense of $2.3 million for the year ended December 31, 2007. The significant increase in 2008 is primarily driven by interest expense of $9.2 million on the debt used to finance the acquisition of Haverstick on December 31, 2007 and a non-cash mark to market adjustment for financial derivatives of $1.7 million. The net other expense of $2.3 million in 2007 was primarily attributable to approximately $1.8 million of an impairment charge, recorded in the fourth quarter of 2007, related to the carrying value of investments in unconsolidated affiliates to fair value as well as $1.2 million of interest expense incurred on our previous credit facility. Provision (Benefit) for Income Taxes. Our effective income tax rate for the year ended December 31, 2007 represented a negative 5% income tax provision compared to a positive 1% income tax benefit for the year ended December 28, 2008. The tax provision for the year ended December 31, 2007 included an increase to the valuation allowance of $9.8 million against the deferred tax assets. The tax benefit for the year ended December 28, 2008 included an increase to the valuation allowance of $2.5 million against the deferred tax assets and reflects a reduced tax benefit of $32.6 million relating to nondeductible goodwill impairment charges. Income (Loss) from Discontinued Operations. Loss from discontinued operations decreased from a loss of $12.6 million in 2007 to a loss of $5.5 million during 2008. In December 2008, we made the decision to exit three of our acquired SYS businesses that are not core to our stated strategy and that have been dilutive to our profitability. The businesses to be divested or exited provide interactive video surveillance and information analysis products, digital broadcasting products and incident response management systems. These actions are being taken as part of our ongoing integration efforts of recently acquired companies and cost reduction initiatives. Included in the loss for 2008 are asset impairments including goodwill and purchased intangibles and other assets of approximately $4.5 million and $1.4 million of net operating losses. These losses were partially offset by the favorable resolution of contingencies related to our wireless businesses which were divested in 2007. In 2007, the $12.6 million loss was primarily due to the impairment of assets related to the wireless deployment business of $13.4 million, an impairment of goodwill of $7.2 million related to this business, a $1.9 million loss from the disposal of our deployment business and a $1.1 million excess facility accrual. These charges were all partially offset by a gain of $14.8 million on the sale of the wireless engineering services business operations and a gain of $2.6 million on the sale of the EMEA business. Revenues and net loss before taxes generated by these discontinued businesses in 2008 were approximately $2.0 million and $6.8 million, respectively, compared to $85.7 million and $12.7 million, respectively, in 2007. See Note 3 to the Notes to the Consolidated Financial Statements for further discussion of these transactions. Results of Operations Comparison of Results for the Year Ended December 31, 2006 to the Year Ended December 31, 2007 Revenues. Revenues by operating segment for the years ended December 31, 2006 and 2007 are as follows (in millions): 45 2006 2007 $ change % change Public Safety & Security Segment $ 55.6 $ 51.1 $ (4.5 ) (8.0 )% Kratos Government Solutions Segment 97.5 142.5 45.0 46.2 % Total revenues $ 153.1 $ 193.6 $ 40.5 26.5 % Table of Contents Revenues increased $40.5 million from $153.1 million in 2006 to $193.6 million in 2007, reflecting an increase of $45.0 million in our Kratos Government Solutions segment, primarily due to the acquisition of MRC in October 2006, which contributed $70.5 million in revenues in 2007 and $17.2 million in 2006. This increase of $53.3 million was partially offset by decreases due to the reduction of one program with annualized revenues of nearly $5.7 million that was consolidated by one of our Federal Government customers as well as, to a lesser degree, other program delays and losses resulting in reduced revenues of $2.6 million in other businesses within our Government Solutions segment. Reductions in our Public Safety & Security segment of $4.5 million were primarily related to our exit of the municipal wireless business in the first quarter of 2007. As described in the section "Critical Accounting Principles and Estimates" and in the notes to Consolidated Financial Statements, a portion of our revenue is derived from fixed-price contracts whereby revenue is calculated using the percentage-of-completion method based on the ratio of total costs incurred to date compared to estimated total costs to complete the contract. These estimates are reviewed monthly on a contract-by-contract basis, and are revised periodically throughout the life of the contract such that adjustments to profit resulting from revisions are made cumulative to the date of the revision. Significant management judgments and estimates, including the estimated costs to complete projects, which determine the project's percent complete, must be made and used in connection with the revenue recognized in any accounting period. Material differences may result in the amount and timing of our revenue for any period if management makes different judgments or utilizes different estimates. During the reporting periods contained herein, we did experience revenue and margin adjustments of certain projects based on the aforementioned factors, but the effect of such adjustments, both positive and negative, when evaluated in total were determined to be immaterial to the consolidated financial statements. Cost of Revenues. Cost of revenues increased $37.8 million or 30.4% from $124.2 million for the year ended December 31, 2006 to $162.0 million for the year ended December 31, 2007 primarily due to the increase in total revenues. The increase was primarily attributable to cost of revenues of approximately $14.6 million related to the MRC acquisition, offset by decreases in cost of revenues as a result of the reduced revenues in our PSS segment discussed above. Gross margin during the year ended December 31, 2007 of 16.3% decreased from a 2006 gross margin of 18.9%. The decrease in gross margin primarily resulted from a change in the mix of Government Services revenue versus Public Safety & Security revenue. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased 2.6% from $38.6 million to $39.5 million for the years ended December 31, 2006 and 2007, respectively. The increase of $1.0 million is primarily due to an increase in costs reflecting the acquisition of MRC and an increase in external consulting and professional fees, such as legal and accounting, partially offset by a reduction in stock compensation expense of $4.9 million from 2006, which decreased from $5.9 million in 2006 to $1.0 million in 2007. Included in the selling, general and administrative expenses (SG&A) for 2006 and 2007 are amortization of purchased intangibles of $2.1 million and $2.8 million, respectively. The increase in amortization year over year is also a result of the MRC acquisition. As a percentage of revenues, selling, general and administrative expenses decreased from 25.2% in 2006 to 20.4% in 2007. Excluding the impact of the amortization of purchased intangibles and stock compensation expense, SG&A decreased from 20.0% to 18.5% of revenues for 2006 and 2007, respectively. Stock Option Investigation, Related Fees and Recoveries. In the summer of 2006, our current executive management team, which has been in place since 2004, initiated an investigation of our past stock option granting practices (the "Equity Award Review") in reaction to media reports regarding stock option granting practices of public companies. Our 2007 costs of $10.6 million included $14.0 million in legal, accounting and other professional fees related to our Equity Award Review 46 Table of Contents which was completed in September 2007 and the ongoing government inquiries by the Department of Justice and the now completed SEC investigation. This amount was partially offset by $3.4 million related to the recovery of assets from our settlement with our former stock option administrator related to damages for the theft of our stock options and common stock which occurred in 2002 and 2003 and was discovered during our internal review of our option granting practices. See Item 3. Legal Proceedings for a further discussion of these items. Litigation Settlement Charge. In March 2008, following a voluntary mediation of 2004 and 2007 securities litigation, the parties reached a tentative agreement to settle the class action lawsuits. See Item 3. Legal Proceedings for a further discussion of these items. We accrued an estimated $4.9 million related to its costs for the settlement of these matters. Impairment and Restructuring Charges. Impairment and restructuring charges decreased $20.6 million from $21.8 million in 2006 to $1.2 million in 2007. During 2006, we recorded $21.8 million in impairment and restructuring charges as a result of a change in strategic focus of our PSS segment and a consolidation of our headquarter facilities, which included $18.3 million for goodwill impairment related to acquisitions made in the PSS segment. This was due in part to changes in the industry and the strategic focus, the impact of recent and future expected operating performance, as well as operational challenges from significant employee turnover that we encountered after the completion of the earn-out periods in early 2006. The balance of the charge was related to an asset impairment of approximately $1.8 million, an unused facility charge of approximately $1.4 million related to facilities consolidation and severance costs associated with restructuring activities of approximately $0.3 million. The costs in 2007 of $1.2 million included $0.8 million for an excess facility accrual for obligations under facility leases with unused office space as a result of the recent divestitures of our wireless network services businesses, $0.2 million related to the impairment of leasehold improvements for these facilities and $0.2 million related to an impairment of fixed assets. Other Expense, Net. For the year ended December 31, 2006, net other expense was $0.9 million compared to net other expense of $2.3 million for the year ended December 31, 2007. The other income in 2006 was due to interest income on the note receivable relating to the sale of our Mexican subsidiary partially offset by interest expense for the borrowings on the line of credit used to fund the acquisition of MRC in October 2006. In 2007, in accordance with EITF 87-24, Allocation of Interest to Discontinued Operations , interest expense on the debt of $2.2 million that was required to be repaid as a result of the sales of our wireless network services business was allocated to discontinued operations for the periods presented. See Note 3 Discontinued Operations. Consequently, in 2007 the interest cost for the Line of Credit borrowings used to fund the MRC acquisition was primarily allocated to discontinued operations. The net other expense of $2.3 million in 2007 was primarily attributable to approximately $1.8 million of an impairment charge, recorded in the fourth quarter of 2007, related to the carrying value of investments in unconsolidated affiliates to fair value as well as $1.2 million of interest expense incurred on our credit facility. Provision (Benefit) for Income Taxes. Our effective income tax rate for the year ended December 31, 2006 represented a negative 43% income tax provision compared to a negative 5% income tax provision for the year ended December 31, 2007. The tax provision of $13.8 million for the year ended December 31, 2006 included an increase to the valuation allowance of $15.9 million against the deferred tax assets. The tax provision for the year ended December 31, 2007 included an increase to the valuation allowance of $9.8 million against the deferred tax assets. Income (Loss) from Discontinued Operations. Loss from discontinued operations increased from a loss of $11.7 million in 2006 to a loss of $12.6 million during 2007. The increase was primarily due to the impairment of assets related to the wireless deployment business of $13.4 million, an impairment of goodwill of $7.2 million related to this business, a $1.9 million loss from the disposal of our deployment business and a $1.1 million excess facility accrual. These charges were all partially offset by a gain of 47 Table of Contents $14.8 million on the sale of the wireless engineering services business operations and a gain of $2.6 million on the sale of the EMEA business. Revenues and net loss before taxes generated by these businesses in 2006 were approximately $201.7 million and $9.8 million, respectively, compared to $85.7 million and $12.7 million, respectively, in 2007. The decrease year over year was impacted by the divestitures of the wireless network services businesses in 2007. See Note 3 to the Notes to the Consolidated Financial Statements for further discussion of these transactions. Backlog As of December 28, 2008, our backlog was approximately $750 million, of which $160 million was funded. Backlog is our estimate of the amount of revenue we expect to realize over the remaining life of awarded contracts and task orders that we have in hand as of the measurement date. Our total backlog consists of funded and unfunded backlog. We define funded backlog as estimated future revenue under government contracts and task orders for which funding has been appropriated by Congress and authorized for expenditure by the applicable agency, plus our estimate of the future revenue we expect to realize from our commercial contracts that are under firm orders. Our funded backlog does not include the full potential value of our contracts, because Congress often appropriates funds to be used by an agency for a particular program of a contract on a yearly of quarterly basis, even though the contract may call for performance over a number of years. As a result, contracts typically are only partially funded at any point during their term, and all or some of the work to be performed under the contracts may remain unfunded unless and until Congress makes subsequent appropriation and the procuring agency allocates funding to the contract. Unfunded backlog reflects our estimate of future revenue under awarded government contracts and task orders for which either funding has not yet been appropriated or expenditure has not yet been authorized. Our total backlog does not include estimates of revenue from government-wide acquisition contracts, or (GWAC) contracts, or General Services Administration, or (GSA), schedules beyond awarded or funded task orders, but our unfunded backlog does include estimates of revenue beyond awarded or funded task orders for other types of indefinite delivery, indefinite quantity, or (ID/IQ), contracts, based on our experience under such contracts and similar contracts. Unfunded backlog also includes priced options, which consist of the aggregate contract revenues expected to be earned as a result of a customer exercising an option period that has been specifically defined in the original contract award. Contracts undertaken by us may extend beyond one year. Accordingly, portions are carried forward from one year to the next as part of backlog. Because many factors affect the scheduling of projects, no assurance can be given as to when revenue will be realized on projects included in our backlog. Although funded backlog represents only business which is considered to be firm, we cannot guarantee that cancellations or scope adjustments will not occur. The majority of funded backlog represents contracts under the terms of which cancellation by the customer would entitle us to all or a portion of our costs incurred and potential fees. Management believes that year-to-year comparisons of backlog are not necessarily indicative of future revenues. The actual timing of receipt of revenues, if any, on projects included in backlog could change because many factors affect the scheduling of projects. In addition, cancellation or adjustments to contracts may occur. Backlog is typically subject to large variations from quarter to quarter as existing contracts are renewed of new contracts are awarded. Additionally, all United States government contracts included in backlog, whether or not funded, may be terminated at the convenience of the United States government. 48 Table of Contents Liquidity and Capital Resources As of December 28, 2008, we had consolidated cash and cash equivalents of $3.2 million, consolidated long-term and short-term debt of $81.9 million, and consolidated stockholders' equity of $146.9 million. Our principal sources of liquidity are cash flows from operations and borrowings under our credit facility. Our operating cash flow is used to finance trade accounts receivable, fund capital expenditures, our ongoing operations, litigation and government inquiries, service our debt and make strategic acquisitions. Financing trade accounts receivable is necessary because, on average, our customers do not pay us as quickly as we pay our vendors and employees for their goods and services. Cash from continuing operations is primarily derived from our customer contracts in progress and associated changes in working capital components. A summary of our net cash used in operating activities from continuing operations from our consolidated statement of cash flows is as follows (in millions): Cash used in operating activities from continuing operations for 2008 increased by $3.6 million from 2007 primarily due to approximately $4.8 million that was used to fund the securities litigation settlement and approximately $5.5 million that was paid in 2008 related to our internal stock investigation we completed in 2007. These amounts were partially offset by cash receipts of approximately $4.9 million resulting from our recovery from the theft of stock options and other recoveries from our various insurance carriers. Cash used in operating activities of continuing operations for 2007 decreased by $3.8 million from 2006, primarily due to a decrease in days sales outstanding from 109 days to 101 days, after adjustment for the MRC transaction in 2006 and the Haverstick transaction in 2007, partially offset by payment related to our internal stock option investigation, as well as the timing of payments of our expenses. Cash used in investing activities from continuing operations are summarized as follows (in millions): Cash paid for acquisitions and contingent acquisition consideration accounted for the most significant outlays for investing activities the years 2006 and 2007 as a result of the implementation of our strategies to diversify our business while focusing on our core competencies. These acquisitions included Haverstick in 2007 and MRC in 2006. In 2008, our acquisitions were primarily funded with the issuance of stock; consequently the cash paid for acquisitions in 2008 relates to transaction costs paid for Haverstick, SYS and DFI, less cash acquired from DFI and SYS of $6.3 million. 49 Years Ended December 31, 2006 2007 2008 Net cash used in operating activities of continuing operations $ (4.9 ) $ (1.1 ) $ (4.7 ) 2006 2007 2008 Investing activities: Sale/maturity of short-term investments $ — $ — $ 0.3 Cash paid for contingent acquisition consideration (8.5 ) (8.9 ) — Cash paid for acquisitions, net of cash acquired (59.1 ) (63.9 ) (1.2 ) Proceeds/(payments) from the disposition of discontinued operations 18.9 57.3 (0.2 ) Cash transferred (to) from restricted cash (1.0 ) 1.0 (0.4 ) Capital expenditures (1.2 ) (0.9 ) (0.9 ) Net cash used in investing activities from continuing operations $ (50.9 ) $ (15.4 ) $ (2.4 ) Table of Contents Investing activities in 2006 and 2007 also included proceeds of $18.9 million and $57.3 million respectively, directly attributable to our sale of our discontinued operations. In 2008, we received $2.4 million in final payment of the note related to the working capital adjustment for the sale of our domestic wireless engineering business to LCC which was offset by payments to Platinum Equity for the working capital adjustment related to the sale of our domestic wireless deployment business. Capital expenditures consist primarily of investment in computer hardware and software and improvement of our physical properties in order to maintain suitable conditions to conduct our business. Cash provided by financing activities from continuing operations are summarized as follows (in millions): In October 2006 we replaced a previously negotiated credit facility of $15 million with KeyBank National Association with a new credit facility of $85.0 million from KeyBank to fund the acquisition of MRC. During 2007, we entered into two amendments to our credit facility, one in March and the other in June, which reduced the total facility to $35 million as a result of the divestitures of our wireless network services businesses. In December 2007, we successfully negotiated a new $85.0 million credit facility with Key Bank, which was used primarily to fund the Haverstick acquisition. In 2008, we utilized the December 2007 credit facility to fund acquisition costs associated with the acquisitions of SYS and DFI. Proceeds from the issuance of common stock in 2006 are related to the exercise of employee stock options. In 2008, we reactivated our Employee Stock Purchase Plan (ESPP) and received approximately $0.2 million as payment for the issuance of common stock under this plan. Cash provided by (used in) discontinued operations are summarized as follows (in millions): Investing cash flow consists of capital expenditures incurred by our wireless network services segment. Financing cash flows is the result of proceeds received on the exercise of stock options by the wireless network services employees. 50 2006 2007 2008 Financing activities: Proceeds from issuance of common stock $ 0.4 $ — $ — Proceeds from issuance of common stock under employee stock purchase plan — — 0.2 Borrowings under credit facility 85.0 88.5 7.9 Repayments under credit facility (34.0 ) (64.0 ) (4.6 ) Repayment of capital lease obligations (0.3 ) (0.4 ) (0.2 ) Debt issuance costs (1.2 ) (3.0 ) (0.5 ) Net cash provided by financing activities from continuing operations $ 49.9 $ 21.1 $ 2.8 2006 2007 2008 Operating cash flows $ 7.4 $ 0.2 $ (1.1 ) Investing cash flows (6.6 ) (1.6 ) — Financing cash flows 0.1 — — Effect of exchange rates on cash and cash equivalents 2.7 — — Net cash flows of discontinued operations $ 3.6 $ (1.4 ) $ (1.1 ) Table of Contents Off Balance Sheet Arrangements We have no material off-balance sheet arrangements as defined in Regulation S-K, Item 303(a)(4)(ii). Contractual Obligations and Commitments In connection with our business acquisitions, we have agreed to make additional future payments to sellers based on final purchase price adjustments and the expiration of certain indemnification obligations. Pursuant to the provisions of SFAS 141, such amounts are accrued, and therefore, recorded when the contingency is resolved beyond a reasonable doubt and, hence, the additional consideration becomes payable. In 2007, we paid $4.6 million of working capital adjustments and approximately $4.3 million of the holdback amounts to the former MRC shareholders in accordance with the Purchase Agreement. As of December 28, 2008, we have approximately $3.7 million of cash holdback amounts that will be released subject to indemnity rights due for the MRC and Haverstick acquisitions. The MRC holdback of approximately $2.5 million was originally due in April 2008 and this date has been extended to provide additional time to resolve outstanding indemnification obligations. We expect to make this payment in 2009 when the indemnification obligation has been resolved unless the amount of our claim exceeds the amount of the holdback. The Haverstick holdback of $1.2 million has scheduled release dates in December 2008 and September 2009. The holdback payment due in December 2008 was not made pending the resolution of an outstanding indemnification claim. The holdback arrangements accrue interest in accordance with the terms of the purchase agreements. On December 31, 2007, we entered into a credit facility of $85.0 million with KeyBanc Capital Markets which replaced the October 2, 2006 credit agreement with Key Bank. This credit facility provides for two term loans consisting of a first lien term note of $50.0 million and a second lien term note of $10.0 million, as well as a first lien $25 million revolving line of credit. The $10.0 million term loan has a five and one half-year term with principal payments of $25,000 required quarterly beginning on March 31, 2008 through March 31, 2013 with the final balance of $9.5 million due on June 30, 2013. The $50.0 million term loan has a five year term with principal payments of $0.6 million required quarterly beginning on March 31, 2008, $1.3 million in 2009, $2.5 million in 2010, and $4.1 million in 2011 and 2012. The term loans have a provision which states that once the full amount of the note has been borrowed, the notes cannot be paid down and reborrowed again. The revolving line of credit has a four year term which expires on December 31, 2011 and contains provisions typical in such arrangements. All loans under the new credit facility have an interest rate equal to a base rate defined as a fluctuating rate per annum equal to the higher of (a) the Federal Funds Rate plus 0.5% and (b) the rate of interest in effect for such day as publicly announced from time to time by KeyBank as its "prime rate" plus a margin for the term loans of 6.5% to 7.5% and a margin of 1.0% to 3.25% on the revolving line of credit. The applicable margin at date of borrowing is determined by the ratio of our aggregate debt to our EBITDA for the previous four fiscal quarters. We used the credit facility to fund the acquisition of Haverstick and to retire the outstanding debt from the October 2006 agreement. The credit facility is collateralized by the assets of the Company. In March 2008, we entered into a tentative agreement to settle the 2004 and 2007 securities class action litigation actions (described in Part II, Item 1 Legal Proceedings), and as a result, we recorded a $4.9 million charge in the quarter ended December 31, 2007 to accrue our share of the settlement amounts, and an estimate for a contingent liability associated with legal proceedings related to the derivative actions, net of the amounts to be covered by our insurance carriers. As a consequence of recording this legal settlement, we did not meet certain of the financial covenants in accordance with the credit agreement. Accordingly, on March 27, 2008, we obtained an amendment and waiver from our lenders to waive the impact of the legal settlement amounts on our financial covenants as of December 31, 2007 and the affected future periods. The amendment also amended the credit agreement to provide for an increase in the LIBOR floor rate to 4.25% and to require that we set 51 Table of Contents aside in a restricted account approximately 50% of the proceeds of the recovery from the theft of stock options by our former stock option administrator, or approximately $1.7 million, to fund these settlement amounts. In April 2008, we transferred $1.7 million to a restricted cash account and in July 2008, we transferred an additional $0.6 million that we received from the insurance carriers as settlement on the theft of stock options to this restricted account. The lenders have also reserved the right to require us to utilize the entire amount of the $3.4 million in proceeds received from the theft of stock options to permanently pay down indebtedness. This right can be exercised no earlier than 60 days from March 27, 2008 and expires upon our compliance with financial covenants under the credit agreement for the four consecutive quarters commencing after January 1, 2008. The cost related to this amendment was recorded as deferred financing costs. On June 26, 2008, we entered into a second amendment to our credit facility in order to obtain changes necessary to complete the merger with SYS. The amendment specifically approves our assumption of the unsecured subordinated convertible notes issued by SYS as subordinated debt under the credit facility provided that a subordination agreement is obtained from the note holders representing no less than 95% of the aggregate principal amount of all subordinated notes. This condition was satisfied in July 2008. In addition, the amendment provides for an add-back for amounts representing actual transaction costs incurred by an acquired entity in the computation of Consolidated EBITDA, as defined in the credit agreement, in any acquisition in which 100% of the purchase price is paid by our equity securities. As of December 28, 2008, we had outstanding convertible notes payable which were acquired as the result of the SYS acquisition totaling $3.1 million, of which $0.8 million was payable to related parties. The convertible notes payable are unsecured and subordinate to our bank debt and bear interest at 10% per annum payable quarterly. Principal is due February 14, 2009 and the notes are convertible at any time into shares of common stock at a conversion rate of $2.86 per share. In February 2009, in the interest of preserving our cash due to the current macroeconomic conditions, we provided each note holder with the option to: (1) be paid cash in accordance with the original agreement; (2) extend the note for an additional 18 months at the existing 10% rate and modify the conversion feature to the lower of the existing conversion price of $2.86 per share or the Kratos closing share value on February 13, 2009; or (3) convert the principal balance into Kratos shares at the lower of the existing conversion price of $2.86 or the Kratos closing share value on February 13, 2009 less a 10% discount. As of February 28, 2009, $1.8 million of the notes have been paid, $1.0 million of the notes have been extended to August 14, 2010, and $25,000 have been converted to common shares. Holders of approximately $0.2 million of the notes have not responded. On July 16, 2008, we came to an agreement with Platinum Equity on a working capital adjustment of $5.0 million. The adjustment was to be paid in installments with the first amount of $2.5 million due on July 31, 2008 and payments of $0.5 million monthly thereafter until paid in full in December 2008. We did not make the scheduled $2.5 million payment due as of July 31, 2008; payments of $1.0 million were made in August and September 2008, respectively, and $0.5 million was paid in December 2008. As of December 28, 2008, the balance of $2.5 million, plus accrued interest on the payments outstanding, has been reflected in other current liabilities in the accompanying consolidated balance sheets. Other Liquidity Matters We intend to fund our cash requirements with cash flows from operating activities, and borrowings under our current credit facilities and potential future credit facilities. We believe these sources should 52 Table of Contents be sufficient to meet our cash needs for at least the next 12 months. We expect that the acquired businesses of SYS and DFI, which were not included in our 2008 cash flows until the date of acquisition will contribute additional working capital and cash flows. In 2008, we paid approximately $4.8 million related to the 2004 and 2007 securities litigation settlements, as discussed in Note 17—Legal Matters to the audited consolidated financial statements included in Item 15 of Part IV of this Annual Report. This amount was partially funded by $2.2 million from the restricted cash account we were required to fund as a result of the first amendment to our current credit facility. We expect to be reimbursed for $0.6 million of the payment related to the 2004 securities litigation settlement by our insurance carrier by the final settlement date of the litigation, which is anticipated during the first half of 2009. We also funded $5.5 million in 2008 for legal fees incurred on our internal stock option investigation which we completed in 2007. In addition, if we become subject to significant judgments, settlements, or fines related to the matters discussed in Note 17 Legal Matters, or any other matters, or incur legal fees in excess of our current expectations, we could be required to make significant payments that could materially and adversely affect our financial condition, potentially impacting our ability to access the capital markets and our compliance with our debt covenants. As discussed in Part I, Item 1A, "Risk Factors" of this Annual Report on Form 10-K, our quarterly and annual operating results have fluctuated in the past and may vary in the future due to a variety of factors, many of which are external to our control. If the conditions in our industry deteriorate or our customers cancel or postpone projects or if we are unable to sufficiently increase our revenues or further reduce our expenses, or if there is a real likelihood of continuing resolutions in 2009 for civilian and DOD agencies, we may experience, in the future, a significant long-term negative impact to our financial results and cash flows from operations. In such a situation, we could fall out of compliance with our financial and other covenants which, if not waived, could limit our liquidity and capital resources and we could be unable to make a scheduled debt payment. As of December 28, 2008, we were in compliance with all financial covenants under the credit agreements. We currently carry a significant amount of debt and have experienced recurring losses and negative cash flows from continuing operations. Given the highly leveraged liquidity position, any down-turn in our operating earnings or cash flows could impair our ability to comply with the financial covenants of our existing credit facility. Our ability to execute on additional business opportunities may be limited due to existing borrowing capacity. If we believe a covenant violation is more than likely to occur in the near future, we would seek relief from our lenders. This relief, if available, would have some cost to us and such relief might not be on terms as favorable as those in the existing credit agreement. If we were to actually default due to our failure to meet the financial covenants of our credit agreement and inability to obtain a waiver from the lenders, our credit agreement could require us to immediately repay all amounts then outstanding under the credit agreement and/or require us to pay interest at default rates per the credit agreement. In the event we were required to repay the amount outstanding under the existing credit facility, we would need to obtain alternative sources of financing to continue our operating activities at existing levels. There can be no assurance that alternative financing would be available on acceptable terms or at all. The credit agreements contain covenants which impose certain restrictions on our ability to, among other things, incur additional debt, pay dividends, make investments or sell assets. Additionally, certain non-recurring cash inflows such as proceeds from asset sales, insurance recoveries, and equity offerings may have to be used to pay down indebtedness and may not be reborrowed. In addition, the credit agreements contain certain financial covenants which are defined by the terms of the agreements. These financial covenants include a maximum first lien leverage ratio, a maximum total leverage ratio, a minimum liquidity ratio, a minimum fixed charge coverage ratio, and a minimum consolidated 53 Table of Contents EBITDA at various dates for the $50.0 million term loan and the $25.0 million revolver as outlined in the following table. The $10.0 million subordinated term loan also provides for similar financial covenants. As of December 28, 2008, our outstanding balance on the facility was $78.8 million and the weighted average interest rate on the debt borrowed during 2008 was 10.66%. This includes $9.3 million of interest expense and financing costs related to the December 31, 2007 facility. The replacement of the October 2006 facility resulted in a write-off of $1.0 million in deferred financing costs. We have $2.4 million in deferred financing costs outstanding as of December 28, 2008 which are related to the new facility and are being amortized over the four, five and five and one half-year life of the respective underlying notes. On February 11, 2008, we entered into three derivative financial instruments with Key Bank to reduce our exposure to its variable interest rates on its outstanding debt. These instruments initially hedged $70 million of its LIBOR-based floating rate debt with the amounts hedged decreasing over time. The derivatives mature on March 31, 2010 and March 31, 2011 and result in an average fixed rate of 3.16% for the term of the agreements. Initially, we designated these instruments as cash flow hedges. In March 2008, as a result of the amendment to our credit facility, which included a LIBOR floor rate of 4.25%, we determined that these instruments were no longer highly effective as a hedge. The net loss associated with the derivatives for the twelve months ended December 28, 2008 was $1.7 million. Future gains and losses on these derivative instruments will continue to be recognized in our Consolidated Statement of Operations. The following table summarizes our currently existing contractual obligations and other commitments at December 28, 2008, and the effect such obligations could have on our liquidity and cash flow in future periods (in millions): (1) Date Maximum First Lien Leverage Ratio Maximum Total Leverage Ratio Minimum Liquidity Ratio Minimum Fixed Charge Coverage Ratio Minimum Consolidated EBITDA (in millions) 2008 3.22 to 4.76:1.00 3.76 to 5.68:1.00 1.56 to 1.33:1.00 1.05 to 0.50:1.00 $16.1 to $19.4 2009 2.97 to 2.33:1.00 2.78 to 3.50:1.00 1.60 to 1.58:1.00 1.11 to 1.02:1.00 $19.8 to $21.5 2010 1.75 to 2.00:1.00 2.25 to 2.50:1.00 1.54 to 1.49:1.00 1.10 to 1.06:1.00 $21.5 to $23.4 2011 1.75:1.00 2.25:1.00 1.55 to 1.53:1.00 1.10:1.00 $24.4 to $26.5 2012 1.75:1.00 2.25:1.00 1.42 to 1.54:1.00 1.10:1.00 $26.7 to $27.6 Payments due/forecast by Period Total 2009 2010-2011 2012-2013 2014 and After Debt, net of interest(1) $ 81.9 $ 5.9 $ 46.1 $ 29.9 $ — Capital leases(5) 2.0 0.4 0.8 0.6 0.2 Estimated interest on debt(2) 26.1 9.3 13.8 3.0 0.0 Other liabilities(3) 3.7 3.7 — — — Purchase orders(4) 34.7 31.3 2.3 0.5 0.6 Operating leases(5) 19.4 8.0 8.4 2.6 0.4 Unrecognized tax benefits, including interest and penalties(6) 2.4 0.8 0.8 0.0 0.8 Total commitments and recorded liabilities $ 170.2 $ 59.4 $ 72.2 $ 36.6 $ 2.0 The Key Bank Credit Facility. The payments shown are our present forecast which contemplates that we will pay off the Key Bank Credit Facility by the due date of June 2013. See "Notes to Consolidated Financial Statements" Note 7 for further details. 54 Table of Contents (2) Includes interest payments based on current interest rates for variable rate debt and fixed rate debt based upon our swap arrangements. See "Notes to Consolidated Financial Statements" Note 7 for further details. (3) Primarily the obligations under the working capital adjustment clause and holdback payments related to the acquisition of MRC and Haverstick. See "Notes to Consolidated Financial Statements" Note 5 for further details. (4) Purchase orders include commitments in which a written purchase order has been issued to a vendor, but the goods have not been received or services have not been performed. (5) See "Notes to Consolidated Financial Statements" Note 8 for further details. (6) The FIN 48 obligations shown in the above table represent certain uncertain tax positions. The years for which the uncertain tax positions will reverse have been estimated in scheduling the obligations in the table above. As of December 28, 2008 we have $1.5 million of standby letters of credit outstanding. Our letters of credit are related to our prior workers compensation program, as support for our performance bond program and for our work overseas. Additional information regarding our financial commitments at December 28, 2008 is provided in the notes to our consolidated financial statements. See "Notes to Consolidated Financial Statements, Note 16—Commitments and Contingencies." Critical Accounting Principles and Estimates We have identified the following critical accounting policies that affect our more significant judgments and estimates used in the preparation of our consolidated financial statements. The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect the reported amounts of assets and liabilities, stockholders' equity, revenues and expenses, and related disclosures of contingent assets and liabilities. On a periodic basis, as deemed necessary, we evaluate our estimates, including those related to revenue recognition, allowance for doubtful accounts, valuation of long-lived assets including identifiable intangibles and goodwill, accounting for income taxes including the related valuation allowance, accruals for partial self-insurance, contingencies and litigation and contingent acquisition consideration. We explain these accounting policies in the notes to the audited consolidated financial statements and at relevant sections in this discussion and analysis. These estimates are based on the information that is currently available and on various other assumptions that are believed to be reasonable under the circumstances. Actual results could vary from those estimates under different assumptions or conditions. Revenue recognition. We generate almost all of our revenue from three different types of contractual arrangements: cost-plus-fee contracts, time-and-materials contracts, and fixed-price contracts. Revenue on cost-plus-fee contracts is recognized to the extent of allowable costs incurred plus an estimate of the applicable fees earned. We consider fixed fees under cost-plus-fee contracts to be earned in proportion to the allowable costs incurred in performance of the contract. We recognize the relevant portion of the expected fee to be awarded by the customer at the time such fee can be reasonably estimated, based on factors such as our prior award experience and communications with the customer regarding performance, including any interim performance evaluations rendered by the customer. Revenue on time-and-material contracts is recognized to the extent of billable rates times hours delivered for services provided, to the extent of material cost for products delivered to customers, and to the extent of expenses incurred on behalf of the customers. We have three basic categories of fixed price contracts: fixed unit price, fixed price-level of effort, and fixed price-completion. Revenue recognition methods on fixed-price contracts will vary depending on the nature of the work and the contract terms. Revenues on fixed-price service contracts are 55 Table of Contents recorded as work is performed in accordance with Staff Accounting Bulletin 104 " Revenue Recognition " (SAB 104). SAB 104 generally requires revenue to be deferred until all of the following have occurred: (1) there is a contract in place, (2) delivery has occurred, (3) the price is fixed or determinable, and (4) collectibility is reasonably assured. Revenues on fixed-price contracts that require delivery of specific items may be recorded based on a price per unit as units are delivered. Revenue for fixed price contracts in which we are paid a specific amount to provide services for a stated period of time is recognized ratably over the service period. A portion of our fixed price-completion contracts are within the scope of SOP 81-1. For these contracts revenue is recognized using the percentage-of-completion method based on the ratio of total costs incurred to date compared to estimated total costs to complete the contract. Estimates of costs to complete include material, direct labor, overhead, and allowable general and administrative expenses for our government contracts. These cost estimates are reviewed and, if necessary, revised monthly on a contract-by-contract basis. If, as a result of this review, we determine that a loss on a contract is probable, then the full amount of estimated loss is charged to operations in the period it is determined that it is probable a loss will be realized from the full performance of the contract. In certain instances in which it is impractical to estimate the final outcome of the project margin, but it is certain that we will not incur a loss on the project, we may record revenue equal to cost incurred, at zero margin. In the event that our cost incurred to date may be in excess of our funded contract value, we may defer those costs until the associated contract value has been funded by the customer. Once the final estimate of the outcome of the project margin is determined, we will record revenue using the percentage-of-completion method of accounting based on the ratio of total costs incurred to date compared to the estimated total costs to complete the project. Significant management judgments and estimates, including but not limited to the estimated costs to complete projects, must be made and used in connection with the revenue recognized in any accounting period. A cancellation, schedule delay, or modification of a fixed-price contract which is accounted for using the percentage-of-completion method may adversely affect our gross margins for the period in which the contract is modified or cancelled. Under certain circumstances, a cancellation or negative modification could result in us having to reverse revenue that we recognized in a prior period, thus significantly reducing the amount of revenues we recognize for the period in which the adjustment is made. Correspondingly, a positive modification may positively affect our gross margins. In addition, a schedule delay or modifications can result in an increase in estimated cost to complete the project, which would also result in an impact to our gross margin. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates. It is the our policy to review any arrangement containing software or software deliverables and services against the criteria contained in SOP 97-2, "Software Revenue Recognition" , and related technical practice aids. Under the provisions of SOP 97-2 we review the contract value of software deliverables and services and determine allocations of the contract value based on Vendor Specific Objective Evidence ("VSOE"). All software arrangements requiring significant production, modification, or customization of the software are accounted for in conformity with ARB 45, using the relevant guidance in SOP 81-1. Our contracts may include the provision of more than one of our services. In these situations, we apply the guidance of FASB's Emerging Issues Task Force (EITF) Issue 00-21, Revenue Arrangements with Multiple Deliverables. Accordingly, for applicable arrangements, revenue recognition includes the proper identification of separate units of accounting and the allocation of revenue across all elements based on relative fair values, with proper consideration given to the guidance provided by other authoritative literature. 56 Table of Contents Under certain of our contractual arrangements, we may also recognize revenue for out-of-pocket expenses in accordance with EITF 01-14 "Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred." Depending on the contractual arrangement, these expenses may be reimbursed with or without a fee. Under certain of our contracts, we provide supplier procurement services and materials for our customers. The Company records revenue on these arrangements on a gross or net basis in accordance with EITF 99-19, "Reporting Revenue Gross as a Principal versus Net as an Agent," depending on the specific circumstances of the arrangement. We consider the following criteria, among others, for recording revenue on a gross or net basis: (1) Whether we act as a principal in the transaction; (2) Whether we take title to the products; (3) Whether we assume risks and rewards of ownership, such as risk of loss for collection, delivery or returns; (4) Whether we serve as an agent or broker, with compensation on a commission or fee basis; and (5) Whether we assume the credit risk for the amount billed to the customer subsequent to delivery. For our federal contracts, we follow U.S. government procurement and accounting standards in assessing the allowability and the allocability of costs to contracts. Due to the significance of the judgments and estimation processes, it is likely that materially different amounts could be recorded if we used different assumptions or if the underlying circumstances were to change. We closely monitor compliance with, and the consistent application of, our critical accounting policies related to contract accounting. Business operations personnel conduct periodic contract status and performance reviews. When adjustments in estimated contract revenues or costs are required, any significant changes from prior estimates are included in earnings in the current period. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel who are independent from the business operations personnel performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are scrutinized for compliance with regulatory standards by our personnel, and are subject to audit by the DCAA. From time to time, we may proceed with work based on client direction prior to the completion and signing of formal contract documents. We have a formal review process for approving any such work. Revenue associated with such work is recognized only when it can be reliably estimated and realization is probable. We base our estimates on previous experiences with the client, communications with the client regarding funding status, and our knowledge of available funding for the contract or program. Allowance for doubtful accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the potential inability of certain customers to make required future payments on amounts due to us. Management determines the adequacy of this allowance by periodically evaluating the aging and past due nature of individual customer accounts receivable balances and considering the customer's current financial situation as well as the existing industry economic conditions and other relevant factors that would be useful towards assessing the risk of collectibility. If the future financial condition of our customers were to deteriorate, resulting in their inability to make specific required payments, additions to the allowance for doubtful accounts may be required. In addition, if the financial condition of our customers improves and collections of amounts outstanding commence or are reasonably assured, then we may reverse previously established allowances for doubtful accounts. Changes to estimates of contract value are recorded as adjustments to revenue and not as a component 57 Table of Contents of the allowance for doubtful accounts. We write off accounts receivable when they become uncollectible and payments subsequently received on such receivables are credited to the allowance for doubtful accounts. Long-lived and Intangible Assets. We account for long-lived assets in accordance with the provisions of SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets ("SFAS 144"). SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This Statement requires that long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability is measured by comparing the carrying amount of an asset to the expected future net cash flows generated by the asset. If it is determined that the asset may not be recoverable and if the carrying amount of an asset exceeds its estimated fair value, an impairment charge is recognized to the extent of the difference. SFAS 144 requires companies to separately report discontinued operations, including components of an entity that either have been disposed of (by sale, abandonment or in a distribution to owners) or classified as held for sale. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. In accordance with SFAS 144, we assess the impairment of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could individually or in combination trigger an impairment review include the following: • significant underperformance relative to expected historical or projected future operating results; • significant changes in the manner of our use of the acquired assets or the strategy for our overall business; • significant negative industry or economic trends; • significant decline in our stock price for a sustained period; and • our market capitalization relative to net book value. If we determined that the carrying value of intangibles and long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we would record an impairment equal to the excess of the carrying amount of the asset over its estimated fair value. On a quarterly basis, we assess whether events or changes in circumstances have occurred that potentially indicate the carrying value of long-lived assets may not be recoverable. Goodwill and Purchased Intangible Assets. The purchase price of an acquired business is allocated to the underlying tangible and intangible assets acquired and liabilities assumed based upon their respective fair market values, with the excess recorded as goodwill. Such fair market value assessments require judgments and estimates that can be affected by contract performance and other factors over time, which may cause final amounts to differ materially from original estimates. For acquisitions completed through December 28, 2008, adjustments to fair value assessments are recorded to goodwill over the purchase price allocation period (typically not exceeding twelve months). Adjustments related to income tax uncertainties through December 28, 2008, were also recorded to goodwill. We have established certain accruals in connection with indemnities and other contingencies from our acquisitions. These accruals and subsequent adjustments have been recorded during the purchase price allocation period for acquisitions. The accruals were determined based upon the terms of the purchase or sales agreements and, in most cases, involve a significant degree of judgment. Management has recorded these accruals in accordance with its interpretation of the terms of the purchase or sale 58 Table of Contents agreements, known facts, and an estimation of probable future events based on management's experience. We perform impairment tests for goodwill as the last day of our fiscal year, or when evidence of potential impairment exists. When it is determined that impairment has occurred, a charge to operations is recorded. In order to test for potential impairment, the company uses a discounted cash flow analysis, corroborated by comparative market multiples where appropriate. Adverse equity market conditions and the resulting decline in current market multiples and the company's stock price as of December 28, 2008, have led to a goodwill impairment charge totaling $105.8 million in our Government Solutions segment. We will continue to monitor the recoverability of the carrying value of its goodwill and other long-lived assets. Given continued significant decline in the stock market in general and specifically our stock price in 2009, we believe it is more likely than not that this could be an indication of additional goodwill impairment and could potentially result in a triggering event under SFAS 142 and an additional goodwill impairment charge in the first quarter of 2009. The principal factors used in the discounted cash flow analysis requiring judgment are the projected results of operations, weighted average cost of capital (WACC), and terminal value assumptions. The WACC takes into account the relative weights of each component of the company's consolidated capital structure (equity and debt) and represents the expected cost of new capital adjusted as appropriate to consider lower risk profiles associated with longer term contracts and barriers to market entry. The terminal value assumptions are applied to the final year of the discounted cash flow model. Due to the many variables inherent in the estimation of a business's fair value and the relative size of the company's recorded goodwill, differences in assumptions may have a material effect on the results of the company's impairment analysis. Accounting for income taxes and tax contingencies. In July 2006, the FASB issued FASB Interpretation 48, "Accounting for Uncertainty in Income Taxes" ("Interpretation 48"). Interpretation 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS 109, "Accounting for Income Taxes." Interpretation 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Interpretation 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted the provisions of Interpretation 48 effective January 1, 2007. As part of the process of preparing our consolidated financial statements we are required to estimate our provision for income taxes in each of the tax jurisdictions in which we conduct business. This process involves estimating our actual current tax expense in conjunction with the evaluation and measurement of temporary differences resulting from differing treatment of certain items for tax and accounting purposes. These temporary differences result in the establishment of deferred tax assets and liabilities, which are recorded on a net basis and included in our consolidated balance sheet. We then assess on a periodic basis the probability that our net deferred tax assets will be recovered and, therefore realized from future taxable income and to the extent we believe that recovery is not more likely than not, a valuation allowance is established to address such risk resulting in an additional related provision for income taxes during the period. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, tax contingencies, unrecognized tax benefits, and any required valuation allowance, including taking into consideration the probability of the tax contingencies being incurred. Management assesses this probability based upon information provided to us by our tax advisors, our legal advisors and similar tax cases. If at a later time our assessment of the probability of these tax contingencies changes, our accrual for such tax uncertainties may increase or decrease. We have a valuation allowance at December 28, 2008, due to management's overall assessment of risks and uncertainties related to our future ability to realize and, hence, utilize certain deferred tax 59 Table of Contents assets, primarily consisting of net operating losses, carry forward temporary differences and future tax deductions resulting from certain types of stock option exercises, before they expire. The 2008 effective tax rate at December 28, 2008 for annual and interim reporting periods could be impacted if uncertain tax positions that are not recognized at December 28, 2008 are settled at an amount which differs from our estimate. Finally, during 2009, if we are impacted by a change in the valuation allowance as of December 28, 2008 resulting from a change in judgment regarding the realizability of deferred tax assets beyond December 28, 2008, such effect will be recognized in the interim period in which the change occurs. Accrual for partial self-insurance. We maintain an accrual for our health and workers compensation partial self-insurance, which is a component of total accrued expenses in the consolidated balance sheets. Management determines the adequacy of these accruals based on a monthly evaluation of our historical experience and trends related to both medical and workers compensation claims and payments, information provided to us by our insurance broker, industry experience and average lag period in which claims are paid. If such information indicates that our accruals require adjustment, we will, correspondingly, revise the assumptions utilized in our methodologies and reduce or provide for additional accruals as deemed appropriate. We also carry stop-loss insurance that provides coverage limiting our total exposure related to each medical and workers compensation claim incurred, as defined in the applicable insurance policies. The medical and workers compensation limits per claim are $50,000 and $250,000, respectively. Contingencies and litigation. We are currently involved in certain legal proceedings. We estimate a range of liability related to pending litigation where the amount and range of loss can be estimated. We record our estimate of a loss when the loss is considered probable and estimable. Where a liability is probable and there is a range of estimated loss and no amount in the range is more likely than any other number in the range, we record the minimum estimated liability related to the claim in accordance with SFAS 5, "Accounting for Contingencies." As additional information becomes available, we assess the potential liability related to our pending litigation and revise our estimates. Revisions in our estimates of potential liability could materially impact our results of operations. See Part I, Item 3 "Legal Proceedings" for additional information. Share-Based Payments. We account for share-based compensation arrangements in accordance with the provisions of Statement of Financial Accounting Standards 123R ("SFAS 123R") "Share-Based Payments," which requires the measurement and recognition of compensation expense for all share-based payment awards to employees and directors based on estimated fair values.. The valuation provisions of SFAS 123R apply to new awards and to awards that are outstanding on the effective date and subsequently modified or cancelled. We use the Black-Scholes option valuation model to estimate the fair value of our stock options at the grant date. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. Our employee stock options are generally subject to vesting restrictions and are generally not transferable. Option pricing models require the input of highly subjective assumptions including the expected stock price volatility over the term of the award, the expected life of an option and the number of awards ultimately expected to vest. Changes in these assumptions can materially affect the fair value estimates of an option. Furthermore, the estimated fair value of an option does not necessarily represent the value that will ultimately be realized by an employee. We used historical data to estimate the expected forfeiture rate, intrinsic and historical data to estimate the expected price volatility, and a weighted-average expected life formula to estimate the expected option life. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for the estimated life of the option. 60 Table of Contents Estimates of share-based compensation expenses are significant to our consolidated financial statements, but these expenses are based on option valuation models and will never result in the payment of cash by us. For this reason, and because we do not view share-based compensation as related to our operational performance, we exclude estimated share-based compensation expense when evaluating the business performance of our operating segments. Recently Issued Accounting Pronouncements In September 2006, the FASB issued SFAS 157, "Fair Value Measurements," (SFAS 157) which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement indicates, among other things, that a fair value measurement assumes that the transaction to sell an asset or transfer a liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. SFAS 157 defines fair value based upon an exit price model. Relative to SFAS 157, the FASB issued FASB Staff Positions (FSP) 157-1, 157-2, and 157-3. FSP 157-1 amends SFAS 157 to exclude SFAS 13 and its related interpretive accounting pronouncements that address leasing transactions, while FSP 157-2 delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. FSP 157-3 clarifies the principles in SFAS 157 on the fair value measurement of assets when the market for that asset is not active. The Company adopted SFAS 157 as of January 1, 2008, with the exception of the application of the statement to non-recurring nonfinancial assets and nonfinancial liabilities. Refer to Note 10 to the Consolidated Financial Statements for additional discussion on fair value measurements. In February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement 115," (SFAS 159) which is effective for fiscal years beginning after November 15, 2007. This statement permits entities to choose to measure many financial instruments and certain other items at fair value. This statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. Unrealized gains and losses on items for which the fair value option is elected would be reported in earnings. The Company has adopted SFAS 159 as of January 1, 2008 and has elected not to measure any additional financial instruments or other items at fair value. In December 2007, the FASB issued SFAS 141R, Business Combinations , or SFAS 141R. SFAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations we engaged in were recorded and disclosed according to SFAS 141, Business Combinations , until December 29, 2008. We expect SFAS 141R will have an impact on our consolidated financial statements, but the nature and magnitude of the specific effects will depend upon the nature, terms and size of the acquisitions we consummate after the effective date of December 29, 2008. In December 2007, the FASB issued SFAS 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin 51 , or SFAS 160. SFAS 160 addresses the accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling 61 Table of Contents interest, changes in a parent's ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of SFAS 160, but do not expect the adoption to have a material impact on our consolidated financial statements. In April 2008, the FASB issued FSP 142-3, Determination of the Useful Life of Intangible Assets , or FSP 142-3, which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142. This pronouncement requires enhanced disclosures concerning a company's treatment of costs incurred to renew or extend the term of a recognized intangible asset. FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of FSP 142-3, but do not expect the adoption to have a material impact on our consolidated financial statements. In May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted Accounting Principles, or SFAS 162. SFAS 162 identifies the sources of accounting principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles, or GAAP, in the U.S. SFAS 162 is effective 60 days following the SEC approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. We currently adhere to the hierarchy of GAAP as presented in SFAS 162, and adoption is not expected to have a material impact on our consolidated financial statements. In December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative Arrangements , or EITF 07-1. EITF 07-1 focuses on defining a collaborative arrangement as well as the accounting for transactions between participants in a collaborative arrangement and between the participants in the arrangement and third parties. The EITF concluded that both types of transactions should be reported in each participant's respective income statement. EITF 07-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and should be applied retrospectively to all prior periods presented for all collaborative arrangements existing as of the effective date. We are currently evaluating the impact of EITF 07-1, but do not expect the adoption to have a material impact on our consolidated financial statements. Related Party Transactions For detailed information regarding related party transactions, see Note 15 of our consolidated financial statements. Item 7A. Quantitative and Qualitative Disclosures About Market Risk We are exposed to market risk in connection with changes in interest rates, primarily in connection with three outstanding interest rate swaps which do not qualify for cash flow hedge accounting and balances under our credit facility with KeyBank National Association. Based on our average outstanding balances during the year ended December 28, 2008 a 1% change in the LIBOR rate would impact our financial position and results of operations by approximately $0.8 million over the next year. Cash and cash equivalents as of December 28, 2008 were $3.2 million and are primarily invested in money market interest bearing accounts. A hypothetical 10% adverse change in the average interest rate on our money market cash investments and short-term investments would have had no material effect on net income for the year ended December 28, 2008. 62 Table of Contents Item 8. Financial Statements and Supplementary Data The information required by this Item is included in Part IV Item 15(a)(1) and (2) of this Annual Report on Form 10-K. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures We maintain disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities and Exchange Act of 1934, as amended ("Exchange Act"), designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to our management, including our Principal Executive Officer and Principal Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost benefit relationship of possible controls and procedures. As required by Rule 13a-15(e) promulgated under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Principal Executive Officer and Principal Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of December 28, 2008. Management's Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO Framework). Based on this evaluation, our management concluded that our internal control over financial reporting is effective as of December 28, 2008. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies and procedures may deteriorate. Management's assessment over our internal control over financial reporting has been audited by Grant Thornton LLP, an independent registered public accounting firm, as stated in their report appearing below, which expresses an unqualified opinion on management's assessment and on the effectiveness of our internal control over financial reporting as of December 28, 2008. On June 28, 2008, we completed the acquisition of SYS Technologies (SYS) and, as permitted by SEC guidance, we excluded from our assessment of the effectiveness of our internal control over financial reporting as of December 28, 2008, the internal control over financial reporting of this entity. Total assets related to SYS of $69.9 million and $33.2 million of revenue since the date of acquisition 63 Table of Contents are included in our consolidated financial statements as of and for the year ended December 28, 2008. We plan to integrate SYS's historical internal control over financial reporting into our own internal control over financial reporting in 2009. Accordingly, certain changes will be made to our internal control over financial reporting until such time as this integration is complete. On December 24, 2008 we completed the acquisition of Digital Fusion, Inc. (DFI) and, as permitted by SEC guidance, we excluded from our assessment of the effectiveness of our internal control over financial reporting as of December 28, 2008, the internal control over financial reporting of this entity. Total assets related to DFI of $46.9 million and no revenues are included in our consolidated financial statements as of and for the year ended December 28, 2008. We plan to integrate DFI's historical internal control over financial reporting into our own internal control over financial reporting in 2009. Accordingly, certain changes will be made to our internal control over financial reporting until such time as this integration is complete. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial accounting and reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the fourth quarter of the fiscal year ended December 28, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 64 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders Kratos Defense & Security Solutions, Inc. We have audited Kratos Defense & Security Solutions, Inc. (a Delaware Corporation) and subsidiaries' (the "Company") internal control over financial reporting as of December 28, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. Our audit of, and opinion on, the Company's internal control over financial reporting does not include internal control over financial reporting of two wholly owned subsidiaries, SYS Technologies and Digital Fusion, Inc., whose financial statements reflect total assets and revenues constituting 37 and 11 percent, respectively, of the related consolidated financial statement amounts as of and for the year ended December 28, 2008. As indicated in Management's Report on Internal Control Over Financial Reporting, SYS Technologies and Digital Fusion, Inc. were acquired during 2008 and therefore, management's assertion on the effectiveness of the Company's internal control over financial reporting excluded internal control over financial reporting of SYS Technologies and Digital Fusion, Inc. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Kratos Defense & Security Solutions, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 28, 2008, based on criteria established in Internal Control—Integrated Framework issued by COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Kratos Defense & Security Solutions, Inc. and subsidiaries as of December 31, 2007 and December 28, 2008, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 28, 2008 and our report dated March 9, 2009 expressed an unqualified opinion thereon. /s/GRANT THORNTON LLP San Diego, CA March 9, 2009 65 Table of Contents Item 9B. Other Information On March 6, 2009, the Board of Directors approved a new form of Indemnification Agreement (the "Indemnification Agreement") to be available for current and future officers and directors. The Indemnification Agreement provides, among other things, that subject to the procedures set forth in the Indemnification Agreement: (i) the Company will indemnify the Indemnitee (as defined in the Indemnification Agreement) to the fullest extent permitted by law in the event Indemnitee was, is or becomes a party to or witness or other participant in, or is threatened to be made a party to or witness or other participant in, a Proceeding (as defined in the Indemnification Agreement) by reason of (or arising in part out of) an Indemnifiable Event (as defined in the Indemnification Agreement); (ii) if requested by Indemnitee, and subject to certain exceptions, the Company will advance Expenses (as defined in the Indemnification Agreement) to the Indemnitee; (iii) if there is a Change of Control (as defined in the Indemnification Agreement), the Company will seek the advice of independent legal counsel with respect to all matters thereafter arising concerning the rights of Indemnitee to indemnity payments and advances under the Indemnification Agreement or any provision of the Company's charter or bylaws; (iv) the rights of the Indemnitee under the Indemnification Agreement are in addition to any other rights the Indemnitee may have under the Company's charter or bylaws or the Delaware General Corporations Law or otherwise; and (v) to the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, the Indemnitee will be covered to the maximum extent of the coverage available for any Company director or officer. In addition, the Indemnification Agreement establishes guidelines as to the defense and settlement of claims by the parties and the period of limitations. The foregoing summary of the Indemnification Agreement is qualified in its entirety by reference to the full text of the Indemnification Agreement attached as Exhibit 10.6 hereto and incorporated by reference herein. 66 Table of Contents PART III Item 10. Directors and Executive Officers of the Registrant The information required by this item is incorporated by reference of the Registrant's Proxy Statement or Form 10-K/A, which we will file with the SEC within 120 days after the end of fiscal 2008. Item 11. Executive Compensation The information required by this item is incorporated by reference to the Registrant's Proxy Statement or Form 10-K/A, which we will file with the SEC within 120 days after the end of fiscal 2008. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this item is incorporated by reference to the Registrant's Proxy Statement or Form 10-K/A, which we will file with the SEC within 120 days after the end of fiscal 2008. Item 13. Certain Relationships and Related Transactions The information required by this item is incorporated by reference to the Registrant's Proxy Statement or Form 10-K/A, which we will file with the SEC within 120 days after the end of fiscal 2008. Item 14. Principal Accountant Fees and Services The information required by this item is incorporated by reference to the Registrant's Proxy Statement or Form 10-K/A, which we will file with the SEC within 120 days after the end of fiscal 2008. PART IV Item 15. Exhibits, Financial Statement Schedules (a) Financial Statements and Financial Statement Schedules (1) Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets as of December 31, 2007 and December 28, 2008 Consolidated Statements of Operations for the Years Ended December 31, 2006 and 2007 and December 28, 2008 Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2006 and 2007 and December 28, 2008 Consolidated Statements of Cash Flows for the Years Ended December 31, 2006 and 2007 and December 28, 2008 Notes to Consolidated Financial Statements All schedules for which provision is made in the applicable accounting regulations of the SEC are not required under the related instructions or are inapplicable and therefore have been omitted. (2) Exhibits 67 Table of Contents 68 Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/Period End Date Filed-Furnished Herewith 2.1 Agreement and Plan of Merger, dated as of November 21, 2008, by and among Kratos Defense & Security Solutions, Inc., Dakota Merger Sub, Inc. and Digital Fusion, Inc. Certain exhibits and schedules referenced in the Agreement and Plan of Merger have been omitted in accordance with Item 601(b)(2) of Regulation S-K. A copy of the omitted exhibits and schedules will be furnished supplementally to the Securities and Exchange Commission upon request. 8-K 11/24/08 2.2 Equity Purchase Agreement, dated February 17, 2006, by and between Sakoki LLC and the Registrant. 8-K 02/23/06 2.3 Addendum and Waiver Related to the Equity Purchase Agreement, dated June 26, 2006, by and between Sakoki LLC and the Registrant. 10-Q 06/30/06 2.4 Merger Agreement, dated August 8, 2006, by and among the Registrant, WFI Government Services, Inc., MRC Merger Registrant, Inc. and Madison Research Corporation. 8-K 08/14/06 2.5 Agreement dated as of March 9, 2007 by and between LCC Wireless Engineering Services Limited and the Registrant. 10-K 12/31/06 2.6 Equity Purchase Agreement, dated April 20, 2007, by and between the Registrant and Strategic Project Services, LLC. 10-K 12/31/06 2.7 Asset Purchase Agreement, dated May 29, 2007, by and between the Registrant and LCC International, Inc. 8-K 05/30/07 2.8 Asset Purchase Agreement, dated July 7, 2007, by and between the Registrant and Burgundy Acquisition Corporation. 8-K 07/12/07 2.9 Agreement and Plan of Merger, dated November 2, 2007, by and among the Registrant, Kratos Government Solutions, Inc., Haverstick Acquisition Corporation and Haverstick Consulting, Inc. 8-K 11/07/07 2.10 Agreement and Plan of Merger and Reorganization, dated February 20, 2008 by and among the Registrant, White Shadow, Inc. and SYS. 8-K 02/21/08 3.1 Amended and Restated Certificate of Incorporation. 10-Q 09/30/01 3.2 Certificate of Ownership and Merger of Kratos Defense & Security Solutions, Inc. into Wireless Facilities, Inc. 8-K 09/12/07 3.3 Amended and Restated Bylaws of the Registrant. 10-K/A 04/29/08 3.4 Certificate of Designations, Preferences and Rights of Series A Preferred Stock. 10-Q 09/30/01 3.5 Certificate of Designations, Preferences and Rights of Series B Preferred Stock. 8-K/A 06/05/02 Table of Contents 69 Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/Period End Date Filed-Furnished Herewith 3.6 Certificate of Designation of Series C Preferred Stock. 8-K 12/17/04 4.1 Specimen Stock Certificate. S-1 08/18/99 4.2 Rights Agreement, dated as of December 16, 2004, between the Registrant and Wells Fargo, N.A. 8-K 12/17/04 10.1# 1997 Stock Option Plan. S-1 08/18/99 10.2# Form of Stock Option Agreement pursuant to the 1997 Stock Option Plan and related terms and conditions. S-1/A 09/10/99 10.3# 1999 Equity Incentive Plan. S-1 08/18/99 10.4# Form of Stock Option Agreement pursuant to the 1999 Equity Incentive Plan. S-1/A 09/10/99 10.5# 1999 Employee Stock Purchase Plan and related offering documents. S-1 08/18/99 10.6# Form of Indemnity Agreement by and between the Registrant and certain officers and directors of the Registrant. * 10.7# 2000 Nonstatutory Stock Option Plan. 10-Q 09/30/00 10.8# Form of Stock Option Agreement and Grant Notice used in connection with the 2000 Nonstatutory Stock Option Plan. 10-Q 09/30/00 10.9# Amended and Restated Severance and Change of Control Agreement dated March 28, 2006 between the Registrant and Deanna Lund. 10-K 12/31/05 10.10# Amended and Restated Severance and Change of Control Agreement dated March 28, 2006 between the Registrant and James Edwards. 10-K 12/31/05 10.11# Nonqualified Deferred Compensation Plan. 10-K 12/31/05 10.12# 2005 Equity Incentive Plan. S-8 08/01/05 10.13# Form of Stock Option Agreement pursuant to the 2005 Equity Incentive Plan. S-8 08/01/05 10.14# Form of Restricted Stock Unit Agreement and Form of Notice of Grant under the Registrant's 2005 Equity Incentive Plan. 8-K 01/17/07 10.15 Credit Agreement, dated as of March 16, 2005, by and among the Registrant, KeyBank National Association and KeyBanc Capital Markets. 10-K 12/31/05 10.16 Credit Agreement, dated October 2, 2006, by and among the Registrant, KeyBank National Association and KeyBanc Capital Markets as lead arranger and sole book runner, dated October 2, 2006. 8-K 08/14/06 10.17# Severance and Change of Control Agreement dated as of July 12, 2007 between the Registrant and Laura L. Siegal. 10-K 09/11/07 10.18 Form of Subordinated Promissory Note issued by LCC International, Inc. to the Registrant. 8-K 05/30/07 Table of Contents 70 Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/Period End Date Filed-Furnished Herewith 10.19 Form of Subordination Agreement executed by LCC International, Inc., the Registrant and Bank of America, N.A. 8-K 05/30/07 10.20 Second Amendment to Credit Agreement, dated as of June 1, 2007, by and among the Registrant, the lenders party thereto and KeyBank National Association. 8-K 06/01/07 10.21 Note Sale Agreement, dated July 3, 2007, by and between SPCP Group, LLC International, Inc. and the Registrant. 8-K 07/10/07 10.22 Assignment Agreement, dated July 3, 2007, by and among the Registrant, SPCP Group LLC, LCC International, Inc. and Bank of America, N.A. 8-K 07/10/07 10.23 Form of Earnout Agreement executed by the Registrant and Burgundy Acquisition Corporation. 8-K 07/12/07 10.24 Facility Letter, dated October 24, 2007, by and between the Registrant and KeyBanc Capital Markets. 8-K 11/07/07 10.25 First Lien Credit Agreement among Kratos Defense & Security Solutions, Inc., KeyBank National Association, as Administrative Agent and Lender and the other financial institutions parties thereto and KeyBanc Capital Markets as lead arranger and book runner, dated as of December 31, 2007. 8-K 01/07/08 10.26 Second Lien Credit Agreement among Kratos Defense & Security Solutions, Inc., KeyBank National Association, as Administrative Agent and Lender, the other financial institutions parties thereto and KeyBanc Capital Markets as lead arranger and book runner, dated as of December 31, 2007. 8-K 01/07/08 10.27 Form of Voting Agreement, dated February 20, 2008, by and among the Registrant and the shareholders of SYS. 8-K 02/21/08 10.28 Form of Voting Agreement, dated February 20, 2008, by and among SYS and the stockholders of the Registrant. 8-K 02/21/08 10.29 Amendment and Waiver of First Lien Credit Agreement, dated as of March 27, 2008, by and among the Registrant, Keybank National Association as Administrative Agent and the Lenders party thereto. 8-K 04/02/08 10.30 Amendment and Waiver of Second Lien Credit Agreement, dated as of March 27, 2008, by and among the Registrant, KeyBank National Association as Administrative Agent and the Lenders party thereto. 8-K 04/02/08 10.31 Second Amendment to First Lien Credit Agreement, dated as of June 26, 2008, among the Registrant, KeyBank National Association, as Administrative Agent and Lender and the other financial institutions parties thereto and KeyBanc Capital Markets as lead arranger and book runner. 8-K 06/28/08 Table of Contents # Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/Period End Date Filed-Furnished Herewith 10.32 Second Amendment to Second Lien Credit Agreement, dated as of June 26, 2008, among the Registrant, KeyBank National Association, as Administrative Agent and Lender, the other financial institutions parties thereto and KeyBanc Capital Markets as lead arranger and book runner. 8-K 06/28/08 10.33# Amended and Restated Executive Employment Agreement, dated as of August 4, 2008, by and between the Registrant and Eric DeMarco. 10-Q 06/29/08 10.34# Amended and Restated Executive Employment Agreement, dated as of August 4, 2008, by and between the Registrant and Deanna Lund. 10-Q 06/29/08 10.35# Amended and Restated Executive Employment Agreement, dated as of August 4, 2008, by and between the Registrant and Laura Siegal. 10-Q 06/29/08 21.1 List of Subsidiaries. S-4 11/24/2008 23.1 Consent of Independent Registered Public Accounting Firm. * 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002. * 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes Oxley Act of 2002. * 32.1 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Eric M. DeMarco. * 32.2 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 for Deanna Lund. * Indicates a management contract or compensatory plan or arrangement required to be filed as an exhibit to this form. 71 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 10, 2009 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated: 72 KRATOS DEFENSE & SECURITY SOLUTIONS, INC. By: /s/ ERIC M. DEMARCO Eric M. DeMarco President and Chief Executive Officer (Principal Executive Officer) Signature Title Date /s/ ERIC M. DEMARCO Eric M. DeMarco President, Chief Executive Officer and Director March 10, 2009 /s/ DEANNA H. LUND Deanna H. Lund Senior Vice President, Chief Financial Officer (Principal Financial Officer) March 10, 2009 /s/ LAURA L. SIEGAL Laura L. Siegal VP and Corporate Controller Officer (Principal Accounting Officer) March 10, 2009 /s/ SCOTT ANDERSON Scott Anderson Director March 10, 2009 /s/ BANDEL CARANO Bandel Carano Director March 10, 2009 /s/ SCOT JARVIS Scot Jarvis Director March 10, 2009 /s/ SAM LIBERATORE Sam Liberatore Director March 10, 2009 /s/ WILLIAM HOGLUND William Hoglund Director March 10, 2009 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Stockholders Kratos Defense & Security Solutions, Inc. We have audited the accompanying consolidated balance sheets of Kratos Defense & Security Solutions, Inc. (a Delaware corporation) and subsidiaries (the "Company") as of December 31, 2007 and December 28, 2008, and the related consolidated statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 28, 2008. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kratos Defense & Security Solutions, Inc. and subsidiaries as of December 31, 2007 and December 28, 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 28, 2008 in conformity with accounting principles generally accepted in the United States of America. As discussed in Note 9 to the consolidated financial statements, on January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48 "Accounting for Uncertainty in Income Taxes—An Interpretation of FASB Statement No. 109" . We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Kratos Defense & Security Solutions, Inc.'s internal control over financial reporting as of December 28, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO ) and our report dated March 9, 2009 expressed an unqualified opinion thereon. /s/GRANT THORNTON LLP San Diego, CA March 9, 2009 73 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Consolidated Balance Sheets December 31, 2007 and December 28, 2008 (in millions, except par value and number of shares) See accompanying notes to consolidated financial statements. 74 2007 2008 Assets Current assets: Cash and cash equivalents $ 8.6 $ 3.2 Restricted cash — 0.4 Accounts receivable, net 77.0 100.5 Income taxes receivable 1.0 0.7 Prepaid expenses 7.4 3.6 Notes receivable 2.6 — Other current assets 8.7 6.9 Current assets of discontinued operations 1.6 0.9 Total current assets 106.9 116.2 Property and equipment, net 6.9 7.2 Goodwill 194.5 152.2 Other intangibles, net 19.9 32.2 Investments in unconsolidated affiliates 0.3 — Other assets 6.7 4.3 Non current assets of discontinued operations 0.1 0.3 Total assets $ 335.3 $ 312.4 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 22.7 $ 18.4 Accrued expenses 14.5 13.5 Accrued compensation 9.9 14.5 Billings in excess of costs and earnings on uncompleted contracts 10.9 9.7 Accrual for contingent acquisition consideration 2.9 3.7 Income taxes payable 0.2 — Accrual for unused office space 1.0 1.2 Other current liabilities 13.4 8.8 Current portion of long-term debt 2.6 5.9 Current portion of capital lease 0.1 0.2 Current liabilities of discontinued operations 5.3 5.3 Total current liabilities 83.5 81.2 Long-term debt, net of current portion 72.9 76.0 Accrual for unused office space, net of current portion 1.4 0.5 Capital lease 1.1 0.9 Deferred tax liabilities 2.0 — Other liabilities 4.5 5.0 Non current liabilities of discontinued operations 2.7 1.9 Total liabilities 168.1 165.5 Commitments and contingencies Stockholders' equity: Preferred stock, 5,000,000 shares authorized Series B Convertible Preferred Stock, $.001 par value, 10,000 shares outstanding at December 31, 2007 and December 28, 2008 (liquidation preference $5.0 million at December 28, 2008) — — Common stock, $.001 par value, 195,000,000 shares authorized; 78,998,922 and 128,169,634 shares issued and outstanding at December 31, 2007 and December 28, 2008, respectively — — Additional paid-in capital 412.7 503.5 Accumulated deficit (245.5 ) (356.6 ) Total stockholders' equity 167.2 146.9 Total liabilities and stockholders' equity $ 335.3 $ 312.4 Table of Contents KRATOS DEFENSE & SECURITIES SOLUTIONS, INC. Consolidated Statements of Operations Years ended December 31, 2006 and 2007 and December 28, 2008 (in millions, except per share amounts) See accompanying notes to consolidated financial statements. 75 2006 2007 2008 Revenues $ 153.1 $ 193.6 $ 297.3 Cost of revenues 124.2 162.0 237.8 Gross profit 28.9 31.6 59.5 Selling, general and administrative expenses 38.6 39.5 51.7 Research and development expenses — — 1.0 Recovery of unauthorized issuance of stock options and stock option investigation and related fees — 10.6 (4.5 ) Litigation settlement charge — 4.9 — Impairment and restructuring charges 21.8 1.2 106.1 Operating loss from continuing operations (31.5 ) (24.6 ) (94.8 ) Other expense: Interest expense, net (0.7 ) (1.2 ) (10.0 ) Impairment of investments in unconsolidated affiliates — (1.8 ) — Other income (expenses), net (0.2 ) 0.7 (1.5 ) Total other expense, net (0.9 ) (2.3 ) (11.5 ) Loss from continuing operations before income taxes (32.4 ) (26.9 ) (106.3 ) Provision (benefit) for income taxes from continuing operations 13.8 1.3 (0.7 ) Loss from continuing operations (46.2 ) (28.2 ) (105.6 ) Loss from discontinued operations (11.7 ) (12.6 ) (5.5 ) Net loss $ (57.9 ) $ (40.8 ) $ (111.1 ) Basic loss per common share: Loss from continuing operations $ (0.63 ) $ (0.38 ) $ (1.14 ) Loss from discontinued operations (0.16 ) (0.17 ) (0.06 ) Net loss per common share: $ (0.79 ) $ (0.55 ) $ (1.20 ) Diluted loss per common share: Loss from continuing operations $ (0.63 ) $ (0.38 ) $ (1.14 ) Loss from discontinued operations (0.16 ) (0.17 ) (0.06 ) Net loss per common share: $ (0.79 ) $ (0.55 ) $ (1.20 ) Weighted average common shares outstanding: Basic 73.5 74.0 92.6 Diluted 73.5 74.0 92.6 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Consolidated Statements of Stockholders' Equity Years ended December 31, 2006 and 2007 and December 28, 2008 (in millions) See accompanying notes to consolidated financial statements. 76 Convertible Preferred Stock Common Stock Accumulated Other Comprehensive Loss Additional Paid-In Capital Accumulated Deficit Total Stockholders' Equity Shares Amount Shares Amount Balance, December 31, 2005 — $ — 72.2 $ — $ 379.3 $ (146.7 ) $ (2.9 ) $ 229.7 Conversion of Series B convertible preferred stock — — 1.5 — — — — — Issuance of common stock for exercise of stock options — — 0.2 — 0.5 — — 0.5 Stock based compensation — — — — 11.9 — — 11.9 Components of comprehensive income: Net loss — — — — — (57.9 ) — (57.9 ) Foreign currency translation gain, net of income taxes of $0.3 million — — — — — — 1.5 1.5 Reclassification adjustment—foreign currency translation gain, included in net loss — — — — — — 1.4 1.4 Total comprehensive loss (55.0 ) Balance, December 31, 2006 — $ — 73.9 $ — $ 391.7 $ (204.6 ) $ — $ 187.1 Issuance of common stock for exercise of stock options — — 0.1 — — — — — Common stock issued for acquisitions — — 4.6 — 12.0 — — 12.0 Paid-in capital for contingent consideration — — — — 7.4 — — 7.4 Cumulative effect adjustment upon adoption of FIN 48 — — — — — (0.1 ) — (0.1 ) Stock-based compensation — — 0.4 — 1.6 — — 1.6 Net loss and total comprehensive loss — — — — — (40.8 ) — (40.8 ) Balance, December 31, 2007 — $ — 79.0 $ — $ 412.7 $ (245.5 ) $ — $ 167.2 Stock issued for Employee Stock Purchase Plan — — 0.2 — 0.2 — — 0.2 Common stock issued for acquisitions — — 48.1 — 80.2 — — 80.2 Stock options issued for acquisitions — — — — 7.0 — — 7.0 Paid in capital for contingent consideration — — 0.9 — 2.3 — — 2.3 Stock based compensation — — — — 1.1 — — 1.1 Net loss and total comprehensive loss — — — — — (111.1 ) — (111.1 ) Balance, December 28, 2008 — $ — 128.2 $ — $ 503.5 $ (356.6 ) $ — $ 146.9 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Consolidated Statements of Cash Flows Years ended December 31, 2006 and 2007 and December 28, 2008 (in millions) See accompanying notes to consolidated financial statements. 77 2006 2007 2008 Operating activities: Net loss $ (57.9 ) $ (40.8 ) $ (111.1 ) Less: Loss from discontinued operations (11.7 ) (12.6 ) (5.5 ) Loss from continuing operations (46.2 ) (28.2 ) (105.6 ) Adjustments to reconcile loss from continuing operations to net cash used in operating activities from continuing operations: Depreciation and amortization 4.7 4.3 7.5 Deferred income taxes 13.6 0.6 (2.0 ) Accrual for settlement of securities litigation — 4.9 — Goodwill impairment charges 18.3 — 105.8 Asset impairment charges 1.8 2.5 0.2 Disposal of property and equipment 0.1 — 0.4 Provision for doubtful accounts 0.2 0.8 1.1 Stock-based compensation 6.9 0.9 1.1 Mark to market on swaps — — 1.7 Changes in assets and liabilities, net of acquisitions: Accounts receivable (8.4 ) 5.0 (1.1 ) Prepaid expenses 0.3 (0.1 ) 4.2 Other assets (1.3 ) (4.8 ) 5.6 Accounts payable 5.0 (0.8 ) (10.3 ) Accrued expenses (6.3 ) 1.8 (2.0 ) Accrued compensation 1.3 (1.5 ) (2.9 ) Billings in excess of costs and earnings on uncompleted contracts 1.2 0.4 (2.2 ) Accrual for contingent acquisition consideration 0.1 1.4 0.8 Income tax receivable and payable 3.0 1.6 0.5 Accrual for unused office space 0.9 (0.1 ) (0.7 ) Other liabilities (0.1 ) 10.2 (6.8 ) Net cash used in operating activities from continuing operations (4.9 ) (1.1 ) (4.7 ) Investing activities: Sale/maturity of short-term investments — — 0.3 Cash paid for contingent acquisition consideration (8.5 ) (8.9 ) — Cash paid for acquisitions, net of cash acquired (59.1 ) (63.9 ) (1.2 ) Proceeds/(payments) from the disposition of discontinued operations 18.9 57.3 (0.2 ) Cash transferred (to) from restricted cash (1.0 ) 1.0 (0.4 ) Capital expenditures (1.2 ) (0.9 ) (0.9 ) Net cash used in investing activities from continuing operations (50.9 ) (15.4 ) (2.4 ) Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Consolidated Statements of Cash Flows (Continued) Years ended December 31, 2006 and 2007 and December 28, 2008 (in millions) See accompanying notes to consolidated financial statements. 78 2006 2007 2008 Financing activities: Proceeds from issuance of common stock 0.4 — — Proceeds from issuance of common stock under employee stock purchase plan — — 0.2 Borrowings under credit facility 85.0 88.5 7.9 Repayments under credit facility (34.0 ) (64.0 ) (4.6 ) Repayment of capital lease obligations (0.3 ) (0.4 ) (0.2 ) Debt issuance costs (1.2 ) (3.0 ) (0.5 ) Net cash provided by financing activities from continuing operations 49.9 21.1 2.8 Net cash flows of continuing operations (5.9 ) 4.6 (4.3 ) Cash flows of discontinued operations Operating cash flows 7.4 0.2 (1.1 ) Investing cash flows (6.6 ) (1.6 ) — Financing cash flows 0.1 — — Effect of exchange rates on cash and cash equivalents 2.7 — — Net cash flows of discontinued operations 3.6 (1.4 ) (1.1 ) Net increase (decrease) in cash and cash equivalents (2.3 ) 3.2 (5.4 ) Cash and cash equivalents at beginning of year 7.7 5.4 8.6 Cash and cash equivalents at end of year $ 5.4 $ 8.6 $ 3.2 Supplemental disclosure of cash flow information: Cash paid during the year for interest $ (0.2 ) $ 2.8 $ 8.7 Net cash (received) paid during the year for income taxes $ (0.7 ) $ (1.4 ) $ 1.3 Noncash investing and financing activities: Common stock and stock options issued for acquisitions $ — $ 12.0 $ 87.2 Paid in capital for contingent consideration $ — $ 7.4 $ 2.3 Liability for contingent cash consideration $ — $ 1.2 $ — Supplemental disclosures of non-cash investing and financing transactions: Fair value of assets acquired in acquisitions $ 80.1 $ 111.1 $ 116.8 Fixed assets financed $ — $ 1.2 $ — Liabilities assumed in acquisitions $ 6.3 $ 20.9 $ 23.9 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (a) Description of Business Kratos Defense & Security Solutions, Inc. ("Kratos" or "the Company") was initially incorporated in the state of New York on December 19, 1994, commenced operations in March 1995 and was reincorporated in Delaware in 1998. Kratos historically conducted business in three segments: Wireless Network Services, Government Network Services and Enterprise Network Services. The Company was an independent, global provider of outsourced communications and security systems engineering and integration services for the wireless communications industry through its Wireless Network Services division ("WNS"), the U.S. government through its Government Network Services division ("GNS"), now referred to as the Kratos Government Solutions ("KGS") segment, and enterprise customers through its Enterprise Network Services division ("ENS"), now referred to as the Public Safety & Security ("PSS") segment. In 2006 and 2007, the Company undertook a transformation strategy that culminated in the divestiture in 2007 of its remaining wireless-related businesses and has aggressively pursued business with the federal government, primarily the U.S. Department of Defense, through strategic acquisition. The Company's divestiture of its European wireless engineering services business which was discontinued and held for sale in December 2006 was completed in March 2007. In addition, the Company's divestiture of its domestic wireless engineering services business was completed in June 2007 and the divestiture of its wireless deployment services business was completed in July 2007. Accordingly, the accompanying financial statements reflect the divestiture of the domestic wireless engineering services and wireless network deployment business and the results of operations through the date of divestiture as discontinued operations in the accompanying statements of operations. As a result of the divestment of the Company's wireless related assets and businesses in 2007, the Company changed its name from Wireless Facilities, Inc. to Kratos Defense & Security Solutions, Inc. on September 12, 2007. The name was changed to reflect the Company's revised focus as a defense contractor and security systems integrator for the federal government and for state and local agencies and reflects the Company's business going forward. All previous financial statements prior to September 12, 2007 were issued under the Company's previous name, Wireless Facilities, Inc. (b) Principles of Consolidation The consolidated financial statements include the accounts of Kratos and its wholly-owned subsidiaries for which all inter-company transactions have been eliminated in consolidation. Kratos and its subsidiaries are collectively referred to herein as the "Company." Investments in unconsolidated affiliates are accounted for using the cost method as the Company owns less than 20% and has no significant influence over the affiliates. (c) Fiscal Year The Company's year end was on the last day of the year, December 31 st with interim fiscal periods ending on the last day of the calendar month of each quarter for fiscal years 2006 and 2007. In 2008, the Company's year end was the last Sunday of the year, December 28, with interim fiscal periods ending on the last Sunday of the last month of each calendar quarter. The fiscal years ended December 31, 2006 and 2007 and December 28, 2008 all contained 52 calendar weeks. 79 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) (d) Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (US GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Such estimates include revenue recognition, allowance for doubtful accounts, valuation of long-lived assets including identifiable intangibles and goodwill, accounting for income taxes including the related valuation allowance on the deferred tax asset and uncertain tax positions, accruals for partial self-insurance, contingencies and litigation and contingent acquisition consideration. In the future, the Company may realize actual results that differ from the current reported estimates and if the estimates that we have used change in the future, such changes could have a material impact on the Company's consolidated financial position, results of operations and cash flows. (e) Revenue Recognition The Company generates almost all of its revenue from three different types of contractual arrangements: cost-plus-fee contracts, time-and-materials contracts, and fixed-price contracts. Revenue on cost-plus-fee contracts is recognized to the extent of allowable costs incurred plus an estimate of the applicable fees earned. The Company considers fixed fees under cost-plus-fee contracts to be earned in proportion to the allowable costs incurred in performance of the contract and recognizes the relevant portion of the expected fee to be awarded by the customer at the time such fee can be reasonably estimated, based on factors such as our prior award experience and communications with the customer regarding performance, including any interim performance evaluations rendered by the customer. Revenue on time-and-material contracts is recognized to the extent of billable rates times hours delivered for services provided, to the extent of material cost for products delivered to customers, and to the extent of expenses incurred on behalf of the customers. The Company has three basic categories of fixed price contracts: fixed unit price, fixed price-level of effort, and fixed price-completion. Revenue recognition methods on fixed-price contracts will vary depending on the nature of the work and the contract terms. Revenues on fixed-price service contracts are recorded as work is performed in accordance with Staff Accounting Bulletin 104 "Revenue Recognition" (SAB 104). SAB 104 generally requires revenue to be deferred until all of the following have occurred: (1) there is a contract in place, (2) delivery has occurred, (3) the price is fixed or determinable, and (4) collectibility is reasonably assured. Revenues on fixed-price contracts that require delivery of specific items may be recorded based on a price per unit as units are delivered. Revenue for fixed price contracts in which the Company is paid a specific amount to provide services for a stated period of time is recognized ratably over the service period. A portion of our fixed price-completion contracts are within the scope of Statement of Position 81-1 "Accounting for Performance of Construction-Type and Certain Production-Type Contracts" (SOP 81-1). For these contracts, revenue is recognized using the percentage-of-completion method based on the ratio of total costs incurred to date compared to estimated total costs to complete the contract. Estimates of costs to complete include material, direct labor, overhead, and allowable general and administrative expenses for our government contracts. These cost estimates are reviewed and, if 80 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) necessary, revised monthly on a contract-by-contract basis. If, as a result of this review, the Company determines that a loss on a contract is probable, then the full amount of estimated loss is charged to operations in the period it is determined that it is probable a loss will be realized from the full performance of the contract. In certain instances in which it is impractical to estimate the final outcome of the project margin, but it is certain that the Company will not incur a loss on the project, the Company may record revenue equal to cost incurred, at zero margin. In the event that the cost incurred to date may be in excess of our funded contract value, the Company may defer those costs until the associated contract value has been funded by the customer. Once the final estimate of the outcome of the project margin is determined, the Company will record revenue using the percentage-of-completion method of accounting based on the ratio of total costs incurred to date compared to the estimated total costs to complete the project. Significant management judgments and estimates, including but not limited to the estimated costs to complete projects, must be made and used in connection with the revenue recognized in any accounting period. A cancellation, schedule delay, or modification of a fixed-price contract which is accounted for using the percentage-of-completion method may adversely affect our gross margins for the period in which the contract is modified or cancelled. Under certain circumstances, a cancellation or negative modification could result in the Company having to reverse revenue that was recognized in a prior period, thus significantly reducing the amount of revenues recognized for the period in which the adjustment is made. Correspondingly, a positive modification may positively affect gross margins. In addition, a schedule delay or modifications can result in an increase in estimated cost to complete the project, which would also result in an impact to gross margins. Material differences may result in the amount and timing of our revenue for any period if management made different judgments or utilized different estimates. It is the Company's policy to review any arrangement containing software or software deliverables and services against the criteria contained in SOP 97-2, "Software Revenue Recognition" , and related technical practice aids. Under the provisions of SOP 97-2, the Company reviews the contract value of software deliverables and services and determines allocations of the contract value based on Vendor Specific Objective Evidence ("VSOE") or fair value for each of the elements. All software arrangements requiring significant production, modification, or customization of the software are accounted for in conformity with Accounting Research Bulletin 45 "Long-Term Construction-Type Contracts" (ARB 45), using the relevant guidance in SOP 81-1. The Company's contracts may include the provision of more than one of its services. In these situations, the Company applies the guidance of FASB's Emerging Issues Task Force (EITF) Issue 00-21, "Revenue Arrangements with Multiple Deliverables". Accordingly, for applicable arrangements, revenue recognition includes the proper identification of separate units of accounting and the allocation of revenue across all elements based on relative fair values, with proper consideration given to the guidance provided by other authoritative literature. Under certain of the Company's contractual arrangements, the Company may also recognize revenue for out-of-pocket expenses in accordance with EITF 01-14 " Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred. " Depending on the contractual arrangement, these expenses may be reimbursed with or without a fee. 81 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) Under certain of its contracts, the Company provides supplier procurement services and materials for its customers. The Company records revenue on these arrangements on a gross or net basis in accordance with EITF 99-19, " Reporting Revenue Gross as a Principal versus Net as an Agent ," depending on the specific circumstances of the arrangement. The Company considers the following criteria, among others, for recording revenue on a gross or net basis: (1) Whether the Company acts as a principal in the transaction; (2) Whether the Company takes title to the products; (3) Whether the Company assumes risks and rewards of ownership, such as risk of loss for collection, delivery or returns; (4) Whether the Company serves as an agent or broker, with compensation on a commission or fee basis; and (5) Whether the Company assumes the credit risk for the amount billed to the customer subsequent to delivery. For federal contracts, the Company follows U.S. government procurement and accounting standards in assessing the allowability and the allocability of costs to contracts. Due to the significance of the judgments and estimation processes, it is likely that materially different amounts could be recorded if different assumptions were used or if the underlying circumstances were to change. The Company closely monitors compliance with, and the consistent application of, its critical accounting policies related to contract accounting. Business operations personnel conduct periodic contract status and performance reviews. When adjustments in estimated contract revenues or costs are required, any significant changes from prior estimates are included in earnings in the current period. Also, regular and recurring evaluations of contract cost, scheduling and technical matters are performed by management personnel who are independent from the business operations personnel performing work under the contract. Costs incurred and allocated to contracts with the U.S. government are scrutinized for compliance with regulatory standards by the Company's personnel, and are subject to audit by the DCAA. From time to time, the Company may proceed with work based on client direction prior to the completion and signing of formal contract documents. The Company has a formal review process for approving any such work. Revenue associated with such work is recognized only when it can be reliably estimated and realization is probable. The Company bases its estimates on previous experiences with the client, communications with the client regarding funding status, and its knowledge of available funding for the contract or program. As of December 31, 2007 and December 28, 2008, approximately $0.4 million and $0.9 million, respectively, of the Company's unbilled accounts receivable balance were under an authorization to proceed or work order from its customers where a formal purchase order had not yet been received. (f) Derivative Instruments In managing interest rate risk exposure, the Company entered into interest rate swap agreements. An interest rate swap is a contractual exchange of interest payments between two parties. A standard interest rate swap involves the payment of a fixed rate time a notational amount by one party in 82 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) exchange for a floating rate times the same notational amount from another party. As interest rates change, the difference to be paid or received is accrued and recognized as interest expense or income over the life of the agreement. These instruments are not entered into for trading purposes. Counterparties to the Company's interest rate swap agreements are major financial institutions. In accordance with SFAS 133, " Accounting for Derivative Instruments and Certain Hedging Activities", as amended by SFAS 137 and 138 , the Company recognizes interest rate swap agreements on the consolidated balance sheet at fair value. The interest rate swap agreements are marked to market with changes in fair value recognized in either other comprehensive income (loss) or in the carrying value of the hedged portions of fixed rate debt, as applicable (hedge accounting). Hedge accounting is discontinued when it is determined that a derivative instrument is not highly effective as a hedge. Hedge accounting is also discontinued when: (1) the derivative instrument expires; is sold, terminated or exercised; or is no longer designated as a hedge instrument because it is unlikely that a forecasted transaction will occur; (2) a hedged firm commitment no longer meets the definition of a firm commitment; or (3) management determines that designation of the derivative as a hedging instrument is no longer appropriate. When hedge accounting is discontinued, the derivative instrument will be either terminated, continue to be carried on the balance sheet at fair value, or redesignated as the hedging instrument in either a cash flow or fair value hedge, if the relationship meets all applicable hedging criteria. Any asset or liability that was previously recorded as a result of recognizing the value of a firm commitment will be removed from the balance sheet and recognized as a gain or loss in current period earnings. Any gains or losses that were accumulated in other comprehensive income from hedging a forecasted transaction will be recognized immediately in current period earnings, if it is probable that the forecasted transaction will not occur. (g) Research and Development Costs incurred in research and development activities are expensed as incurred. (h) Income Taxes The Company records deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company maintains a valuation allowance on the deferred tax assets for which it is more likely than not that the Company will not realize the benefits of these tax assets in future tax periods. The valuation allowance is based on estimates of future taxable income by tax jurisdiction in which the Company operates, the number of years over which the deferred tax assets will be recoverable, and scheduled reversals of deferred tax liabilities. In accordance with the recognition standards established by Financial Accounting Standards Board (FASB) Interpretation. (FIN) 48— "Accounting for Uncertainty in Income Taxes—an interpretation of 83 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) FASB Statement 109" , the Company makes a comprehensive review of its portfolio of uncertain tax positions regularly. In this regard, an uncertain tax position represents the Company's expected treatment of a tax position taken in a filed tax return, or planned to be taken in a future tax return or claim, which has not been reflected in measuring income tax expense for financial reporting purposes. Until these positions are sustained by the taxing authorities, the company has not recognized the tax benefits resulting from such positions and reports the tax effects as a liability for uncertain tax positions in its consolidated statements of financial position. (i) Stock-Based Compensation The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards (SFAS) 123R— Share-Based Payment . All of the Company's stock compensation plans are considered equity plans under SFAS 123R, and compensation expense recognized is net of estimated forfeitures over the vesting period. The Company issues stock options, and stock awards under its existing plans. The fair value of stock options is estimated on the date of grant using a Black-Scholes option-pricing model and is expensed on a straight-line basis over the vesting period of the options, which is generally four years. The fair value of stock awards is determined based on the closing market price of the Company's common stock on the grant date and is adjusted at each reporting date based on the amount of shares ultimately expected to vest. Compensation expense for stock awards is expensed over the vesting period, usually four to ten years. The Company has no awards with market or performance conditions. Compensation expense for stock issued under our employee stock purchase plan is estimated on the beginning date of the offering period using a Black-Scholes option-pricing model and is expensed on a straight-line basis over the period of the offering, which is generally 6 months. For the years ended December 31, 2006, December 31, 2007 and December 28, 2008, there was no incremental tax benefit from stock options exercised in the period due to expected tax losses for the year. The Company recorded cash received from the exercise of stock options of $0.5 million and $0.0 million in 2006 and 2007, respectively. No stock options were exercised in 2008. The following table shows the amounts recognized in the consolidated financial statements for 2006, 2007 and 2008 84 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) for share-based compensation expense related to stock options, stock awards and to stock options offered under our employee stock purchase plan (in millions). (j) Net Income (Loss) per Common Share The Company calculates net income (loss) per share in accordance with SFAS 128, "Earnings Per Share". Under SFAS 128, basic net income (loss) per common share is calculated by dividing net income (loss) by the weighted-average number of common shares outstanding during the reporting period. Diluted net income (loss) per common share reflects the effects of potentially dilutive securities (in millions). (k) Allowance for Doubtful Accounts The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments, which results in bad debt expense. Management periodically determines the adequacy of this allowance by evaluating the comprehensive risk profiles of all individual customer receivable balances including, but not limited to, the customer's financial condition, credit agency reports, financial statements and overall current economic conditions. Additionally, on certain contracts whereby the Company performs services for a prime/general contractor, a specified percentage of the invoiced trade accounts receivable may be retained by the customer until the project is completed. The Company periodically reviews all retainages for collectibility and records allowances for doubtful accounts when deemed appropriate, based on its assessment of the associated credit risks. Total retainages included in billed accounts receivable were $0.2 million and $1.2 million at December 31, 2007 and December 28, 2008, respectively. Changes to estimates of contract value are recorded as adjustments to revenue and not as a component of the allowance for doubtful accounts. 85 Year ended December 31, 2006 Year ended December 31, 2007 Year ended December 28, 2008 Cost of revenues $ 1.0 $ 0.0 $ 0.0 Selling, general and administrative expenses 5.9 0.9 1.1 Total cost of employee share-based compensation included in operating loss from continuing operations, before income tax 6.9 0.9 1.1 Amount charged to loss from discontinued operations 5.0 0.7 0.0 Total charged against operations $ 11.9 $ 1.6 $ 1.1 Impact on net loss per common share: Basic $ (0.16 ) $ (0.02 ) $ (0.01 ) Diluted $ (0.16 ) $ (0.02 ) $ (0.01 ) 2006 2007 2008 Anti-dilutive weighted shares from stock options excluded from calculation 12.2 8.3 18.4 Anti-dilutive weighted shares from preferred stock excluded from calculation 1.4 1.0 1.0 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) The following table outlines the balance of the Company's Allowance for Doubtful Accounts for 2006, 2007 and 2008. It identifies the additional provisions each year as well as the write-offs that utilized the allowance (in millions). (l) Cash Equivalents and Short-Term Investments The Company's cash equivalents consist of its highly liquid investments with an original maturity of three months or less when purchased by the Company. The Company has evaluated its investments in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) 115, "Accounting for Certain Investments in Debt and Equity Securities." Based on such evaluation, the Company's management has determined that all of its investment securities are properly classified as available-for-sale. Based on the Company's intent and board-approved investment policy and its ability to liquidate debt securities maturing after one year, the Company classifies such short-term investment securities within current assets. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of Stockholders' Equity within the caption "Accumulated Other Comprehensive Income (Loss)." The amortized cost basis of debt securities is periodically adjusted for amortization of premiums and accretion of discounts to maturity. Such amortization is included as a component of interest income (expense), net. The amortized cost basis of securities sold is based on the specific identification method and all such realized gains and losses are recorded as a component within other income (expense). Interest and dividends on securities classified as available-for-sale are included in interest income. The Company has restricted cash accounts of approximately $0.4 million which are required to collateralize a credit card program and a deposit relating to the run out of a now terminated workers compensation program. (m) Inventory Inventories which are comprised primarily of supplies including parts and materials are stated at the lower of cost or market. The Company regularly reviews inventory quantities on hand, future purchase commitments with its suppliers, and the estimated utility of its inventory. If the Company review indicates a reduction in utility below carrying value, it reduces its inventory to a new cost basis. As of December 31, 2007 and December 28, 2008, the Company had $2.1 million of inventories which were reflected in other current assets of continuing operations on the consolidated balance sheets. (n) Property and Equipment, Net Property and equipment consists primarily of computer equipment, software, leasehold improvements and office-related equipment and is recorded at cost. Equipment acquired under capital leases is recorded at the present value of the future minimum lease payments. Depreciation is 86 Allowance for Doubtful Accounts Balance at Beginning of Year Provisions Write-offs/ Recoveries Balance at End of Year Year ended December 31, 2006 $ 0.5 $ 0.2 $ (0.4 ) $ 0.3 Year ended December 31, 2007 $ 0.3 $ 0.8 $ (0.3 ) $ 0.8 Year ended December 28, 2008 $ 0.8 $ 1.1 $ (0.7 ) $ 1.2 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) calculated using the straight-line method over the estimated useful life of each asset, which is one to three years for computer equipment, five years for furniture and office equipment, and five to ten years for software for the Company's enterprise systems. Equipment and facilities acquired under capital leases are amortized over the shorter of the lease term or the estimated useful life of the asset. Improvements, which significantly improve and extend the useful life of an asset, are capitalized over the shorter of the lease period or the estimated useful life. Expenditures for maintenance and repairs are charged to operations as incurred. In accordance with Statement of Position 98-1, " Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), the Company expenses all internal-use software costs incurred in the preliminary project stage and capitalizes certain direct costs associated with the development and purchase of internal-use software within property and equipment. Capitalized costs are amortized on a straight-line basis over the estimated useful lives of the software. (o) Leases The Company uses its incremental borrowing rate in the assessment of lease classification as capital or operating and defines the initial lease term to include renewal options determined to be reasonably assured. The Company conducts operations primarily under operating leases. Most lease agreements contain incentives for tenant improvements, rent holidays, or rent escalation clauses. For incentives for tenant improvements, the Company records a deferred rent liability and amortizes the deferred rent over the term of the lease as a reduction to rent expense. For rent holidays and rent escalation clauses during the lease term, the Company records minimum rental expenses on a straight-line basis over the term of the lease. For purposes of recognizing lease incentives, the Company uses the date of initial possession as the commencement date, which is generally when the Company is given the right of access to the space and begins to make improvements in preparation of intended use. (p) Acquisitions Acquisitions are accounted for using the purchase method and the results of acquired businesses are included in the financial statements from the dates of acquisition. Under the purchase method of accounting, the cost, including transaction costs, are allocated to the underlying net tangible and identifiable intangible assets, based on their respective estimated fair values. The excess of the purchase price over the estimated fair values of the net assets acquired is recorded as goodwill. (q) Goodwill and Other Intangible Assets, Net In accordance with the provisions of SFAS 142, "Goodwill and Other Intangible Assets" (SFAS 142), the Company performs impairment tests for goodwill as of the last day of each fiscal year, or when evidence of potential impairment exists. When it is determined that impairment has occurred, a charge to operations is recorded. Goodwill and other purchased intangible asset balances are included in the identifiable assets of the business segment to which they have been assigned. Any goodwill impairment, as well as the amortization of other purchased intangible assets, is charged against the respective business segments' operating income. 87 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) In accordance with SFAS 142, the Company classifies intangible assets into three categories: (1) intangible assets with finite lives subject to amortization, (2) intangible assets with indefinite lives not subject to amortization, and (3) goodwill. The Company tests intangible assets with finite lives for impairment if conditions exist that indicate the carrying value may not be recoverable. Such conditions may include an economic downturn in a geographic market or a change in the assessment of future operations. The Company records an impairment charge when the carrying value of the finite lived intangible asset is not recoverable by the cash flows generated from the use of the asset. The Company determines the useful lives of identifiable intangible assets after considering the specific facts and circumstances related to each intangible asset. Factors considered when determining useful lives include the contractual term of any agreement, the history of the asset, the Company's long-term strategy for the use of the asset, any laws or other local regulations which could impact the useful life of the asset, and other economic factors, including competition and specific market conditions. Intangible assets that are deemed to have finite lives are amortized, generally on a straight-line basis, over their useful lives, ranging from 1 to 12 years. (r) Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of Long-lived assets and certain identifiable intangibles are reviewed for impairment in accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets , whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to future net cash flows (undiscounted and without interest) expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. (s) Fair Value of Financial Instruments SFAS 107, "Disclosures about Fair Value of Financial Instruments," requires that fair values be disclosed for the Company's financial instruments. The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, billings in excess of costs and earnings on uncompleted contracts approximate fair value due to the short-term nature of these instruments. The fair value of the Company's long-term debt and capital lease obligations is estimated based on the quoted market prices for the same or similar issues or on the current rates offered to the Company for debt of the same remaining maturities. (t) Comprehensive Income (Loss) SFAS 130, "Reporting Comprehensive Income," establishes rules for the reporting of comprehensive income (loss) and its components. Comprehensive income (loss) consists of net income (loss) and other gains and losses affecting shareholders' investment that, under accounting principles generally accepted in the United States of America are excluded from net income (loss). 88 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) (u) Foreign Currency Translation In accordance with SFAS 52 "Foreign Currency Translation," the financial statements of the Company's foreign subsidiaries where the functional currency has been determined to be the local currency are translated into United States dollars using year-end rates of exchange for assets and liabilities and rates of exchange that approximate the rates in effect at the transaction date for revenues, expenses, gains and losses. In 2007 and 2008, all foreign subsidiaries are accounted for as discontinued operations in the accompanying financial statements. (v) Concentration of Credit Risk The Company maintains cash balances at various financial institutions and such balances commonly exceed the $100,000 insured (temporarily increased to $250,000 through December 31, 2009) amount by the Federal Deposit Insurance Corporation. The Company has not experienced any losses in such accounts and management believes that the Company is not exposed to any significant credit risk with respect to such cash and cash equivalents. Financial instruments, which subject the Company to potential concentrations of credit risk, consist principally of the Company's billed and unbilled accounts receivable. The Company's accounts receivable result from sales to customers within the federal government, state and local agencies and with commercial customers in various industries. The Company performs ongoing credit evaluations of its commercial customers. Credit is extended based on evaluation of the customer's financial condition. Collateral is not required. The accounts receivable are recorded at invoiced amount and do not bear interest. See Note 13 for a discussion of our significant customers. (w) Debt Issuance Costs Fees paid to obtain debt financing or amendments under such debt financing are treated as debt issuance costs and are capitalized and amortized over the expected term of the related debt. These payments are shown as a financing activity in the consolidated statements of cash flows. (x) Liquidity The Company currently carries a significant amount of debt and has experienced recurring losses and negative cash flows from continuing operations. Given the Company's highly leveraged liquidity position, any down-turn in its operating earnings or cash flows could impair its ability to comply with the financial covenants of its existing credit facility. Its ability to execute on additional business opportunities may be limited due to its existing borrowing capacity. If the Company believed a covenant violation is more than likely to occur in the near future, it would seek relief from its lenders. This relief, if available, would have some cost to the Company and such relief might not be on terms as favorable as those in its existing Credit Agreement. If the Company were to actually default due to its failure to meet the financial covenants of its Credit Agreement and inability to obtain a waiver from the lenders, the Company's Credit Agreement could require the Company to immediately repay all amounts then outstanding under the Credit Agreement and/or require the Company to pay interest at default rates per the Credit Agreement. In the event the Company was required to repay the amount outstanding under the existing credit facility, it would need to obtain alternative sources of financing to 89 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) continue its operating activities at existing levels. There can be no assurance that alternative financing would be available on acceptable terms or at all. (y) Recent Accounting Pronouncements New Accounting Standards Adopted In September 2006, the FASB issued SFAS 157, "Fair Value Measurements," (SFAS 157) which is effective for fiscal years beginning after November 15, 2007 and for interim periods within those years. This statement defines fair value, establishes a framework for measuring fair value and expands the related disclosure requirements. This statement applies under other accounting pronouncements that require or permit fair value measurements. The statement indicates, among other things, that a fair value measurement assumes that the transaction to sell an asset or transfer a liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. SFAS 157 defines fair value based upon an exit price model. Relative to SFAS 157, the FASB issued FASB Staff Positions (FSP) 157-1, 157-2, and 157-3. FSP 157-1 amends SFAS 157 to exclude SFAS 13 and its related interpretive accounting pronouncements that address leasing transactions, while FSP 157-2 delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis. FSP 157-3 clarifies the principles in SFAS 157 on the fair value measurement of assets when the market for that asset is not active. The Company adopted SFAS 157 as of January 1, 2008, with the exception of the application of the statement to non-recurring nonfinancial assets and nonfinancial liabilities. Refer to Note 10 to the Consolidated Financial Statements for additional discussion on fair value measurements. In February 2007, the FASB issued SFAS 159, "The Fair Value Option for Financial Assets and Financial Liabilities—Including an amendment of FASB Statement 115," (SFAS 159) which is effective for fiscal years beginning after November 15, 2007. This statement permits entities to choose to measure many financial instruments and certain other items at fair value. This statement also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. Unrealized gains and losses on items for which the fair value option is elected would be reported in earnings. The Company has adopted SFAS 159 as of January 1, 2008 and has elected not to measure any additional financial instruments or other items at fair value. Future Adoption of Accounting Standards In December 2007, the FASB issued SFAS 141R, "Business Combinations" , or SFAS 141R. SFAS 141R establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, any business combinations we engaged in were previously recorded and disclosed according to SFAS 141, Business Combinations , until December 29, 2008. We 90 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) expect SFAS 141R will have an impact on our consolidated financial statements, but the nature and magnitude of the effects will depend upon the nature, terms and size of the acquisitions we consummate after the effective date of December 29, 2008. In December 2007, the FASB issued SFAS 160, "Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin. 51 ," or SFAS 160. SFAS 160 addresses the accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent's ownership interest, and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. SFAS 160 is effective for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of SFAS 160, but do not expect the adoption to have a material impact on our consolidated financial statements. In April 2008, the FASB issued FSP 142-3, Determination of the Useful Life of Intangible Assets , or FSP 142-3, which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS 142. This pronouncement requires enhanced disclosures concerning a company's treatment of costs incurred to renew or extend the term of a recognized intangible asset. FSP 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008. We are currently evaluating the impact of FSP 142-3, but do not expect the adoption to have a material impact on our consolidated financial statements. In May 2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted Accounting Principles, or SFAS 162. SFAS 162 identifies the sources of accounting principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles, or GAAP, in the U.S. SFAS 162 is effective 60 days following the SEC approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. We currently adhere to the hierarchy of GAAP as presented in SFAS 162, and adoption is not expected to have a material impact on our consolidated financial statements. In December 2007, the FASB ratified EITF Issue 07-1, Accounting for Collaborative Arrangements , or EITF 07-1. EITF 07-1 focuses on defining a collaborative arrangement as well as the accounting for transactions between participants in a collaborative arrangement and between the participants in the arrangement and third parties. The EITF concluded that both types of transactions should be reported in each participant's respective income statement. EITF 07-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years and should be applied retrospectively to all prior periods presented for all collaborative arrangements existing as of the effective date. We are currently evaluating the impact of EITF 07-1, but do not expect the adoption to have a material impact on our consolidated financial statements. In March 2008, the FASB issued SFAS 161, "Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement. 133" (SFAS 161). This statement is intended to improve transparency in financial reporting by requiring enhanced disclosures of an entity's derivative instruments and hedging activities and their effects on the entity's financial position, financial 91 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 1. Organization and Summary of Significant Accounting Policies (Continued) performance, and cash flows. SFAS 161 applies to all derivative instruments within the scope of SFAS 133, "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133) as well as related hedged items, bifurcated derivatives, and nonderivative instruments that are designated and qualify as hedging instruments. Entities with instruments subject to SFAS 161 must provide more robust qualitative disclosures and expanded quantitative disclosures. SFAS 161 is effective prospectively for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application permitted. The Company is currently evaluating the disclosure implications of this statement and anticipates that the statement will not have a significant impact on the Company's Consolidated Financial Statements. In June 2008, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) Emerging Issues Task Force (EITF) 03-6-1, "Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities." Under the FSP, unvested share-based payment awards that contain rights to receive nonforfeitable dividends (whether paid or unpaid) are participating securities, and should be included in the two-class method of computing EPS. The FSP is effective for fiscal years beginning after December 15, 2008, and interim periods within those years, and is not expected to have a significant impact on the Company's Consolidated Financial Statements. Note 2. Goodwill and Other Intangible Assets Goodwill The Company performs its annual impairment test for goodwill in accordance with SFAS 142 , "Goodwill and Other Intangible Assets" as of the last day of the fiscal year or when evidence of potential impairment exists. The Company's testing approach utilizes a discounted cash flow analysis corroborated by comparative market multiples to determine the fair value of its businesses for comparison to their corresponding book values. If the book value exceeds the estimated fair value for a business, a potential impairment is indicated and SFAS 142 prescribes the approach for determining the impairment amount, if any. In 2006, changes in the industry and the strategic focus of the Company, as well as operational challenges from employee turnover that the Company encountered after the completion of the earn-out period, led to a goodwill impairment charge of $18.3 million in the Public Safety and Security segment. The Company had no tax basis in this goodwill and there was no tax benefit derived from the impairment charge. In December 2008, the Company concluded that the decision to exit three businesses acquired with the SYS merger and included in the KGS reporting segment met the criteria to be classified as held for sale. The Company also concluded this was a triggering event under SFAS 142 that required a review of the Company's goodwill and intangibles assets with indefinite lives. Because the three business units were never integrated into the KGS reporting unit, and as such, the benefits of the acquired goodwill were never realized by the rest of the reporting unit, the goodwill of the disposed businesses was not adjusted based upon the relative fair values of the businesses disposed and businesses retained. An impairment charge of $3.3 million related to the separately assigned goodwill of these businesses was recorded as part of the loss from discontinued operations (see Note 3). 92 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 2. Goodwill and Other Intangible Assets (Continued) Because of the timing of the disposals mentioned above, the required impairment test of the KGS goodwill and intangible assets with indefinite lives was included with the Company's required annual impairment test of goodwill. The annual impairment test for goodwill was performed using a discounted cash flow analysis supported by comparative market multiples to determine the fair values of the Company's segments versus their book values. The test as of December 28, 2008, indicated that the book values for the KGS segment, excluding Digital Fusion (DFI), which was purchased on December 24, 2008, exceeded the fair values of these businesses and resulted in the Company recording a charge totaling $105.8 million in its KGS segment for the impairment of goodwill. The impairment charge is primarily driven by adverse equity market conditions that caused a decrease in current market multiples and the Company's stock price as of December 28, 2008, compared with the test performed as of December 31, 2007. Given continued significant decline in the stock market in general and specifically our stock price in 2009, we believe it is more likely than not that this could be an indication of additional goodwill impairment and could potentially result in a triggering event under SFAS 142 and an additional goodwill impairment charge in the first quarter of 2009. The Company had tax basis in a portion of the goodwill impaired in 2008. The Company had previously recorded a deferred tax liability for the tax amortization of this goodwill. The deferred tax liability was considered to have an indefinite life, and as such, the liability was not considered as support for deferred tax assets. When the impairment to goodwill was taken, book basis of the goodwill was now less than tax basis, resulting in a deferred tax asset and corresponding increase to the valuation allowance. The Company has claimed a tax benefit on its financial statements of approximately $2.0 million, the amount of the deferred tax liability prior to impairment. Prior to recording the goodwill impairment, the company tested the purchased intangible assets and other long-lived assets at these businesses as required by SFAS 144, " Accounting for the Impairment or Disposal of Long-lived Assets ," and the carrying value of these assets were determined not to be impaired. The changes in the carrying amounts of goodwill by operating segment for the years ended December 31, 2006, December 31, 2007 and December 28, 2008, are as follows (in millions): 93 Public Safety & Security Government Solutions Total Balance as of December 31, 2005 $ 18.3 $ 76.1 $ 94.4 Acquisitions — 53.8 53.8 Impairments (18.3 ) — (18.3 ) Balance as of December 31, 2006 $ — $ 129.9 $ 129.9 Acquisitions and purchase accounting adjustments — 64.6 64.6 Balance as of December 31, 2007 $ — $ 194.5 $ 194.5 Acquisitions and purchase accounting adjustments — 63.5 63.5 Impairments — (105.8 ) (105.8 ) Balance as of December 28, 2008 $ — $ 152.2 $ 152.2 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 2. Goodwill and Other Intangible Assets (Continued) Purchased Intangible Assets The following tables set forth information for finite-lived intangible assets subject to amortization (in millions): The aggregate amortization expense for finite-lived intangible assets was $2.1 million, $2.8 million and $5.0 million for the years ended December 31, 2006 and 2007, and December 28, 2008, respectively. The increase in finite-lived intangibles in 2008 is related to the acquisitions of SYS Technologies (SYS) on June 28, 2008 and DFI on December 24, 2008. Refer to the schedule below and to Note 5 of the Consolidated Financial Statements (in millions, except amortization period). There is no amortization for DFI since it was acquired on December 24, 2008. 94 As of December 31, 2007 As of December 28, 2008 Gross Value Accumulated Amortization Net Value Gross Value Accumulated Amortization Net Value Acquired finite-lived intangible assets Customer relationships $ 15.1 $ (2.6 ) $ 12.5 $ 23.0 $ (5.0 ) $ 18.0 Contracts and backlog 11.6 (4.2 ) 7.4 17.1 (6.6 ) 10.5 Developed technology — — — 3.1 (0.2 ) 2.9 Non-compete agreements 1.3 (1.3 ) 0.0 1.3 (1.3 ) 0.0 Trade names 0.4 (0.4 ) 0.0 1.2 (0.4 ) 0.8 Total $ 28.4 $ (8.5 ) $ 19.9 $ 45.7 $ (13.5 ) $ 32.2 As of December 28, 2008 Gross Value Accumulated Amortization Net Value Weighted Average Amortization Period (years) SYS Acquired Intangible Assets Customer relationships $ 1.0 $ (0.1 ) $ 0.9 10 Contracts and backlog 3.0 (0.3 ) 2.7 7.1 Developed technology 3.1 (0.1 ) 3.0 10 Trade names 0.9 (0.1 ) 0.8 10 Total SYS $ 8.0 $ (0.6 ) $ 7.4 8.9 DFI Acquired Intangible Assets Customer relationships $ 4.2 $ — $ 4.2 9.9 Contracts and backlog 5.1 — 5.1 5.2 Total DFI $ 9.3 $ — $ 9.3 7.3 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 2. Goodwill and Other Intangible Assets (Continued) Information about estimated amortization expense for intangible assets subject to amortization for the five years succeeding December 28, 2008, is as follows (in millions): Note 3. Discontinued Operations On February 17, 2006, the Company entered into a definitive agreement to divest all of its operations in Mexico for total approximate cash consideration of $18.0 million, which approximated the net book value of the operations, including $13.2 million of liabilities associated with a loss contingency. The transaction closed on March 10, 2006. The transaction was structured as a sale of the Company's subsidiaries in Mexico, and the purchase price consisted of $1.5 million in cash paid on February 17, 2006, plus a secured promissory note payable in installments through December 31, 2006. The note was secured by pledges of assets and a personal guaranty. The final closing balance sheet as of February 17, 2006 resulted in net asset adjustments aggregating to a total approximate $18.9 million consideration, $1.5 million which was paid on February 17, 2006, with the remaining $17.4 million payable by means of the promissory note in installments through December 31, 2006 with an interest rate of 7.5% per annum. The remaining note receivable balance was paid in December 2006. No amounts remain outstanding on the note receivable. On December 28, 2006, the Board of Directors of the Company approved a plan to divest portions of the Company's business where critical mass had not been achieved. This plan involved the divestiture of the Company's EMEA (Europe, Middle East and Asia) operations and its remaining South American operations. The Company determined that these operations met the criteria to be classified as held for sale. Accordingly, these operations were reflected as discontinued in accordance with SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" in the accompanying consolidated financial statements commencing as of and for the year ended December 31, 2006. The EMEA operations were sold to LCC International, Inc. (LCC) on March 9, 2007 for $4.0 million in cash, $3.3 million of which was received on that date. We also received approximately $1.8 million from our EMEA operations, prior and subsequent to the closing date as payment on outstanding intercompany debt. The balance of the $0.7 million sales price was withheld as security for the satisfaction of certain indemnification obligations and was payable on a date that is the earlier of March 31, 2008 or the date that the buyer files its 10-K for the fiscal year ended December 31, 2007. The sale of EMEA generated a gain on disposition of $3.3 million. In the fourth quarter of 2007, the Company recorded a reserve of $0.7 million on the remaining sales price holdback based on the 95 Amortization Expense 2009 $ 5.7 2010 5.0 2011 4.7 2012 3.4 2013 3.4 Thereafter 10.0 $ 32.2 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 3. Discontinued Operations (Continued) Company's assessment of LCC's available liquidity and ability to pay following the Company's review of LCC's most recently file financial statements, thereby reducing the net estimated gain on this transaction to $2.6 million. On April 20, 2007, the Company entered into an Equity Purchase Agreement to sell all of the issued and outstanding equity of its interests of its wholly owned subsidiary WFI Brazil Techlogia en Telecomunicaciones LTDA, to Strategic Project Services, LLC (SPS). The consideration included the assumption of substantially all outstanding liabilities of WFI Brazil, nominal cash consideration, and additional earn-out consideration based on 25 percent of net receivables collected subsequent to the closing date. The Company recorded an impairment charge of approximately $5.2 million as of December 31, 2006 to reduce the current carrying value of the Brazil operations to their estimated fair value based upon current indications of interest. In the second quarter of 2007, when this business was sold, a gain on disposition of $0.2 million was recorded primarily due to lower than expected selling costs. On May 29, 2007, the Company entered into an Asset Purchase Agreement with LCC pursuant to which the Company agreed to sell to LCC all of the assets used in the conduct of the operation of the Company's Wireless Network Services business segment that provides engineering services to the non-government wireless communications industry in the United States. The transaction was completed on June 4, 2007. The aggregate consideration paid by LCC in connection with the Acquisition was $46 million. LCC delivered a subordinated promissory note for the principal amount of $21.6 million (the " Subordinated Promissory Note "), paid $17 million at closing and paid final working capital adjustments of $2.4 million through an amendment to the Subordinated Promissory Note, and the Company retained an estimated $5.0 million in net working capital of the business. On July 5, 2007, the Company announced that it had sold the $21.6 million Subordinated Promissory Note in a transaction arranged by KeyBanc Capital Markets ("KeyBanc"). The Company received approximately $19.6 million in net cash proceeds, reflecting a discount from par value of less than five percent and aggregate transaction fees of approximately $1 million, which includes a $0.75 million fee to KeyBanc, an affiliate of the Company's lender. The note was acquired by a fund affiliated with Silver Point Capital, L.P. ("Silver Point"). The Company did not provide any guaranty for LCC's payment obligations. Post closing adjustments were also covered by the note. On August 10, 2007, in accordance with the terms of the acquisition agreement, the Company provided the closing balance sheet working capital calculation, which indicated a $2.6 million working capital adjustment was due to the Company as an increase to the balance of the Subordinated Promissory Note. LCC had thirty days to review the calculation and notify the Company of any dispute. The Company and LCC agreed to a final working capital calculation of $2.4 million. The Company collected $2.3 million in January 2008, net of a $0.1 million discount from Silver Point in accordance with the terms of the note agreement. This amount is presented as part of notes receivable in the consolidated balance sheet as of December 31, 2007. On July 7, 2007, the Company entered into a definitive agreement with an affiliate of Platinum Equity to sell the Company's wireless deployment business. Platinum Equity is a Los Angeles based private equity firm whose portfolio includes service and distribution businesses in a number of equity 96 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 3. Discontinued Operations (Continued) sectors. The total consideration for the acquisition was $24 million including $18 million in cash at closing, subject to post closing working capital adjustments, and an aggregate $6 million in a three-year earn-out arrangement through 2010. The transaction included a Transition Services Agreement for the transition of certain services for a period of nine months. The assets sold to an affiliate of Platinum Equity include all of the Company's wireless deployment business, and the Wireless Facilities name. The transaction closed on July 24, 2007. On September 25, 2007, in accordance with the acquisition agreement, the Company provided its working capital calculation to Platinum Equity. On July 16, 2008, the Company came to an agreement with Platinum Equity on a working capital adjustment of $5.0 million. In connection with that resolution, the earn-out arrangement was terminated. The adjustment was to be paid in installments with the first amount of $2.5 million due on July 31, 2008 and payments of $0.5 million monthly thereafter until paid in full in December 2008. The Company did not make the scheduled $2.5 million payment due as of July 31, 2008. Payments of $1.0 million were made in August and September of 2008, with an additional $0.5 million paid in December 2008. As of December 28, 2008, the balance of $2.5 million plus accrued interest on the outstanding balance has been reflected in other current liabilities. The Company determined that the U.S. engineering and U.S. deployment operations met the criteria to be classified as held for sale in the first quarter of 2007. Accordingly, the Company has reflected these operations as discontinued and assessed these assets for impairment in accordance with SFAS 144, " Accounting for the Impairment or Disposal of Long-Lived Assets ". The Company determined that the assets of the U.S. deployment operations were impaired and recorded an impairment charge of approximately $13.4 million in the first quarter of 2007. The fair value of the assets was determined by utilizing the sale price less estimated costs to sell the business. The Company recorded a gain in discontinued operations from the sale of the U.S. engineering operations of $14.8 million in the second quarter of 2007. Upon the divestiture of the deployment business on July 24, 2007, the Company recorded a loss from disposal of $1.9 million, reflecting the closing working capital adjustment and final closing balance sheet. In addition, the Company recorded a charge in the third quarter of 2007 for an excess facility accrual of approximately $1.1 million related to certain facility leases of Deployment field offices that were not assumed by Platinum. The determination that the U.S. engineering business and U.S. deployment operations met the criteria to be classified as held for sale in the first quarter of 2007 was also a triggering event under SFAS 142 " Goodwill and Other Intangible Assets " ("SFAS 142") that resulted in an accelerated review of the Company's goodwill and intangibles assets with indefinite lives. In accordance with SFAS 142, the Company allocated the goodwill for the WNS reporting unit based upon the fair value of the engineering business and the deployment business. The fair values used were based upon market information obtained as a result of the sale of the businesses. This resulted in an impairment charge of approximately $7.2 million related to goodwill for this reporting unit which was recorded in the first quarter of 2007. During the due diligence process related to the acquisition of SYS Technologies (SYS), which occurred on June 28, 2008, senior management identified three business units of SYS which are non-core to Kratos' base national security and public security businesses. These businesses provide video surveillance and information analysis products, digital broadcasting products and incident 97 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 3. Discontinued Operations (Continued) response management systems. In December of 2008, after evaluating these businesses further, a decision was made to dispose of and sell all three business units. In accordance with SFAS 144, these business units are classified as held for sale and reported in discontinued operations as of and for the year ended December 28, 2008, respectively. The Company recorded a $4.5 million impairment charge in the fourth quarter of 2008 primarily related to the impairment of goodwill and intangibles allocated to these businesses. In February 2009, two of the businesses were sold for an aggregate cash consideration of approximately $0.3 million. The Company currently expects to sell the third remaining business in the first half of 2009. In addition, in accordance with EITF 87-24, Allocation of Interest to Discontinued Operations ("EITF 87-24"), interest expense incurred on the debt that was required to be repaid as a result of the sales of our discontinued businesses was allocated to discontinued operations for the periods presented. During the years ended December 31, 2006 and 2007, and December 28, 2008, interest expense allocated to discontinued operations was approximately $0.0 million, $2.2 million and $0.0 million, respectively. The following table presents the results of discontinued operations (in millions): Following is a summary of the assets and liabilities of discontinued operations as of December 31, 2007 and December 28, 2008 (in millions) for each of the operations: 98 Year ended December 31, 2006 Year ended December 31, 2007 Year ended December 28, 2008 Revenue $ 201.7 $ 85.7 $ 2.0 Loss before taxes (9.8 ) (12.7 ) (6.8 ) Provision (benefit) for income taxes 1.9 (0.4 ) (1.3 ) Net loss $ (11.7 ) $ (12.6 ) $ (5.5 ) December 31, 2007 December 28, 2008 Cash $ 0.3 $ 0.1 Accounts receivable, net 0.8 0.4 Other current assets 0.5 0.4 Current assets of discontinued operations $ 1.6 $ 0.9 Non-current assets of discontinued operations $ 0.1 $ 0.3 Accounts payable $ — $ 0.1 Accrued expenses 3.7 4.1 Unrecognized tax benefits 1.2 0.8 Other current liabilities 0.4 0.3 Current liabilities of discontinued operations $ 5.3 $ 5.3 Non-current unrecognized tax benefits $ 2.0 $ 1.1 Other non-current liabilities 0.7 0.8 Non-current liabilities of discontinued operations $ 2.7 $ 1.9 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 4. Investments in Unconsolidated Affiliates Tactical Survey Group, Inc. ("TSG") In February 2004, the Company paid $1.0 million in cash to bring its total stock ownership position in Tactical Survey Group, Inc. (TSG), a privately-held company that provides expertise in developing, deploying and integrating tactical survey systems for use in government and commercial applications, to 11%. Pursuant to the provisions of APB Opinion 18, "The Equity Method of Accounting for Investments in Common Stock", this investment was accounted for under the equity method of accounting due to the presence of significant influence deemed to exist based on the significant number of subcontracts that the Company has entered into with TSG and the presence of a Kratos employee on TSG's board of directors. During the third quarter of 2006, TSG was no longer considered a significant subcontractor to the Company. This factor, combined with the lack of current representation on TSG's board of directors resulted in the Company concluding effective September 29, 2006 that significant influence no longer existed. Accordingly, the investment in TSG no longer met the conditions for the use of the equity method of accounting and has been accounted for under the cost method since September 29, 2006. There were no equity earnings related to this investment during the period this investment was accounted for under the equity method of accounting. The balance of the Company's investment in TSG at December 31, 2006 totaled $1.2 million. The Company evaluates the realizability of its investment in TSG according to the provisions of APB Opinion 18 and FAS 115-1 and FAS 124-1. The Company periodically obtains and reviews the financial statements of TSG. Based on this review, and recent indicators of fair value, an impairment charge of $0.9 million was recorded in 2007 to reduce the carrying value of this investment as of December 31, 2007 to $0.3 million. During the second quarter of 2008, the Company sold its remaining interest in TSG for $0.3 million recognizing no gain or loss on the sale. CommVerge Solutions, Inc. The Company has an investment in CommVerge Solutions, Inc., a privately-held wireless network planning and deployment company. The balance of the Company's investment in CommVerge Solutions, Inc. at December 31, 2006 totaled $0.9 million. Management periodically obtains and reviews the most recent financial performance and financial forecasts available from CommVerge which may include information regarding project status and current progress of the business. Based on this review, an impairment charge of $0.9 million was recorded to reduce the carrying value of this investment as of December 31, 2007 to $0.0 million. This investment is accounted for under the cost method and has been classified on the consolidated balance sheet under the caption "Investments in unconsolidated affiliates." One of the Company's directors is also a director of CommVerge Solutions, Inc. Note 5. Acquisitions Digital Fusion Inc. On December 24, 2008, the Company acquired Huntsville, Alabama based Digital Fusion Inc. (DFI) in a stock for stock transaction for approximately $37.0 million. DFI provides Command, Control, Communications, Computing, Intelligence, Surveillance, and Reconnaissance (C4ISR) and technical engineering services, Unmanned Aerial Vehicle (UAV) products and technology and has 99 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) significant engineering, modeling and simulation capabilities. The acquisition of DFI provides Kratos with new customers and an expanded contract vehicle portfolio, in addition to expanding the range of service offerings to existing Kratos customers. Principal customers of DFI include the Army Aviation and Missile Research, Development and Engineering Center (AMRDEC), Army Space and Missile Defense Command/Army Forces Strategic Command ARSTRAT), NASA Marshall Space Flight Center, and certain classified customers. The aforementioned factors are the primary reason for the acquisition and the amount subsequently assigned to goodwill. The purchase price of $37.0 million includes direct transaction costs of $0.9 million. The Company issued 22.9 million shares to DFI shareholders and assumed DFI options, which resulted in the issuance of replacement options to acquire approximately 10.0 million shares of Kratos common stock. The value of the purchase price related to the common stock issued was derived from the number of shares of Kratos common stock issued of 22.9 million, based on 12.8 million shares of DFI common stock outstanding and the exchange ratio of 1.7933 for each DFI share, at a price of $1.27 per share, the average closing price of Kratos shares of common stock on the announcement date and for the two days prior to and two days subsequent to the public announcement of the merger on November 24, 2008. The Company issued replacement options to DFI option holders at the same terms of the options realized at closing subject only to the exchange ratio of 1.7933 for each DFI option. The fair value of the options issued that was allocated to goodwill based upon the Black-Scholes pricing model was $7.0 million. The fair value of unvested options which are related to future service will be expensed as the service is performed over the weighted average vesting period of 1.2 years. No results of operations of DFI are included in the accompanying consolidated financial statements. Since signing the definitive merger agreement in November 2008, senior management of Kratos and DFI have been developing a plan to restructure certain business activities of DFI. The plan includes a comprehensive assessment of personnel, relocation of personnel, and facility consolidation in Huntsville. Personnel and facilities consolidation costs are still being developed, therefore, the estimated restructuring liabilities are subject to change as plans become finalized. The Company expects to finalize the restructuring plan as soon as possible, but no later than December 28, 2009. The following summarizes the preliminary allocation of the purchase price, including transaction costs of $0.9 million, to the fair value of the assets acquired and liabilities assumed at the date of acquisition (in millions): 100 Cash $ 2.3 Accounts receivable, net 10.0 Other current assets, 0.1 Property, plant, and equipment 1.0 Intangible assets 9.3 Goodwill 23.8 Other assets 0.4 Total assets 46.9 Current liabilities (9.0 ) Other liabilities (0.9 ) Net assets acquired $ 37.0 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) The goodwill recorded in this transaction is not tax deductible with the exception of approximately $3.6 million which was tax deductable to DFI. SYS Technologies On June 28, 2008, the Company acquired San Diego-based SYS Technologies ("SYS"). SYS provides a range of Command, Control, Communications, Computing, Intelligence, Surveillance, and Reconnaissance (C4ISR) and net-centric solutions to federal, state, local and other customers. The combination of SYS and Kratos creates a broad, complementary set of offerings, and positions the organization to deliver proven capabilities to a wider spectrum of customers in the areas of highly-specialized engineering and IT solutions and services, specifically in the areas of weapon systems life cycle support and extension, military range operations, missile and weapon system testing, and C4ISR. The amount of goodwill assigned in the allocation of purchase price is primarily attributable to the aforementioned advantages of this acquisition. The purchase price of $55.9 million includes direct transaction costs of $2.4 million and estimated restructuring costs to be paid by Kratos. The value of the purchase price related to the common stock issued was derived from the number of shares of Kratos common stock issued of 25.3 million, based on 20.1 million shares of SYS common stock outstanding and the exchange ratio of 1.2582 for each SYS share, at a price of $2.022 per share, the average closing price of Kratos shares of common stock on the announcement date and for the two days prior to and two days subsequent to the public announcement of the merger on February 21, 2008. Since signing the definitive merger agreement in February 2008, senior management of Kratos and SYS have been developing a plan to restructure and/or exit certain business activities of SYS. The plan includes a comprehensive assessment of personnel, relocation of personnel, facility consolidation and exit strategies for certain lines of business. As of December 28, 2008, the plan tentatively estimates approximately $2.0 million of restructuring costs associated with personnel, and additional costs of $0.5 million for facilities consolidation. Personnel, facilities consolidation and exit costs are still being developed therefore, the estimated restructuring liabilities are subject to change as plans become finalized. The Company expects to finalize the restructuring plan as soon as possible, but no later than June 28, 2009. In addition, the Company identified three business units of SYS that are not core to our business strategy and/or have been dilutive to profitability. The divestiture of these businesses will slightly reduce revenues going forward, and the Company believes will immediately increase profitability and cash flow. The sale of two of these businesses were recently completed subsequent to year end for an aggregate cash consideration of approximately $0.3 million, and it is expected that the sale of the other business will occur during the first half of 2009. These businesses have been classified as discontinued operations in the Company's Consolidated Financial Statements as of December 28, 2008 and the Company has recorded an impairment charge of $4.5 million, primarily resulting from allocated goodwill and purchased intangibles associated with these businesses which is included in loss from discontinued operations in the Consolidated Statement of Operations. The Consolidated Statement of Operations for the year ended December 28, 2008 includes the results of SYS's operations from the date of acquisition, June 28, 2008. 101 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) The following summarizes the allocation of the purchase price, including transaction costs of $2.4 million, to the fair value of the assets acquired and liabilities assumed at the date of acquisition (in millions): The goodwill recorded in this transaction is not tax deductible with the exception of approximately $6.7 million which was tax deductible to SYS. Haverstick Consulting, Inc. On December 31, 2007, the Company acquired Indianapolis, Indiana headquartered Haverstick Consulting, Inc. ("Haverstick") as part of the Kratos Government Solutions segment. Haverstick provides rocket and missile test and evaluation, weapons systems support, and professional services to the U.S. Army, U.S. Air Force, U.S. Navy, NASA, and other federal, state and local agencies. Through the Haverstick acquisition, the Company expanded its customer footprint within the Department of Defense (DOD), and enhanced its presence with the U.S. Air Force, a key growth area for Kratos. The aforementioned factors are the primary reason for the acquisition and the amount subsequently assigned to goodwill. The total purchase price of $92.0 million includes transaction costs incurred by the Company of $0.8 million. The purchase price paid to Haverstick was $91.2 million comprised of $70.3 million in cash and the issuance of 7.48 million shares of the Company's common stock valued at $2.60 per share, or an aggregate stock consideration of $19.4 million based on 7.48 million shares at a price of $2.60 per share, and a working capital adjustment of $1.5 million. The value of the shares issued was determined by averaging the market price of the stock on the announcement date and for the two days prior to and two days subsequent to the public announcement of the acquisition, which occurred on November 5, 2007. The Company held back $8.6 million (the Holdback Consideration) to secure any negative working capital adjustments required by the merger agreement and the Company's indemnity rights. The Holdback Consideration is comprised of both cash and Kratos stock in the amounts of $1.2 million and $7.4 million, respectively, and accrues interest at a rate of LIBOR plus 4% until paid. The indemnity rights component of the Holdback Consideration is scheduled to be released in 50% increments on the 12 th month and 21 st month of the anniversary date of the acquisition. The holdback payment due in 102 Cash $ 4.0 Accounts receivable, net 13.6 Other current assets 1.7 Property, plant, and equipment 1.4 Intangible assets 8.9 Goodwill 40.1 Other assets 0.2 Total assets 69.9 Current liabilities (13.2 ) Other liabilities (0.8 ) Net assets acquired $ 55.9 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) December 2008 was not made pending the resolution of an outstanding indemnification claim which is being disputed by Haverstick. In addition to the indemnity holdback, the agreement also called for a post closing working capital adjustment. In February 2008, the Company and Haverstick agreed on the working capital calculation called for in the agreement. The calculation resulted in a working capital adjustment due to Haverstick in an amount of $1.5 million. The working capital adjustment was paid with 697,315 shares of Company stock on June 30, 2008, valued at $1.3 million, and cash of $0.2 million in April 2008. To fund the acquisition, the Company secured a new credit facility of $85.0 million arranged by KeyBanc Capital Markets. The credit facility, which includes a $25.0 million line of credit and $60.0 million in term notes, replaced the Company's previous credit facility which had an outstanding principal balance of $6.0 million on the date of closing. Until the date on which the shares of stock became salable, interest accrued on the value of the closing stock at a floating rate of one-month LIBOR plus four percent (4%) per annum. The shares became saleable on June 30, 2008 and 167,692 additional shares were issued in satisfaction of the accrued interest. The Consolidated Statements of Operations for the year ended December 28, 2008 includes the results of Haverstick's operations for the entire year. The results of Haverstick's operations are not included in the accompanying Consolidated Statement of Operations for the years ended December 31, 2007 and 2006. The purchase price which includes transaction costs of $0.8 million was accounted for as follows (in millions): The goodwill recorded in this transaction is not tax deductible. Madison Research Corporation On October 2, 2006, the Company acquired Huntsville, Alabama based Madison Research Corporation ("MRC") as part of the Company's KGS segment. MRC offers a broad range of technical, engineering and IT solutions, and has developed core competencies in weapons system lifecycle 103 Cash $ 3.6 Accounts receivable, net 23.5 Other current assets 5.3 Property, plant, and equipment 2.1 Intangible assets 9.3 Goodwill 66.4 Other assets 2.4 Total assets 112.6 Current liabilities (16.9 ) Other liabilities (3.7 ) Net assets acquired $ 92.0 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) support, integrated logistics, test and evaluation, commercial-off-the-shelf software and hardware selection and implementation, software development and systems lifecycle maintenance. The aforementioned factors are the primary reason for the acquisition and the amount subsequently assigned to goodwill. The purchase price was approximately $73.8 million, including a working capital adjustment of $4.6 million and transaction costs of $0.2 million, and is subject to certain additional post-closing adjustments. The Company paid $62.1 million at closing, the working capital adjustment of $4.6 million was paid in April 2007 and the remaining $6.9 million, which has been subsequently adjusted for legal costs and a reduction in contingent cash consideration, was held back to secure the Company's indemnity rights and will be released, subject to indemnity rights, in installments following 6, 12, and 18 months from the date of close. In April 2007, $1.5 million of the hold-back was released and paid to the former shareholders of MRC. In October 2007, a second scheduled holdback payment of $2.8 million was made. The remaining hold back balance of approximately $2.5 million, including accrued interest, as of December 28, 2008, subject to the resolution of certain indemnification matters, is expected to be paid in the first or second quarter of 2009. The results of operations of MRC have been included in the Company's consolidated statement of operations for the periods from the acquisition date of October 2, 2006. The purchase price, including transaction costs of $0.2 million, was accounted for as follows (in millions): The goodwill recorded in this transaction is not tax deductible. Unaudited Pro Forma Financial Information The following tables summarize the supplemental statement of operations information on an unaudited pro forma basis as if the acquisitions of DFI, SYS, Haverstick and Madison had occurred on January 1, 2007, and includes adjustments that were directly attributable to the transactions or were not expected to have a continuing impact on the Company. The pro forma results are for illustrative purposes only for the applicable period and do not purport to be indicative of the actual results which would have occurred had the transaction been completed as of the beginning of the period, nor are 104 Current assets $ 17.8 Property, plant, and equipment 0.4 Intangible assets 8.1 Goodwill 53.8 Total assets 80.1 Current liabilities (6.3 ) Net assets acquired $ 73.8 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) they indicative of results of operations which may occur in the future (all amounts, except per share amounts are in millions): Contingent Acquisition Consideration In connection with certain business acquisitions, the Company may agree to make additional future payments to sellers contingent upon achievement of specific performance-based milestones by the acquired entities. Pursuant to the provisions of SFAS 141, such amounts are accrued, and therefore, recorded by the Company when the contingency is resolved beyond a reasonable doubt and the additional consideration becomes payable. The other current liabilities on the accompanying Consolidated Balance Sheet as of December 28, 2008 include $2.5 million for Madison Research Corporation ("MRC") and $1.2 million for Haverstick. In conjunction with the Haverstick acquisition contingent common stock consideration of $8.4 million is reflected as additional paid in capital for contingent consideration in the accompanying Consolidated Financial Statements. The MRC holdback of approximately $2.5 million was originally due in April 2008 and this date has been extended to provide additional time to resolve outstanding indemnification obligations. The Company expects to make this payment in 2009. The remaining amounts for Haverstick of $1.2 million in cash and $8.8 million in common stock are due in equal payments in December 2008 and September 2009. The December payment to Haverstick was not made pending the resolution of an indemnification claim. The holdback arrangements accrue interest in accordance with the terms of the purchase agreements. 105 2007 As Reported Haverstick Pro forma Adjustments (unaudited) SYS Pro forma Adjustments (unaudited) DFI Pro forma Adjustments (unaudited) 2007 Pro forma Pro forma revenues $ 193.6 $ 94.2 $ 79.0 $ 47.5 $ 414.3 Pro forma net loss $ (40.8 ) $ (5.1 ) $ (0.8 ) $ (0.6 ) $ (47.3 ) Shares outstanding or issued for acquisition 74.0 5.3 25.3 22.9 127.5 Basic and diluted pro forma net loss per share $ (0.55 ) $ (0.37 ) 2008 As Reported SYS Pro forma Adjustments (unaudited) DFI Pro forma Adjustments (unaudited) 2008 Pro forma Pro forma revenues $ 297.3 $ 36.5 $ 61.0 394.8 Pro forma net loss $ (111.1 ) $ (0.1 ) $ (1.5 ) $ (112.7 ) Shares outstanding or issued for acquisition 92.6 12.0 22.9 127.5 Basic and diluted pro forma net loss per share $ (1.20 ) $ (0.88 ) Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 5. Acquisitions (Continued) A summary of the contingent acquisition consideration as of December 31, 2007 and December 28, 2008 is summarized in the following table (in millions): Note 6. Balance Sheet Details Cash and cash equivalents The Company's cash equivalents consist of overnight cash sweep accounts that are invested on a daily basis. As of December 28, 2008, the company had no other short-term investments. The cash and cash equivalents at December 31, 2007 and December 28, 2008 were as follows (in millions): Net unrealized gains and realized gains recorded during the year ended December 31, 2007 and December 28, 2008 were immaterial. The breakdown of certain assets in the consolidated balance sheets consists of the following at December 31, 2007 and 2008 (in millions): Accounts receivable, net 106 Haverstick MRC Total Balance as of December 31, 2007 $ 8.6 $ 2.3 $ 10.9 Post acquisition adjustments and interest accruals 1.4 0.2 1.6 Balance as of December 28, 2008 $ 10.0 $ 2.5 $ 12.5 December 31, 2007 December 28, 2008 Amortized Cost Basis Fair Value Basis Amortized Cost Basis Fair Value Basis Cash $ 3.6 $ 3.6 $ 2.9 $ 2.9 Money market 5.0 5.0 0.3 0.3 Cash and cash equivalents $ 8.6 $ 8.6 $ 3.2 $ 3.2 2007 2008 Billed, current $ 43.3 $ 61.5 Unbilled, current 34.5 40.2 Total current accounts receivable 77.8 101.7 Allowance for doubtful accounts (0.8 ) (1.2 ) Total current accounts receivable, net 77.0 100.5 Unbilled, long term (included in other long term assets) 0.6 0.3 Total accounts receivable, net $ 77.6 $ 100.8 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 6. Balance Sheet Details (Continued) Retainages receivable are $1.5 million and $4.2 million as of December 31, 2007 and December 28, 2008, respectively. Property and equipment, net Depreciation expense was $2.6 million, $1.5 million and $2.5 million for the years ended December 31, 2006 and 2007 and December 28, 2008, respectively. Investments in unconsolidated affiliates Note 7. Debt (a) Credit Agreement On December 31, 2007, the Company entered into a credit facility of $85.0 million with KeyBanc Capital Markets. This credit facility provides for two term loans consisting of a first lien term note of $50.0 million and a second lien term note of $10.0 million, as well as a first lien $25 million revolving line of credit. The $10.0 million term loan has a five and one half-year term with principal payments of $25,000 required quarterly beginning on March 31, 2008 through March 31, 2013 with the final balance of $9.5 million due on June 30, 2013. The $50.0 million term loan has a five year term with principal payments of $0.6 million required quarterly beginning on March 31, 2008, $1.3 million in 2009, $2.5 million in 2010, and $4.1 million in 2011 and 2012. The term loans have a provision which states that once the full amount of the note has been borrowed, the notes cannot be paid down and reborrowed again. The revolving line of credit has a four year term which expires on December 31, 2011. All loans under the new credit facility have an interest rate equal to a base rate defined as a fluctuating rate per annum equal to the higher of (a) the Federal Funds Rate plus 0.5% and (b) the rate of interest in effect for such day as publicly announced from time to time by KeyBank as its "prime rate" plus a margin for the term loans of 6.5% to 7.5% and a margin of 1.0% to 3.25% on the revolving line of credit. The applicable margin at date of borrowing is determined by the ratio of the Company's aggregate debt to its EBITDA for the previous four fiscal quarters. The Company used the 107 Computer equipment $ 4.9 $ 7.1 Software 3.3 1.5 Furniture and office equipment 4.3 5.7 Facility under capital lease 1.2 0.9 Leasehold improvements 1.8 2.4 Property and equipment 15.5 17.6 Accumulated depreciation and amortization (8.6 ) (10.4 ) Total property and equipment, net $ 6.9 $ 7.2 CommVerge, Inc. $ — $ — Tactical Survey Group, Inc. 0.3 — Total investments in unconsolidated affiliates $ 0.3 $ — Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 7. Debt (Continued) credit facility to fund the acquisition of Haverstick and to retire the outstanding debt from an October 2006 credit agreement with Key Bank. The credit agreements contain covenants which impose certain restrictions on the Company's ability to, among other things, incur additional debt, pay dividends, make investments or sell assets. The credit agreements are collateralized by the assets of the Company. Additionally, certain non-recurring cash inflows such as proceeds from asset sales, insurance recoveries, and equity offerings may have to be used to pay down indebtedness and may not be reborrowed. In addition, the credit agreements contain certain financial covenants which are defined by the terms of the agreements. These financial covenants include a maximum first lien leverage ratio, a maximum total leverage ratio, a minimum liquidity ratio, a minimum fixed charge coverage ratio, and a minimum consolidated EBITDA at various dates for the $50.0 million term loan and the $25.0 million revolver as outlined in the following table. The $10.0 million subordinated term loan also provides for similar financial covenants. As of December 28, 2008, the Company's outstanding balance on the facility was $78.8 million and the weighted average interest rate on the debt as of December 28, 2008 was 10.66%. As of December 28, 2008, the unused line of credit under the revolving line of credit was approximately $2.0 million. The only restriction on the use of these funds is that the Company must be in compliance with covenants of the credit facility. The Company was in compliance with all covenants under the credit facility as of December 28, 2008. In March 2008, the Company entered into a tentative agreement to settle its 2004 and 2007 securities class action litigation actions and, as a result, the Company recorded a $4.9 million charge in the quarter ended December 31, 2007 to accrue its share of the settlement amounts and an estimate for a contingent liability associated with legal proceedings related to the derivative actions, net of the amounts to be covered by the Company's insurance carriers. As a consequence of recording this legal settlement, the Company did not meet certain of the financial covenants in accordance with the credit facility. Accordingly, on March 27, 2008, the Company obtained an amendment and waiver from its lenders to waive the impact of the legal settlement amounts on its financial covenants as of December 31, 2007 and the affected future periods. The amendment also amended the credit facility to provide for an increase in the LIBOR floor rate to 4.25% and to require that the Company set aside in a restricted account approximately 50% of the proceeds of the recovery from the theft of stock options by its former stock option administrator, or approximately $1.7 million, to fund these settlement amounts. In April 2008, $1.7 million was transferred to a restricted cash account and in July 2008, an additional $0.6 million was transferred for the amount received from the insurance carriers as settlement on the theft of stock options. In July 2008, the funding of the 2007 Securities Litigation 108 Date Maximum First Lien Leverage Ratio Maximum Total Leverage Ratio Minimum Liquidity Ratio Minimum Fixed Charge Coverage Ratio Minimum Consolidated EBITDA (in millions) 2008 3.22 to 4.76:1.00 3.76 to 5.68:1.00 1.56 to 1.33:1.00 1.05 to 0.50:1.00 $16.1 to $19.4 2009 2.97 to 2.33:1.00 2.78 to 3.50:1.00 1.60 to 1.58:1.00 1.11 to 1.02:1.00 $19.8 to $21.5 2010 1.75 to 2.00:1.00 2.25 to 2.50:1.00 1.54 to 1.49:1.00 1.10 to 1.06:1.00 $21.5 to $23.4 2011 1.75:1.00 2.25:1.00 1.55 to 1.53:1.00 1.10:1.00 $24.4 to $26.5 2012 1.75:1.00 2.25:1.00 1.42 to 1.54:1.00 1.10:1.00 $26.7 to $27.6 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 7. Debt (Continued) Settlement included the use of $1.2 million of the cash from the restricted account. The lenders have also reserved the right to require the Company to utilize the entire amount of the $3.4 million in proceeds received from the theft of stock options to permanently pay down indebtedness. This right can be exercised no earlier than 60 days from March 27, 2008 and expired upon the Company's compliance with financial covenants under the credit facility for the four consecutive quarters commencing after January 1, 2008. The cost of the amendment, which was approximately $0.5 million was recorded as deferred financing costs in current assets on the accompanying consolidated balance sheet which will be amortized over the remaining life of the facility. On June 26, 2008, the Company entered into a second amendment to its credit facility in order to complete the merger with SYS. The amendment specifically approves that certain unsecured subordinated convertible notes issued by SYS be treated as subordinated debt under the credit facility, provided that a Subordination Agreement is obtained from the note holders representing no less than 95% of the aggregate principal amount of all subordinated notes, which was obtained in July 2008. In addition, the amendment provides for an add-back for amounts representing actual transaction costs incurred by an acquired entity in the computation of Consolidated EBITDA, as defined in the credit agreement, in any acquisition in which 100% of the purchase price is paid in equity securities of the Company. On February 11, 2008, the Company entered into three derivative financial instruments with Key Bank to reduce the Company's exposure to its variable interest rates on its outstanding debt. These instruments initially hedged $70 million of its LIBOR-based floating rate debt with the amounts hedged decreasing over time. The derivatives mature on March 31, 2010 and March 31, 2011 and result in an average fixed rate of 3.16% for the term of the agreements. The Company designated these instruments as cash flow hedges. In March 2008, as a result of the amendment to the Company's credit facility, which included a LIBOR floor rate of 4.25%, the Company determined that these instruments were no longer highly effective as a hedge. The net loss associated with marking the derivative financial instruments to market for the twelve months ended December 28, 2008 was $1.7 million and has been reflected in other income (expense). Future gains and losses on these derivative instruments will continue to be recognized in the Company's Statement of Operations. See Note 10. In 2008, the Company paid approximately $1.8 million related to the 2007 securities litigation and $3.0 million related to the 2004 securities litigation settlements in 2008. This amount was partially funded by $2.2 million from the restricted cash account which was funded as a result of the first amendment to the current Credit Facility. The Company expects to be reimbursed for $0.6 million of the payment related to the 2004 securities litigation settlement by the Company's insurance which is anticipated during the first half of 2009. (b) Subordinated Notes As of December 28, 2008, the Company had outstanding convertible notes payable which were acquired as a result of the SYS acquisition totaling $3.1 million, of which $0.8 million was payable to related parties. The convertible notes payable are unsecured and subordinated to the Company's bank debt and bear interest at 10% per annum payable quarterly. Principal is due February 14, 2009 and the notes are convertible at any time into shares of common stock at a conversion rate of $2.86 per share. 109 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 7. Debt (Continued) The balance of the outstanding notes is reflected in current and long-term portion of long-term debt in the accompanying consolidated balance sheets. In February 2009, in the interest of preserving cash due to the current macroeconomic conditions, the Company provided each note holder with the option to: (1) be paid cash in accordance with the original agreement (2) extend the note for an additional 18 months at the existing 10% rate and modify the conversion feature to the lower of the existing conversion price of $2.86 per share or the Kratos closing share value on February 13, 2009, or (3) convert the principal balance of Kratos shares at the lower of the existing conversion price of $2.86 or the Kratos closing share value on February 13, 2009 less a 10% discount. As of February 28, 2009, $1.8 million of the notes have been paid, $1.0 million of the notes have been extended to August 14, 2010, and $25.0 thousand have been converted to common shares. Holders of approximately $0.2 million of the notes have not responded. As of December 28, 2008, approximately $2.1 million of the balance on the subordinated debt is reflected as current portion of long-term debt and approximately $1.0 million is reflected as long-term debt in the accompanying consolidated balance sheets. Future maturities of long-term debt are as follows: 110 2009 $ 5.9 2010 9.9 2011 36.2 2012 16.3 2013 13.6 $ 81.9 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 8. Lease Commitments The Company leases certain facilities and equipment under operating leases having terms expiring at various dates through 2016. Future minimum lease payments under capital and operating leases as of December 28, 2008 are as follows (in millions): Pursuant to the terms of sublease agreements as of December 28, 2008, approximately $0.1 million of sublease income will offset future minimum lease payments. Gross rent expense under operating leases for the years ended December 31, 2006, 2007 and December 28, 2008 were $4.0 million, $4.3 million and $6.6 million, respectively. Total sublease income for the years ended December 31, 2006, 2007 and December 28, 2008 totaling $0.2 million, $0.2 million and $0.4 million, respectively, has been netted against rent expense. Based on management's assessment of assumptions considering existing market conditions, sublease rental rates and recoverability of operating lease expenses for the Company's vacant properties and due to the Company's actions to consolidate facilities, during the fourth quarter of 2006, the Company reevaluated its accrual for unused office space and determined that a portion of its corporate facility would no longer be utilized to the extent previously expected. As a result, the Company calculated the estimated loss on unused office space to increase by approximately $1.4 million in the quarter ended December 31, 2006. In 2007, the Company recorded an additional $0.8 million for an excess facility accrual for obligations under facility leases that were unfavorably impacted by our recent divestitures of our wireless network services businesses which resulted in unused office space. In 2008, the Company recorded an additional $0.1 million for an excess facility accrual as a result of the Consolidation of space that occurred as the Company has integrated its recent acquisitions. The accrual for loss on unused office space was $2.4 million and $1.7 million as of December 31, 2007 and December 28, 2008, respectively. The Company estimates that the remaining accrual will be paid through 2010. These amounts are included in asset impairment and other charges on the Company's statements of operations. The lease on certain office facilities includes scheduled base rent increases over the term of the lease. The total amount of the base rent payments is being charged to 111 Capital Leases Net Operating Leases Year ending December 31, 2009 $ 0.4 $ 8.0 2010 0.4 5.4 2011 0.4 3.0 2012 0.3 1.8 2013 0.3 0.8 Thereafter 0.2 0.4 Total future minimum lease payments $ 2.0 $ 19.4 Less amount representing interest 0.9 Present value of capital lease obligations 1.1 Less current portion 0.2 Long-term capital lease obligations $ 0.9 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 8. Lease Commitments (Continued) expense on the straight-line method over the term of the lease. In addition to the base rent payment, the Company pays a monthly allocation of the building's operating expenses. The Company has recorded deferred rent, included in accrued expenses and other liabilities in the consolidated balance sheets, of $0.8 million and $0.4 million at December 31, 2007 and 2008, respectively, to reflect the excess of rent expense over cash payments since inception of the respective lease. Note 9. Income Taxes The Company adopted the provisions of FIN 48 on January 1, 2007. The total liability for unrecognized tax benefits as of the date of adoption was $4.7 million. Additionally, the Company has a tax refund claim of $2.4 million for which it has not recorded any benefit under FIN 48 or prior standards. As a result of the implementation of FIN 48, the Company recognized a $0.7 million increase in the liability for unrecognized tax benefits, with $0.2 million net decrease in valuation allowance, $0.1 million charged to retained earnings, and $0.4 million recorded to goodwill. In addition, the Company reduced its gross deferred tax assets by $10.8 million for unrecognized tax benefits, which was offset by a reduction in its valuation allowance by the same amount. The following table summarizes the activity related to the Company's unrecognized tax benefits (in millions): Included in the balance of unrecognized tax benefits at December 28, 2008, are $12.8 million of tax benefits that, if recognized, would affect the effective tax rate. Included in this amount is $8.8 million that would become a deferred tax asset if the tax benefit were recognized. As such, this benefit may be impacted by a corresponding valuation allowance depending upon the Company's consolidated financial position at the time the benefits are recognized. The Company recognizes interest and penalties related to unrecognized tax benefits in its provision for income taxes. For the years ended December 31, 2007 and December 28, 2008, the Company recorded $0.2 million and $0.1 million, respectively, in interest or penalties. 112 Total Balance at December 31, 2006 $ 16.4 Increases related to prior periods 5.5 Decreases related to current year tax positions (7.3 ) Expiration of applicable statutes of limitations (1.0 ) Foreign currency translation 0.3 Balance at December 31, 2007 $ 13.9 Increases related to prior periods 0.0 Decreases related to current year tax positions 0.0 Expiration of applicable statutes of limitations (1.0 ) Foreign currency translation (0.1 ) Balance at December 28, 2008 $ 12.8 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 9. Income Taxes (Continued) The Company believes that it is reasonably possible that as much as $3.2 million of the FIN 48 tax liabilities will expire within 12 months of December 28, 2008 due to the expiration of various applicable statutes of limitations and possible settlement of a pending income tax refund claim. The Company is subject to taxation in the U.S. and various state tax jurisdictions. The Company's tax years for 2000 and forward are subject to examination by the U.S. and state tax authorities due to the existence of net operating loss carryforwards. Generally, the Company's tax years for 2002 and forward are subject to examination by various foreign tax authorities. In assessing the realizability of deferred tax assets, management considers on a periodic basis, whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. As such, management has determined that it is appropriate to maintain a full valuation allowance against its deferred tax assets, with the exception of an amount equal to its deferred tax liabilities which can be expected to reverse. Management will continue to evaluate the necessity to maintain a valuation allowance against its deferred tax asset. As of December 28, 2008, the Company had a net deferred tax liability of zero. The deferred tax assets and liabilities are allocated based upon the underlying asset or liability that produced the deferred taxes. As of December 28, 2008, there were no deferred tax assets or liabilities allocated to discontinued operations. The provision (benefit) for income taxes from continuing operations for the years ended December 31, 2006 and 2007 and December 28, 2008 are comprised of the following (in millions): A reconciliation of total income tax provision (benefit) to the amount computed by applying the statutory federal income tax rate of 35% to loss from continuing operations before income tax 113 2006 2007 2008 Current: Federal $ (0.5 ) $ 0.0 $ 0.0 State 0.7 0.7 1.3 Total current 0.2 0.7 1.3 Deferred: Federal 12.1 0.5 (1.7 ) State 1.5 0.1 (0.3 ) Total deferred 13.6 0.6 (2.0 ) Total $ 13.8 $ 1.3 $ (0.7 ) Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 9. Income Taxes (Continued) provision (benefit) for the years ended December 31, 2006 and 2007 and December 28, 2008 is as follows (in millions): The tax effects of temporary differences that give rise to the deferred tax assets and deferred tax liabilities as of December 31, 2007 and 2008 are as follows (in millions): 114 2006 2007 2008 Income tax expense (benefit) at federal statutory rate $ (11.3 ) $ (9.4 ) $ (37.2 ) State taxes, net of federal tax benefit and valuation allowance 2.1 0.7 1.3 Increase (decrease) in federal valuation allowance 15.9 9.9 2.5 Increase (decrease) in reserves for uncertain tax positions 0.1 — — Nondeductible expense 0.6 0.1 0.1 Nondeductible goodwill impairment charges 6.4 — 32.6 Total $ 13.8 $ 1.3 $ (0.7 ) 2007 2008 Deferred tax assets: Allowance for doubtful accounts $ 0.8 $ 0.9 Sundry accruals 0.5 1.1 Vacation accrual 0.7 1.9 Stock-based compensation 7.7 9.8 Property and equipment, principally due to differences in depreciation 1.3 2.5 Investments 2.4 2.9 Net operating loss carryforwards 62.4 79.1 Capital loss carryforward 1.6 1.5 Tax credit carryforwards 0.3 0.3 Deferred revenue — 0.1 Reserves and other 6.7 3.9 84.4 104.0 Valuation allowance (75.0 ) (96.4 ) Total deferred tax assets, net of allowance 9.4 7.6 Deferred tax liabilities: Unearned revenue (0.8 ) (0.5 ) Other intangibles (9.0 ) (5.6 ) Property and equipment, principally due to differences in depreciation (1.6 ) (1.5 ) Total deferred tax liabilities (11.4 ) (7.6 ) Net deferred tax asset (liability) $ (2.0 ) $ (0.0 ) Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 9. Income Taxes (Continued) At December 28, 2008, the Company had federal tax loss carryforwards of $202.8 million (including stock option net operating loss carryforwards) which expire beginning in 2020 and various state tax loss carryforwards of $232.4 million which expire beginning in 2012. Federal and state tax laws impose restrictions on the utilization of net operating loss and tax credit carryforwards in the event of an "ownership change" for tax purposes as defined by Section 382 of the Internal Revenue Code. At December 28, 2008, the Company does not believe that it has incurred any "ownership changes" which would materially limit the utilization of the loss carryforwards. If an "ownership change" does occur, utilization of the net operating loss or credit carryforward amounts may be limited. As discussed elsewhere, deferred tax assets relating to the net operating loss and credit carryforwards are offset by a full valuation allowance. In addition, utilization of state tax loss carryforwards is dependent upon sufficient taxable income apportioned to the states. In assessing the realizability of deferred tax assets, management considers, on a periodic basis, whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. During fiscal 2008, the Company recorded an increase in its valuation allowance of $21.4 million. Of this amount, $2.5 million is a result of current year operations, causing the current year tax expense to increase over the expected expense or benefit. The remaining increase in the valuation allowance is attributed to deferred tax assets acquired in the acquisitions of SYS Technologies and Digital Fusion, Inc. and the true-up of beginning deferred tax assets based on actual tax return filings. The increase was required based on the Company's overall assessment of the risks and uncertainties related to its future ability to realize and utilize the Company's deferred tax assets. Note 10. Fair Value Measurement The Company adopted SFAS 157 as of January 1, 2008, with the exception of the application of the statement to non-recurring nonfinancial assets and nonfinancial liabilities. Non-recurring nonfinancial assets and nonfinancial liabilities for which it has not applied the provisions of SFAS 157 include those measured at fair value in goodwill impairment testing, indefinite lived intangible assets measured at fair value for impairment testing, asset retirement obligations initially measured at fair value, and those initially measured at fair value in a business combination. SFAS 157 establishes a valuation hierarchy for disclosure of the inputs to valuation used to measure fair value. This hierarchy prioritizes the inputs into three broad levels as follows. Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. Level 2 inputs are quoted prices for similar assets and liabilities in active markets or inputs that are observable for the asset or liability, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on the Company's own assumptions used to measure assets and liabilities at fair value. A financial asset or liability's classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. 115 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 10. Fair Value Measurement (Continued) The following table provides the assets and liabilities carried at fair value measured on a recurring basis as of December 28, 2008 (in millions): Fair Value Measurements at December 28, 2008 using The significant Level 2 observable inputs utilized to value the Company's derivative financial instruments are based upon calculations provided by an investment advisor and is validated with the use of a nationally recognized financial reporting service. Carrying amounts and the related estimated fair values of the Company's financial instruments not measured at fair value on a recurring basis at December 28, 2008 and December 31, 2007 are as follows: Cash Surrender Value of Life Insurance Policies—The Company maintains whole life insurance policies on a group of executives for use as a funding source for deferred compensation arrangements. These policies are recorded at their cash surrender value as determined by the insurance carrier. The policies are utilized as a partial funding source for supplemental employee retirement plans and amounts associated with these policies are recorded in other assets in the consolidated statements of financial position. Capital lease obligations—The fair value of capital lease obligations was calculated based on interest rates available for leases with terms and due dates similar to the Company's existing lease arrangements. Long-Term Debt—The fair value of the long-term debt was calculated based on interest rates available for debt with terms and due dates similar to the Company's existing debt arrangements. In 2007, the fair value of the long-term debt was equivalent to the carrying value as the Company entered into the Credit Facility for this debt on December 31, 2007. Note 11. Stockholders' Equity (a) Preferred Stock On May 30, 2002, the Company issued an aggregate of 90,000 shares of Series B Convertible Preferred Stock, at an aggregate purchase price of $45.0 million, in a private placement to entities 116 Total Carrying Value December 28, 2008 Quoted prices in active markets (Level 1) Significant other observable inputs (Level 2) Significant unobservable inputs (Level 3) Derivative liabilities $ 1.7 $ — $ 1.7 $ — 2007 2008 $ in millions Carrying Amount Fair Value Carrying Amount Fair Value Cash surrender value of life insurance policies $ — $ — $ 0.3 $ 0.3 Capital lease obligations $ 1.2 $ 1.2 $ 1.0 $ 0.8 Long-term debt $ 75.5 $ 75.5 $ 78.8 76.2 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) affiliated with one of the directors of the Company (40,000 shares), to a brother of the Chairman and Chief Executive Officer of the Company (10,000 shares) and to an unrelated third-party investor (40,000 shares). The Company received $44.9 million of net proceeds. Each share of Series B Convertible Preferred Stock is convertible into 100 shares of Common Stock for a conversion price of $5.00 per share, which was the fair market value of the common stock at the date of issuance, at the option of the holder at any time, subject to certain provisions in the Series B Preferred Stock Purchase Agreement. Prior to December 31, 2004, 64,517 shares of Series B Convertible Preferred Stock were converted into 6,451,700 shares of the Company's Common Stock. On April 5, 2006, 15,483 shares of Series B Convertible Preferred Stock were converted into 1,548,300 shares of the Company's Common Stock. There was no issuance, redemption or conversion of the Series B Convertible Preferred Stock in the most recent fiscal years ended December 31, 2007 or December 28, 2008. On December 28, 2008, the total liquidation preference equaled $5.0 million. In accordance with EITF 03-06 "Participating Securities and the Two-Class Method under FASB Statement 128", the Company's Series B Preferred Stock was considered a participating security for purposes of computing basic earnings per share. (b) Stock Option Plans and Restricted Stock Unit Plans During the years ended 1997, 1999 and 2000, the Board of Directors approved the 1997 Stock Option Plan (the "1997 Plan"), the 1999 Equity Incentive Plan (the "1999 Plan") and the 2000 Non-statutory Stock Option Plan (the "2000 Plan"), respectively. Further, in February 2005, the Board of Directors approved the 2005 Equity Incentive Plan (the "2005 Plan"). The 2005 Plan was subsequently approved by a majority of the Company's stockholders on May 18, 2005. Stock options granted under the 1997 Plan and 1999 Plan may be incentive stock options or non-statutory stock options and are exercisable for up to ten years following the date of grant. The Company ceased making grants under, and subsequently terminated the 1997 Plan upon completion of its initial public offering. The 2000 Plan permits the grant of non-statutory stock options, which are exercisable for a period following the date of grant as determined by the Board of Directors (generally ten years). Additionally, in July 2004, the Board of Directors resolved that all future stock option grants under all of the Company's stock option plans would be non-statutory stock options, until such further determination by the Board of Directors. Stock option exercise prices for the 1997 Plan, 1999 Plan, 2000 Plan and 2005 Plan must be equal to or greater than the fair market value of the common stock on the date of grant. A cumulative total of 5.3 million, 15.9 million, 6.5 million and 6.5 million shares of common stock have been authorized for issuance under the 1997 Plan, 1999 Plan, 2000 Plan and 2005 Plan, respectively. There remain approximately 2.3 million shares of common stock authorized for the 1997 Plan which are no longer issuable due to the termination of the plan. Digital Fusion Inc. 1998, 1999, 2000, and 2005 Stock Option and Stock Incentive Plans. Digital Fusion, Inc.'s 1998, 1999, 2000, and 2005 Stock Option and Stock Incentive Plans acquired through the Company's acquisition of Digital Fusion, Inc. ("DFI"), were terminated on December 24, 2008, and no further grants were made under these plans after that date. Award grants that were outstanding under these plans on December 24, 2008 will continue to be governed by their existing terms and may be exercised for shares of the Company's common stock at any time prior to the expiration of the ten-year option term or any earlier termination of those options in connection with the optionee's cessation of 117 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) service with the Company. Stock options granted under these plans included incentive stock options or non-statutory stock options. All non-statutory options vest upon change in control and were 100% vested on December 24, 2008. With respect to incentive stock options, the qualified stock option plans provide that the exercise price of each such option must be at least equal to 100% of the fair market value of its common stock on the date of grant. Stock options granted under these plans may generally be exercised from one to ten years after the date of grant. Certain of these options had change in control provisions that extended the exercise period for grants for two years from the transaction closing date. Awards granted under these plans generally vest equally over three years; however, in connection the with Company's acquisition of Digital Fusion, Inc. the plans were amended to include immediate vesting of all unvested grants upon any future change in control of the Company. DFI also had certain options granted outside of its qualified stock option plans. These non-qualified "out of plan" stock options expire 10 years from grant date. On December 28, 2006, the Board of Directors of the Company approved the acceleration of vesting of all unvested options issued prior to June 30, 2006 to purchase shares of common stock of the Company that were held by employees and directors. The acceleration was effective as of December 29, 2006, provided that holders of incentive stock options within the meaning of Section 422 of the Internal Revenue Code of 1986, as amended, were given the election to decline the acceleration of an option if such acceleration would have the effect of changing the status of such option for federal income tax purposes from an incentive stock option to a non-qualified stock option. Options to purchase approximately 2.1 million shares of common stock were subject to this acceleration. The acceleration of these options was undertaken to eliminate the future compensation expense that the Company would have otherwise recognized in its consolidated statement of operations with respect to these options under the Statement of Financial Accounting Standards 123R " Share-Based Payment ", issued by the Financial Accounting Standards Board (" FAS 123R "). The expense that was incurred in 2006 related to the vesting of these options was $ 5.4 million in continuing operations and $4.1 million in discontinued operations. On January 10, 2007, the Compensation Committee of the Board approved a form of Restricted Stock Unit Agreement (the "RSU Agreement") to govern the issuance of restricted stock units ("RSU") to executive officers under the Company's 2005 Plan. Each RSU represents the right to receive a share of common stock (a "Share") on the vesting date. Unless and until the RSUs vest, the Employee will have no right to receive Shares under such RSUs. Prior to actual distribution of Shares pursuant to any vested RSUs, such RSUs will represent an unsecured obligation of the Company, payable (if at all) only from the general assets of the Company. The RSUs that may be awarded to executive officers under the RSU Agreement will vest according to vesting schedules specified in the notice of grant accompanying each grant. We recognize compensation expense on a straight-line basis over the vesting periods based on the market price of our stock on the grant date. The awards granted in 2007 had vesting periods ranged from 11 months to 10 years with accelerated vesting occurring upon a change in control or termination. The awards granted in 2008 had vesting periods ranging from monthly after one year to ten years with accelerated vesting occurring for some of the grants upon a change in control or termination. Upon exercise of the RSU, the Company issues new shares of common stock. 118 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) The Company records compensation expense for employee stock options based on the estimated fair value of the options on the date of grant using the Black-Scholes option-pricing model and the weighted average assumptions (annualized percentages) included in the following table. Awards with graded vesting are recognized using the straight-line method. Fair value under SFAS 123R is determined using the Black-Scholes option-pricing model with the following assumptions: (1) 2006 2007 2008 Expected life:(1) Stock options 3.8 years 10.0 years 5.3 years Risk-free interest rate(2) 4.3% - 5.2% 4.3% - 4.7% 0.0% - 2.1% Volatility(3) 53.4% - 63.4% 56.8% 38.8% - 70.3% Forfeiture rate(4) 23.7% 23.7% 10.6% Dividend yield(5) — — — The expected life of stock options granted under the plan is the life of the option when the option is 100% vested at grant. In 2006, the expected life of unvested options granted under the Plan was based upon historical exercise patterns which the Company believes are representative of future behavior. No unvested options were granted in 2007. In 2008, all unvested options granted related to the acquisition of DFI. As historically, the majority of options granted were part of the Company's now discontinued Wireless Network Services segment and not the Company's KGS segment, the Company did not have historical information related to the expected term of the options granted to DFI. The Company used market information from the Company's peers to estimate the expected life of these grants which was consistent with the methodology previously used by DFI. A majority of the options granted to DFI were 100% vested at grant. (2) The risk-free interest rate is based on U.S. Treasury yields in effect at the time of grant with a term equal to the expected term of the options. (3) The Company estimated the implied volatility of its common stock at the date of grant based on an equally weighted average of trailing volatility and market based implied volatility for the computation in 2006. In 2007 and 2008, the Company estimated implied volatility based upon trailing volatility. (4) Forfeitures are estimated at the time of grant based upon historical information. Forfeitures will be revised, if necessary, in subsequent periods if actual forfeitures differ from estimates. In 2008, the estimated forfeitures for the DFI options were based upon the historical information of DFI option holders. (5) The Company has no history or expectation of paying dividends on its common stock. 119 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) Upon option exercise, the Company issues new shares of common stock. A summary of the status of the Company's stock option plan as of December 28, 2008 and of changes in options outstanding under the plan for the year ended December 28, 2008 is as follows: As of December 28, 2008, there was $0.3 million of total unrecognized stock compensation expense related to nonvested shares which is expected to be recognized over a remaining weighted-average vesting period of 0.9 years. During the years ended December 31, 2006, 2007 and 2008, the following activity occurred under our option plans: Additional information about stock options outstanding at December 28, 2008 with exercise prices less than and greater than $1.17 per share, the exercise price at December 28, 2008 the last trading day of the period, follows (number of shares in thousands): 120 Number of Shares Weighted- Average Exercise Price per Share Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value (000's) (000's) Options outstanding at December 31, 2007 6,173 $ 6.41 5.5 $ 10.5 Options granted 10,023 $ 1.19 Options exercised — — Options forfeited or expired (670 ) $ 5.13 Options outstanding at December 31, 2008 15,526 $ 3.09 5.3 $ 3,250 Options exercisable at December 28, 2008 14,869 $ 3.18 5.2 $ 3,136 2006 2007 2008 Weighted average grant date fair value of options granted $ 2.33 $ 1.54 $ 0.71 Total intrinsic value of options exercised (in thousands) 179 10 — Exercisable Unexercisable Total Stock Options Number of Shares Weighted Average Exercise Price Number of Shares Weighted Average Exercise Price Number of Shares Weighted Average Exercise Price Less than $1.17 5,373 $ 0.65 419 $ 0.96 5,792 $ 0.67 Above $1.17 9,496 $ 4.61 237 $ 1.59 9,733 $ 4.54 Total outstanding 14,869 $ 3.18 656 $ 1.19 15,526 $ 3.09 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) The following table summarizes the Company's Restricted Stock Unit activity: As of December 28, 2008, there was $5.3 million of total unrecognized stock compensation expense related to nonvested restricted stock units which is expected to be recognized over a remaining weighted-average vesting period of 7.6 years. The fair value of RSU awards that vested in 2007 and 2008 was $1.2 million and $0.3 million, respectively, (none in 2006). (c) Employee Stock Purchase Plan In August 1999, the Board of Directors approved the 1999 Employee Stock Purchase Plan (the "Purchase Plan"). A total of 4.4 million shares of Common Stock have been authorized for issuance under the Purchase Plan. The Purchase Plan qualifies as an employee stock purchase plan within the meaning of Section 423 of the Internal Revenue Service Code. The Purchase Plan commenced in November 1999 upon completion of the Company's initial public offering. On November 16, 2005, the Compensation Committee of the Board of Directors elected to suspend all future offerings under the Purchase Plan effective January 1, 2006. On February 27, 2008, the Compensation Committee elected to reinstate offerings under the Purchase Plan effective April 1, 2008. Unless otherwise determined by the Compensation Committee of the Board of Directors, all employees were eligible to participate in the Purchase Plan so long as they are employed by the Company (or a subsidiary designated by the board) for at least 20 hours per week and were customarily employed by the Company (or a subsidiary designated by the board) for at least 5 months per calendar year. Employees who actively participate in the Purchase Plan are eligible to have up to 15% of their earnings for each purchase period withheld pursuant to the Purchase Plan. The amount that was withheld was used at various purchase dates within the offering period to purchase shares of Common Stock. The price paid for Common Stock at each such purchase date is equal the lower of 85% of the fair market value of the Common Stock at the commencement date of that offering period or 85% of the fair market value of the Common Stock on the relevant purchase date. Employees are also able to end their participation in the offering at any time during the offering period, and participation ends automatically upon termination of employment. From the Purchase Plan's inception through December 28, 2008, the cumulative number of shares of Common Stock that have been issued under the Purchase Plan was 2.7 million. During 2008, 162 thousand shares were purchased under the plan for a total purchase price of $252 thousand. At December 28, 2008, approximately 1.7 million shares were available for future issuance. 121 (Shares in Thousands) Restricted Stock Units (000's) Weighted- Average Grant-Date Fair Value Nonvested balance at December 31, 2007 2,156 $ 2.28 Grants 810 $ 2.04 Vested (113 ) $ 2.33 Forfeitures (10 ) $ 2.05 Nonvested balance at December 28, 2008 2,843 $ 2.21 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) The fair value of Kratos's ESPP shares for 2008 was estimated using the Black-Scholes option pricing model. The assumptions and resulting fair values of options granted for 2008 were as follows: (1) Offering Period April 1 to September 30 2008 Expected term (in years)(1) 0.5 years Risk-free interest rate(2) 1.53 % Expected volatility(3) 63.1 % Expected dividend yield(4) 0 % Weighted average grant-date fair value per share $0.60 Offering Period October 1 to December 31 2008 Expected term (in years)(1) 0.25 years Risk-free interest rate(2) 0.85 % Expected volatility(3) 48.4 % Expected dividend yield(4) 0 % Weighted average grant-date fair value per share $0.49 The expected term is equivalent to the offering period. (2) The risk-free interest rate is based on U.S. Treasury yields in effect at the time of grant with a term equal to the expected term. (3) The Company estimated implied volatility based upon trailing volatility. (4) The Company has no history or expectation of paying dividends on its common stock. As of December 28, 2008, there was no unrecognized compensation expense related to the Purchase Plan. The weighted average purchase price per common share issued under the Purchase Plan was $1.56. Employees had payroll deductions totaling $0.4 million for the year ended December 28, 2008 to purchase shares through the Purchase Plan. (d) Stockholder Rights Agreement On December 16, 2004, the Company entered into a Stockholder Right Agreement (the "Rights Agreement"). Under the terms of the Rights Agreement, initially, the Rights will attach to all certificates representing shares of outstanding Company common stock and no separate Rights Certificates will be distributed. Subject to the provisions of the Rights Agreement the Rights will separate from the Company common stock and the "Distribution Date" will occur upon the earlier of (i) ten business days following a public announcement (the date of such announcement being the "Stock Acquisition Date") that person or group of affiliated or associated persons has acquired or obtained the right to acquire beneficial ownership of 15% or more of the then-outstanding Common 122 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 11. Stockholders' Equity (Continued) Stock (an "Acquiring Person"), or (ii) ten business days (or such later date as may be determined by action of the Board of Directors prior to such time as any person becomes an Acquiring Person) following the commencement of a tender offer or exchange offer that would result in a person or group becoming an Acquiring Person. An Acquiring Person does not include certain persons specified in the Rights Agreement. On December 16, 2004, the Company's Board of Directors authorized and declared a dividend of one right (a "Right") to purchase one one-hundredth of a share of the Company's Series C Preferred Stock ("Series C Preferred") for each outstanding share of Common Stock, par value $0.001 ("Common Stock"), to stockholders of record as of the close of business December 27, 2004 (the "Record Date"). Each Right entitles the registered holder, subject to the terms of the Rights Agreement, to purchase from the Company one one-hundredth of a share of Series C Preferred at a purchase price of $54.00, subject to adjustment (the "Purchase Price"). The Rights are not exercisable until the Distribution Date and will expire at the close of business on the tenth anniversary of the Rights Agreement unless earlier redeemed or exchanged by the Company. Note 12. Employee Benefit Plan In 1996, the Company implemented a 401(k) savings plan pursuant to Section 401(k) of the Internal Revenue Code (the "Code"), covering substantially all employees. Participants in the plan may contribute a percentage of compensation, but not in excess of the maximum allowed under the Code. The Company may make contributions at the discretion of its Board of Directors. The Company made contributions of $2.5 million in 2006, $2.1 million in 2007 and $2.7 million in 2008. On November 18, 2004, the Board of Directors adopted the Wireless Facilities, Inc. Nonqualified Deferred Compensation Plan, effective as of January 1, 2005 (the "Plan"). The Plan provides executive officers and other eligible highly compensated employees with the opportunity to enter into agreements to defer up to eighty percent (80%) of their cash compensation derived from base salary, bonus awards and/or commissions. In addition, the Company may, in its sole and absolute discretion, award any participant under the Plan an additional employer contribution. Deferrals are adjusted for gain or loss based on the performance of one or more investment options selected by the participant from among investment funds chosen by the committee appointed to administer the Plan. Participants may elect that distribution of deferred amounts be paid in the form of either a lump sum or in annual installments if the participant terminates employment as a result of his or her retirement. However, all other distributions under the Plan will be made in a single lump sum. Distributions occur upon termination of service or upon such other dates that may be elected by the participant in accordance with the terms of the Plan. The Company, in its sole discretion, may suspend or terminate the Plan or revise or amend it in any respect whatsoever; provided, however, that no such action may reduce amounts credited to deferral accounts and such accounts will continue to be owed to the participants or beneficiaries and will continue to be a liability of the Company. 123 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 13. Significant Customers The following table presents our key customers for the years presented and the percentage of net sales made to such customers (in millions): Our top five customers accounted for approximately 47%, 62% and 63% of our total revenue in 2006, 2007 and 2008, respectively. The following table presents net accounts receivable for customers with significant concentrations (in millions): Note 14. Segment Information The Company has historically organized its business along service lines to include three reportable segments: Wireless Network Services (WNS), Enterprise Network Services (ENS) and Government Network Services (GNS). The Wireless Network Services segment was discontinued in the first quarter of 2007 (see Note 3) and we have renamed the ENS segment to the Public Safety & Security (PSS) segment and the GNS segment to the Government Solutions (KGS), otherwise referred to as Kratos Government Solutions, segment to more accurately describe the underlying business operations. Certain income and charges that are not allocated to segments in the Company's management reports because they are not considered in evaluating the segments' operating performance are categorized as reconciling items in the table below. Due to the aforementioned discontinued operations, prior period amounts have been reclassified in order to conform to the current period presentation and allocation methodology. 124 Key Customer Revenue % of Total Revenue 2006 U.S. Navy $ 34.2 22 % 2007 U.S. Army 46.7 24 % U.S. Navy $ 38.7 20 % 2008 U.S. Navy $ 106.9 36 % U.S. Army $ 49.0 16 % Key Customer Accounts receivable, net % of Total accounts receivable, net 2007 U.S. Army $ 15.2 20 % U.S. Navy $ 10.4 14 % 2008 U.S. Navy $ 26.6 28 % Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 14. Segment Information (Continued) Revenues, operating income (loss) and assets provided by the Company's segments for the years ended December 31, 2006, 2007 and December 28, 2008 are as follows (in millions): Unallocated charges are related to corporate expenses previously allocated to the discontinued wireless network services segment prior to the disposal of those businesses, share based compensation charges and related tax adjustments, impairment and restructuring charges and expenses related to the stock option investigation conducted in 2007. As a result of the divestiture of the WNS businesses, the corporate expenses allocated to the PSS and KGS segments has increased in 2007, negatively impacting the operating income (loss) for these continuing operations. The reconciling amounts in 2006 were impacted by increased stock-based compensation expense due to the Company's adoption of SFAS 123R in January 2006. Amounts related to corporate activities in 2007 were impacted by $10.6 million in costs of the stock option investigation and related costs as well as the recovery from the former stock option administrator. In 2008, there was a benefit of $4.5 million in corporate activities due to insurance reimbursements of costs and losses related to the stock option investigation in 2007 as well as recoveries from the theft of stock options that had not previously been agreed to be covered. See Note 17 to Notes to Consolidated Financial Statements. In 2006, the PSS segment has charges of $18.3 million related to the impairment of goodwill and a $1.8 million impairment of an asset. In 2008, the KGS segment had a goodwill impairment charge of $105.8 million. 125 2006 2007 2008 Revenues: Government Solutions $ 97.5 $ 142.5 $ 246.7 Public Safety & Security 55.6 51.1 50.6 Total revenues $ 153.1 193.6 $ 297.3 Operating income (loss) from continuing operations: Government Solutions $ 8.2 $ 3.3 $ (97.3 ) Public Safety & Security (23.9 ) (6.6 ) (1.0 ) Corporate activities (15.8 ) (21.3 ) 3.5 Total operating loss from continuing operations $ (31.5 ) $ (24.6 ) $ (94.8 ) 2007 2008 Assets: Government Solutions $ 292.4 $ 275.9 Public Safety & Security 22.5 17.2 Discontinued Operations 1.7 1.2 Corporate activities 18.7 18.1 Total assets $ 335.3 $ 312.4 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 15. Related Party Transactions On February 17, 2006, the Company entered into a definitive agreement to divest all of its operations in Mexico for total approximate cash consideration of $18.0 million subject to adjustments for the closing net asset calculations, with $1.5 million payable in cash on signing of the Equity Purchase Agreement and $16.5 million by means of a secured promissory note payable in installments through December 2006, which approximates the net book value of the operations. The purchaser, Sakoki LLC, is a newly-formed entity controlled by Massih Tayebi. Although Massih Tayebi has no current role with the Company, he was a co-founder of the Company, having served as Chief Executive Officer from inception in 1994 through September 2000 and as a director from inception through April 2002. In addition, as of July 31, 2007, Massih Tayebi owned or controlled approximately 8.2% of the total voting power of the Company's capital stock. He is also the brother of Masood Tayebi, who was the Company's Chairman of the Board of Directors until March 6, 2007. Masood Tayebi had no personal financial interest in the transaction and has no role with the entity that has purchased the Mexico Operations. The transaction was approved by the disinterested members of the Company's Board of Directors after consideration of other expressions of interest and an independent valuation analysis. The final closing balance sheet as of February 17, 2006 resulted in net asset adjustments aggregating to a total approximate $18.9 million consideration, $1.5 million which was paid on February 17, 2006, with the remaining $17.4 million payable by means of the promissory note in installments through December 31, 2006 with an interest rate of 7.5% per annum. On June 26, 2006, the Company entered into an Addendum with the buyer to finalize the closing net asset calculations, pursuant to which the parties agreed that the resulting total purchase price was $18.9 million. The Addendum also provided for a conditional waiver that permits the purchaser to make the payment due on August 17, 2006 by September 30, 2006, and for the installments due on November 17, 2006 and December 31, 2006 to be made on or before December 29, 2006. Failure to make the payments on such later dates would have resulted in a restoration of the original terms of the note. The first scheduled note payment of $3.3 million was received from the buyer on May 19, 2006, and the second scheduled note payment of $5.5 million was received in installments of $5.2 million on September 29, 2006 and $0.3 million on October 10, 2006. The remaining note receivable balance of $9.5 million which included accrued interest through December 29, 2006, was paid in full on December 29, 2006. Note 16. Commitments and Contingencies The Company periodically evaluates all pending or threatened contingencies and any commitments, if any, that are reasonably likely to have a material adverse effect on its operations or financial position. The Company assesses the probability of an adverse outcome and determines if it is remote, reasonably possible or probable as defined in accordance with the provisions of SFAS 5, "Accounting for Contingencies." If information available prior to the issuance of the Company's financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the Company's financial statements, and the amount of the loss, or the range of probable loss can be reasonably estimated, then such loss is accrued and charged to operations. If no accrual is made for a loss contingency because one or both of the conditions pursuant to SFAS 5 are not met, but the probability of an adverse outcome is at least reasonably possible, the Company will disclose the nature of the contingency and provide an estimate of the possible loss or range of loss, or state that such an estimate cannot be made. 126 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 16. Commitments and Contingencies (Continued) The Company maintains an accrual for the Company's health and workers compensation partial self-insurance, which is a component of total accrued expenses and current liabilities of discontinued operations in the consolidated balance sheets. Management determines the adequacy of these accruals based on a monthly evaluation of the Company's historical experience and trends related to both medical and workers compensation claims and payments, information provided to the Company by the Company's insurance broker, industry experience and the average lag period in which claims are paid. If such information indicates that the Company's accruals require adjustment, the Company will, correspondingly, revise the assumptions utilized in the Company's methodologies and reduce or provide for additional accruals as deemed appropriate. As of December 31, 2006, 2007 and 2008, the accrual for the Company's partial self-insurance programs approximated $1.8 million, $1.1 million and $0.7 million, respectively. In 2006, 2007 and 2008 the accrual for these programs which was related to continuing operations was $0.2 million, $0.6 million, and $0.4 million, respectively. The Company also carries stop-loss insurance that provides coverage limiting the Company's total exposure related to each medical and workers compensation claim incurred, as defined in the applicable insurance policies. The medical and workers compensation annual claim limits are $50,000 and $250,000, respectively. For 2006 the Company had one claim that exceeded the limits for workers compensation and in 2007 and 2008 no claims exceeded the limits for workers compensation. For 2006 and 2008, the Company had no claim that exceeded the limits for medical insurance and in 2007 three claims exceeded the limits for medical insurance. As of December 28, 2008, the Company had $1.5 million in letters of credit outstanding issued primarily to cover a performance bond program and liabilities in connection with the Company's workers' compensation partial self-insurance which has now been cancelled and $34.7 million of written purchase orders which have been issued to vendors, but the goods have not been received or the services have not been performed. Note 17. Legal Matters Contingencies IPO Securities Litigation Beginning in June 2001, the Company and certain of its officers and directors were named as defendants in several parallel class action shareholder complaints filed in the United States District Court for the Southern District of New York, now consolidated under the caption, In re Wireless Facilities, Inc. Initial Public Offering Securities Litigation, Case 01-CV-4779. In the amended complaint, the plaintiffs allege that the Company, certain of its officers and directors, and the underwriters of the Company's initial public offering ("IPO") violated section 11 of the Securities Act of 1933 and section 10(b) of the Securities Exchange Act of 1934 based on allegations that the Company's registration statement and prospectus failed to disclose material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The plaintiffs seek unspecified monetary damages and other relief. Similar complaints were filed in the same court against hundreds of other public companies ("Issuers") that conducted IPOs of their common stock in the late 1990s and 2000. These complaints have been consolidated into an action captioned In re Initial Public Offering Securities Litigation, 21 MC 92 (the "IPO Cases"). In June 2004, the Issuers (including the Company) executed a partial settlement agreement with the plaintiffs that would have, among other things, resulted in the dismissal with prejudice of all claims 127 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 17. Legal Matters (Continued) against the Issuers and their officers and directors and the assignment of certain potential Issuer claims to the plaintiffs. On February 15, 2005, the district court issued a decision certifying a class action for settlement purposes and granting preliminary approval of the settlement subject to modification of certain bar orders contemplated by the settlement. On August 31, 2005, the court reaffirmed class certification of the settlement class and preliminary approval of the modified settlement in a comprehensive Order. On February 24, 2006, the court dismissed litigation filed against certain underwriters in connection with certain claims to be assigned under the settlement. On April 24, 2006, the district court held a Final Fairness Hearing to determine whether to grant final approval of the settlement, and the court reserved decision at that time. While the partial settlement was pending approval, the plaintiffs continued to litigate against the underwriter defendants. The district court directed that the litigation proceed within a number of "focus cases" rather than all of the 310 cases that had been consolidated. The Company's case is not one of these focus cases. On October 13, 2004, the district court certified the focus cases as class actions. The underwriter defendants appealed that ruling and on December 5, 2006, the Second Circuit Court of Appeals reversed the district court's class certification decision. On April 6, 2007, the Second Circuit denied plaintiffs' rehearing petition, but clarified that the plaintiffs could seek to certify a more limited class in the district court. In light of the Second Circuit opinion, liaison counsel for all issuer defendants, including the Company, informed the district court that the settlement could not be approved because the defined settlement class, like the litigation class, could not be certified. On June 24, 2007, the district court entered an order terminating the proposed settlement. Plaintiffs filed second consolidated amended complaints in the six focus cases on August 14, 2007, 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. On March 26, 2008, the district court denied 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. Briefing on the class certification motion was completed in May 2008. That motion was withdrawn without prejudice on October 10, 2008. On February 25, 2009, liaison counsel for the plaintiffs informed the district court that a settlement had been agreed to in principle, subject to formal approval by the parties and preliminary and final approval by the court. Due to the inherent uncertainties of litigation, the ultimate outcome of this matter cannot be predicted. In accordance with FASB 5, " Accounting for Contingencies ," the Company believes any contingent liability related to this claim is not probable or estimable and therefore no amounts have been accrued in regards to this matter. 2004 Securities Litigation In August 2004, following the Company's announcement on August 4, 2004 that it intended to restate its financial statements for the fiscal years ended December 31, 2000, 2001, 2002 and 2003, the Company and certain of its current and former officers and directors were named as defendants ("Defendants") in several securities class action lawsuits filed in the United States District Court for the Southern District of California. These actions were filed on behalf of those who purchased, or otherwise acquired, the Company's common stock between April 26, 2000 and August 4, 2004. The lawsuits generally alleged that, during that time period, Defendants made false and misleading statements to the investing public about the Company's business and financial results, causing its stock 128 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 17. Legal Matters (Continued) to trade at artificially inflated levels. Based on these allegations, the lawsuits alleged that Defendants violated the Securities Exchange Act of 1934, and the plaintiffs sought unspecified damages. These actions were consolidated into a single action—In re Wireless Facilities, Inc. Securities Litigation, Master File 04CV1589-JAH. Plaintiffs filed a First Amended Consolidated Class Action Complaint on April 1, 2005. Defendants filed their motion to dismiss this first amended complaint on April 14, 2005. The plaintiffs then requested leave to amend their first amended complaint. The plaintiffs filed their Second Amended Complaint on June 9, 2005, this time on behalf of those who purchased, or otherwise acquired, the Company's common stock between May 5, 2003 and August 4, 2004. Defendants filed their motion to dismiss this Second Amended Complaint on July 14, 2005. The motion to dismiss was taken under submission on October 20, 2005 and on March 8, 2006, the Court granted the Defendants' motion. However, plaintiffs were granted the right to amend their complaint within 45 days and subsequently filed their Third Amended Consolidated Class Action Complaint on April 24, 2006. Defendants filed a motion to dismiss this complaint on June 8, 2006. On May 7, 2007, the Court denied the Defendants' motion to dismiss. Defendants' filed their answer to the plaintiffs' complaint on July 13, 2007. In February 2008, following a voluntary mediation of the matter, the parties reached a tentative agreement to settle the class action. In June 2008, the parties executed a Memorandum of Understanding documenting the essential terms of the proposed settlement and on August 8, 2008, the parties filed their joint motions for preliminary approval of the proposed settlement with the Court. The Court granted preliminary approval of the proposed settlement on September 3, 2008. On January 13, 2009, following a motion by the parties, the Court granted final approval of the proposed settlement terms, issued its final judgment on the matter, and entered an order dismissing the case with prejudice. Pursuant to the settlement agreement and final order of the Court, plaintiffs and the class dismissed all claims, with prejudice, in exchange for a cash payment in the total amount of $12 million. The Company's directors' and officers' liability insurers paid the settlement amount in accordance with the Company's insurance policies, less the applicable retention or co-insurance obligations that were paid directly by the Company. The Company's amount of payment toward the settlement was approximately $2.4 million. In the fourth quarter of 2008, the Company paid $3.0 million related to this matter, of which $1.0 million was from its restricted cash account. The Company expects to receive $0.6 million from the insurance carriers for this payment in the first half of 2009. Despite the settlement reached in this action, the Company believes that the allegations lacked merit. In 2004, two derivative lawsuits were filed in the United States District Court for the Southern District of California against certain of the Company's current and former officers and directors: Pedicini v. Wireless Facilities, Inc., Case 04CV1663; and Roth v. Wireless Facilities, Inc., Case 04CV1810. These actions were consolidated into a single action in In re Wireless Facilities, Inc. Derivative Litigation, Lead Case No 04CV1663-JAH. These lawsuits contain factual allegations that are substantially similar to those made in the class action lawsuits, but the plaintiffs in these lawsuits assert claims for breach of fiduciary duty, gross mismanagement, abuse of control, waste of corporate assets, violation of Sarbanes Oxley Act section 304, unjust enrichment and insider trading. The plaintiffs in these lawsuits seek unspecified damages and equitable and/or injunctive relief. The lead plaintiff filed a consolidated complaint on March 21, 2005. On May 3, 2005, the defendants filed motions to dismiss this action, to stay this action pending the resolution of the consolidated non-derivative securities case pending in the Southern District of California, and to dismiss the complaint against certain 129 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 17. Legal Matters (Continued) non-California resident defendants. Pursuant to a request by the Court, Defendants' motions were withdrawn without prejudice pending a decision on defendants' motion to dismiss the complaint against the non-California resident defendants. On March 20, 2007, the Court ruled that it lacked personal jurisdiction over five of the six non-California defendants and dismissed them from the federal derivative complaint. On March 27, 2007, plaintiffs filed an amended derivative complaint setting forth all of the same allegations from the original complaint and adding allegations regarding the Company's stock option granting practices. Basically, plaintiffs allege that the Company "backdated" or "springloaded" employee stock option grants so that the options were granted at less than fair market value. The amended complaint names all of the original defendants (including those dismissed for lack of jurisdiction) as well as nine new defendants. On July 2, 2007, the non-California resident defendants moved to dismiss the complaint for lack of personal jurisdiction. On October 17, 2007, the Court took the motion under submission without oral argument. On February 26, 2008, the Court again ruled that it lacked personal jurisdiction over five of the six non-California defendants and dismissed them from the amended federal derivative complaint. Plaintiffs subsequently moved the Court for certification and entry of final judgment of the Court's order dismissing the non-residents for lack of personal jurisdiction so that the plaintiffs may seek immediate appellate review of the matter. On July 10, 2008, the court granted plaintiffs' motion for certification, which was not opposed by defendants. On August 12, 2008, Plaintiffs filed a notice of appeal of the personal jurisdictional order. Neither a briefing schedule nor a hearing date on the matter is presently set. The parties have conferred and discussed the Court's personal jurisdictional order and notice of appeal and have stipulated to a briefing schedule for any remaining motions to dismiss that the Company, along with the individual defendants subject to the court's jurisdiction, may bring in an effort to dismiss the complaint as to them. Pursuant to the parties' stipulation, such motions must be brought on or before March 26, 2009. The Company believes that the allegations lack merit and intends to vigorously defend all claims asserted. It is impossible at this time to assess whether or not the outcome of these proceedings will have a material adverse effect on the Company. In April 2007, another derivative complaint was filed in the United States District Court for the Southern District of California, Hameed v. Tayebi, Case 07-CV-0680 BTM(RBB) (the "Hameed Action"), against several of the Company's current and former officers and directors. The allegations in this derivative complaint mirrored the amended allegations in the 2004 federal derivative action. Pursuant to a Court order and agreement of the parties, the defendants' responses to the complaint in the Hameed Action were stayed until the Court ruled on the motion to dismiss for lack of personal jurisdiction in the 2004 derivative litigation. As noted above, on February 26, 2008, the Court ruled that it lacked personal jurisdiction over five of the non-California defendants named in the 2004 derivative action, including three that were also named in the Hameed Action. In August 2008, and before defendants had responded to the complaint, Plaintiff voluntarily dismissed the Hameed Action pursuant to Federal Rule of Civil Procedure 41(a). The Company believes that the allegations lacked merit and intended to vigorously defend all claims asserted. In August and September 2004, two virtually identical derivative lawsuits were filed in California Superior Court for San Diego County against certain of the Company's current and former officers and directors. These actions contain factual allegations similar to those of the federal lawsuits, but the plaintiffs in these cases assert claims for violations of California's insider trading laws, breaches of fiduciary duty, abuse of control, gross mismanagement, waste of corporate assets and unjust 130 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 17. Legal Matters (Continued) enrichment. The plaintiffs in these actions seek unspecified damages, equitable and/or injunctive relief and disgorgement of all profits, benefits and other compensation obtained by defendants. These lawsuits have been consolidated into one action—In re Wireless Facilities, Inc. Derivative Litigation, California Superior Court, San Diego County, Lead Case GIC 834253. The plaintiffs filed a Consolidated Shareholder Derivative Complaint on October 14, 2004. This action has been stayed pending a decision in federal court on a motion to dismiss the federal derivative lawsuit. In October 2008, the parties notified the Court of the status of the federal action and the court continued the stay for an additional six months. The Court also ordered the parties to file an updated status report in April 2009. The Company believes that the allegations lack merit and intends to vigorously defend all claims asserted. It is impossible at this time to assess whether or not the outcome of these proceedings will have a material adverse effect on the Company. The Company has recorded an accrual for a contingent liability associated with the legal proceedings related to the derivative actions of $0.7 million based on the Company's estimate of the potential amount it could have to pay in relation to these lawsuits. 2007 Securities Litigation In March and April 2007, there were three federal class actions filed in the United States District Court for the Southern District of California against the Company and several of its current and former officers and directors. These class action lawsuits followed the Company's March 12, 2007 public announcement that it was conducting a voluntary internal review of its stock option granting processes. These actions were consolidated into a single action, In re Wireless Facilities, Inc. Securities Litigation II, Master File 07-CV-0482-BTM-NLS. The consolidated class action complaint was filed on November 19, 2007. In March 2008, following a voluntary mediation of the matter, the parties reached a tentative agreement to settle the class action. In May 2008, the parties executed a Memorandum of Understanding documenting the essential terms of the proposed settlement and on August 8, 2008, the parties filed their joint motions for preliminary approval of the proposed settlement with the Court. The Court granted preliminary approval of the proposed settlement on September 3, 2008. On December 19, 2008, following a motion by the parties, the Court granted final approval of the proposed settlement terms, issued its final judgment on the matter, and entered an order dismissing the case with prejudice. Pursuant to the settlement agreement and final order of the Court, plaintiffs and the class dismissed all claims, with prejudice, in exchange for a cash payment in the amount of $4.5 million. The Company's directors' and officers' liability insurers paid the settlement amount, less the applicable retention or co-insurance obligations and contributions that were paid directly by the Company. In July 2008, the Company paid $1.8 million related to the settlement of this litigation. Despite the settlement reached in this action, the Company believes that the allegations lacked merit. Other Litigation and Government Investigations In January 2005, a former independent contractor of the Company filed a lawsuit in Brazil against the Company's subsidiary, WFI de Brazil, to which he had been assigned for a period of time. He sought to be designated an employee of WFI de Brazil and entitled to severance and related compensation pursuant to Brazilian labor law. The individual sought back wages, vacation pay, stock 131 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 17. Legal Matters (Continued) option compensation and related benefits in excess of $0.5 million. This matter was argued before the appropriate labor court in July 2005 and in July 2006, the labor court awarded the individual the Brazilian currency equivalent of approximately $0.4 million for his back wages, vacation pay and certain other benefits. The Company filed an appeal in the matter on July 20, 2006 and is challenging the basis for the award on several theories. On August 22, 2007, the appeals court partially upheld the Company's appeal, although it upheld the individual's designation as an employee. The court is reviewing possible damage calculations before publishing a final decision. The Company's counsel is preparing a motion for clarification of the judgment due to omissions in the decision. The Company has accrued approximately $0.4 million as of December 28, 2008 related to this matter. On March 28, 2007, three plaintiffs, on behalf of a purported class of similarly situated employees and contractors, filed a lawsuit against the Company in the Superior Court of the State of California, Alameda County. The suit alleges various violations of the California Labor Code and seeks payments for allegedly unpaid straight time and overtime, meal period pay and associated penalties. The Company and the plaintiffs agreed to venue for the suit in San Diego County. Although the Company believes that the allegations lack merit, it has agreed with the plaintiffs to settle their claims for an aggregate amount in the range of $0.3 million to $0.5 million, to include individual and incentive awards, attorneys' fees and administrative costs, subject to court approval. The actual amount paid by the Company will depend upon the number of responses received from members of the purported class of plaintiffs. The Company has recorded an accrual for a contingent liability associated with this legal proceeding in the amount of $0.3 million. On May 3, 2007, Kratos announced that it had a filed a lawsuit against a former employee who previously served as its stock option administrator and left Kratos in mid-2004, and his spouse. The lawsuit sought to recover damages resulting from the theft by a former employee of Kratos stock options and common stock valued in excess of $6.3 million. The thefts, which appear to have taken place during 2002 and 2003, were discovered through the Kratos review of its past practices related to the granting and pricing of employee stock options with the assistance of its outside counsel and forensic computer consultants. The complaint also alleged that the former employee attempted to cover up the scheme by, among other things, deleting entries from the records of Kratos. Kratos promptly reported to the SEC the discovery of the theft. The SEC initiated an inquiry and commenced an enforcement action against the former employee. The U.S. Attorney's Office also forwarded a grand jury subpoena to Kratos seeking records related to the former employee and Kratos' historical option granting practices. The SEC filed a federal lawsuit and obtained a temporary restraining order and asset freeze against the former employee and his spouse. The U.S. Attorney's Office indicted him for the theft and he pled guilty to federal criminal charges and has been sentenced to 46 months in prison and currently is incarcerated. On April 1, 2008, the SEC notified Kratos that it had completed its investigation and that it did not intend to recommend any enforcement action by the SEC against the Company. Kratos has cooperated with, and continues to cooperate with the U.S. Attorney's Office on this matter and otherwise. The former employee and his wife entered into a settlement agreement with Kratos on October 5, 2007, turning over substantially all of their assets to Kratos in settlement of the damages incurred in the theft. On February 15, 2008, the SEC approved the settlement. On February 19, 2008, the court entered a final judgment approving the settlement. Kratos has obtained the assets, which aggregate approximately $3.4 million, and is in the process of liquidating 132 Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 17. Legal Matters (Continued) the remaining assets which approximate $0.1 million in value. In June 2008, Kratos' insurance carrier agreed to reimburse Kratos for $0.6 million related to the theft of stock options. Kratos' directors' and officers' liability insurers have agreed to reimburse it for $4.1 million related to fees previously incurred on the ongoing investigation by the U.S. Attorney's Office as well as fees previously incurred on the SEC investigation. As a result, a benefit for this amount has been recorded in the recovery of unauthorized issuance of stock options and stock option investigation and related fees line item in the accompanying Consolidated Statements of Operations. In addition to the foregoing matters, from time to time, the Company may become involved in various claims, lawsuits and legal proceedings that arise in the ordinary course of business. However, litigation is subject to inherent uncertainties, and an adverse result in these or other matters may arise from time to time that may harm the Company's business. The Company is currently not aware of any such legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse affect on our business, financial condition, operating results or cash flows. Note 18. Quarterly Financial Data (Unaudited) The following financial information reflects all normal and recurring adjustments that are, in the opinion of management, necessary for a fair statement of the results of the interim periods. Summarized quarterly data for the years ended December 31, 2007 and 2008, is as follows (in millions, except per share data): Quarterly Results in 2007 The Company's results by quarter in 2007 were impacted by the divestitures of its wireless network services segment. In the first quarter of 2007 the loss was primarily due to impairment of assets related to the Wireless Deployment business of $13.4 million and an impairment of goodwill related to this business of $7.2 million partially offset by a gain of $3.3 million on the sale of the EMEA business. The second quarter income was impacted by a gain of $14.8 million on the sale of the Wireless Engineering Services business operations. The third quarter was impacted by a $1.9 million loss from the disposal of our deployment business and a $2.1 million excess facility accrual. The fourth quarter was impacted by a gain of $3.4 million related to the recovery of assets under the settlement with the Company's former stock option administrator as well as an expense of $4.9 million related to our estimated cost of the 133 First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal year 2007 Revenues $ 49.0 $ 47.8 $ 47.5 $ 49.3 Gross profit $ 7.3 $ 7.5 $ 8.2 $ 8.6 Operating loss from continuing operations $ (3.3 ) $ (8.3 ) $ (8.4 ) $ (4.6 ) Provision for income taxes $ 0.2 $ 0.3 $ 0.4 $ 0.4 Net income (loss) $ (20.1 ) $ 4.2 $ (13.4 ) $ (11.5 ) Net income (loss) per common share: Basic $ (0.28 ) $ 0.06 $ (0.18 ) $ (0.16 ) Diluted $ (0.28 ) $ 0.06 $ (0.18 ) $ (0.16 ) Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 18. Quarterly Financial Data (Unaudited) (Continued) settlement of our 2004 and 2007 Securities Litigation. See Note 17 to Notes to Consolidated Financial Statements. Quarterly Results in 2008 In the fourth quarter of 2008, the Company recorded a non-cash impairment charge of the carrying value of its goodwill of $105.8 million as a result of adverse equity market conditions and the resulting decline in current market multiples and the company's stock price. The Company recorded benefits for the recovery of unauthorized stock options and fees related to the ongoing investigation by the U.S. Attorney's Office of $0.6 million, $1.0 million and $2.9 million for the second, third and fourth quarters, respectively, as a result of agreements reached with the Company's insurance carriers to cover these losses and expenses. See Note 17 to Notes to Consolidated Financial Statements. Note 19. Subsequent Events As of December 28, 2008, the Company had outstanding convertible notes payable which were acquired as a result of the SYS acquisition totaling $3.1 million. The convertible notes payable are unsecured and subordinated to the Company's bank debt and bear interest at 10% per annum payable quarterly. Principal is due February 14, 2009 and the notes are convertible at any time into shares of common stock at a conversion rate of $2.86 per share. In February 2009, in the interest of preserving cash due to the current macroeconomic conditions, the Company provided each note holder with the option to: (1) be paid cash in accordance with the original agreement; (2) extend the note for an additional 18 months at the existing 10% rate and modify the conversion feature to the lower of the existing conversion price of $2.86 per share or the Kratos closing share value on February 13, 2009; or (3) convert the principal balance of Kratos shares at the lower of the existing conversion price of $2.86 or the Kratos closing share value on February 13, 2009 less a 10% discount. As of February 28, 2009, $1.8 million of the notes have been paid, $1.0 million of the notes have been extended to August 14, 2010, and $25,000 have been converted to common shares. Holders of approximately $0.2 million of the notes have not responded. 134 First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal year 2008 Revenues $ 68.2 $ 72.3 $ 80.6 $ 76.2 Gross profit $ 12.6 $ 12.9 $ 17.5 $ 16.5 Operating income (loss) from continuing operations $ 0.7 $ 2.9 $ 3.8 $ (107.0 ) Provision (benefit) for income taxes $ 0.5 $ 0.4 $ 0.5 $ (2.1 ) Net income (loss) $ (1.9 ) $ 0.8 $ (0.2 ) $ (109.8 ) Net income (loss) per common share: Basic $ (0.02 ) $ 0.01 $ (0.00 ) $ (1.03 ) Diluted $ (0.02 ) $ 0.01 $ (0.00 ) $ (1.03 ) Table of Contents KRATOS DEFENSE & SECURITY SOLUTIONS, INC. Notes to Consolidated Financial Statements (Continued) December 28, 2008 Note 19. Subsequent Events (Continued) Given continued significant decline in the stock market in general and specifically our stock price in 2009, we believe it is more likely than not that this could be an indication of additional goodwill impairment and could potentially result in a triggering event under SFAS 142 and an additional goodwill impairment charge in the first quarter of 2009. 135   QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 10.6 INDEMNIFICATION AGREEMENT This INDEMNIFICATION AGREEMENT (this " Agreement ") is made and entered into this day of , 20 (the "Effective Date") by and between Kratos Defense & Security Solutions, Inc., a Delaware corporation (the " Company "), and [ ] (the " Indemnitee "). WHEREAS, the Company believes it is essential to retain and attract qualified directors and officers; WHEREAS, the Indemnitee is a director and/or officer of the Company; WHEREAS, both the Company and the Indemnitee recognize the increased risk of litigation and other claims being asserted against directors and officers of public companies; WHEREAS, the Company's Certificate of Incorporation (the "Certificate of Incorporation ") and Bylaws (the " Bylaws ") require the Company to indemnify and advance expenses to its directors and officers to the extent permitted by the DGCL (as hereinafter defined); WHEREAS, the Indemnitee has been serving and intends to continue serving as a director and/or officer of the Company in part in reliance on the Certificate of Incorporation and Bylaws; and WHEREAS, in recognition of the Indemnitee's need for (i) substantial protection against personal liability based on the Indemnitee's reliance on the Certificate of Incorporation and Bylaws, (ii) specific contractual assurance that the protection promised by the Certificate of Incorporation and Bylaws will be available to the Indemnitee, regardless of, among other things, any amendment to or revocation of the Bylaws or any change in the composition of the Company's Board of Directors (the " Board ") or acquisition transaction relating to the Company, and (iii) an inducement to continue to provide effective services to the Company as a director and/or officer thereof, the Company wishes to provide for the indemnification of the Indemnitee and to advance expenses to the Indemnitee to the fullest extent permitted by law and as set forth in this Agreement, and, to the extent insurance is maintained by the Company, to provide for the continued coverage of the Indemnitee under the Company's directors' and officers' liability insurance policies. NOW, THEREFORE, in consideration of the premises contained herein and of the Indemnitee continuing to serve the Company directly or, at its request, with another enterprise, and intending to be legally bound hereby, the parties hereto agree as follows: 1. Certain Definitions. (a) A " Change in Control " shall be deemed to have occurred if: (i) any "person," as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended, and the rules and regulations thereunder (the " Exchange Act "), other than (a) a trustee or other fiduciary holding securities under an employee benefit plan of the Company; (b) a corporation owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company; or (c) any current beneficial stockholder or group, as defined by Rule 13d-5 of the Exchange Act, including the heirs, assigns and successors thereof, of beneficial ownership, within the meaning of Rule 13d-3 of the Exchange Act, of securities possessing more than 50% of the total combined voting power of the Company's outstanding securities; hereafter becomes the "beneficial owner," as defined in Rule 13d-3 of the Exchange Act, directly or indirectly, of securities of the Company representing 20% or more of the total combined voting power represented by the Company's then outstanding Voting Securities; (ii) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board and any new director whose election by the Board or nomination 1  for election by the Company's stockholders was approved by a vote of at least two-thirds of the directors then in office who either were directors at the beginning of the period or whose election or nomination for election was previously so approved, cease for any reason to constitute a majority thereof; or (iii) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the Voting Securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into Voting Securities of the surviving entity) at least 80% of the total voting power represented by the Voting Securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company, in one transaction or a series of transactions, of all or substantially all of the Company's assets. (b) " DGCL " shall mean the General Corporation Law of the State of Delaware, as the same exists or may hereafter be amended or interpreted; provided, however, that in the case of any such amendment or interpretation, only to the extent that such amendment or interpretation permits the Company to provide broader indemnification rights than were permitted prior thereto. (c) " Expense " shall mean attorneys' fees and all other costs, expenses and obligations paid or incurred in connection with investigating, defending, being a witness in or participating in (including on appeal), or preparing for any of the foregoing, any Proceeding relating to any Indemnifiable Event. (d) " Indemnifiable Event " shall mean any event or occurrence that takes place either prior to or after the execution of this Agreement, related to the fact that the Indemnitee is or was a director or officer of the Company, or is or was serving at the request of the Company as a director, officer, employee, or agent of another corporation or of a partnership, joint venture, trust or other enterprise, including service with respect to employee benefit plans, or by reason of anything done or not done by the Indemnitee in any such capacity. (e) " Proceeding " shall mean any threatened, pending or completed action, suit, investigation or proceeding, and any appeal thereof, whether civil, criminal, administrative or investigative and/or any inquiry or investigation, whether conducted by the Company or any other party, that the Indemnitee in good faith believes might lead to the institution of any such action. (f) " Reviewing Party " shall mean any appropriate person or body consisting of a member or members of the Company's Board or any other person or body appointed by the Board (including the special independent counsel referred to in Section 6) who is not a party to the particular Proceeding with respect to which the Indemnitee is seeking indemnification. (g) " Voting Securities " shall mean any securities of the Company which vote generally in the election of directors. 2. Indemnification. In the event the Indemnitee was or is a party to or is involved (as a party, witness, or otherwise) in any Proceeding by reason of (or arising in part out of) an Indemnifiable Event, whether the basis of the Proceeding is the Indemnitee's alleged action in an official capacity as a director or officer or in any other capacity while serving as a director or officer, the Company shall indemnify the Indemnitee to the fullest extent permitted by the DGCL against any and all Expenses, liability, and loss (including judgments, fines, ERISA excise taxes or penalties, and amounts paid or to be paid in settlement, and any interest, assessments, or other charges imposed thereon, and any federal, state, local, or foreign taxes imposed on any director or officer as a result of the actual or deemed receipt of any payments under this Agreement) (collectively, " Liabilities ") reasonably incurred or suffered by such person in connection with such Proceeding. The Company shall provide 2 indemnification pursuant to this Section 2 as soon as practicable, but in no event later than 30 days after it receives written demand from the Indemnitee. Notwithstanding anything in this Agreement to the contrary and except as provided in Section 5 below, the Indemnitee shall not be entitled to indemnification pursuant to this Agreement (i) in connection with any Proceeding initiated by the Indemnitee against the Company or any director or officer of the Company unless the Company has joined in or consented to the initiation of such Proceeding or (ii) on account of any suit in which judgment is rendered against the Indemnitee pursuant to Section 16(b) of the Exchange Act for an accounting of profits made from the purchase or sale by the Indemnitee of securities of the Company. 3. Advancement of Expenses. The Company shall advance Expenses to the Indemnitee within 30 business days of such request (an " Expense Advance "); provided, however, that if required by applicable corporate laws such Expenses shall be advanced only upon delivery to the Company of an undertaking by or on behalf of the Indemnitee to repay such amount if it is ultimately determined that the Indemnitee is not entitled to be indemnified by the Company; and provided further, that the Company shall make such advances only to the extent permitted by law. Expenses incurred by the Indemnitee while not acting in his/her capacity as a director or officer, including service with respect to employee benefit plans, may be advanced upon such terms and conditions as the Board, in its sole discretion, deems appropriate. 4. Review Procedure for Indemnification. Notwithstanding the foregoing, (i) the obligations of the Company under Sections 2 and 3 above shall be subject to the condition that the Reviewing Party shall not have determined (in a written opinion, in any case in which the special independent counsel referred to in Section 6 hereof is involved) that the Indemnitee would not be permitted to be indemnified under applicable law, and (ii) the obligation of the Company to make an Expense Advance pursuant to Section 3 above shall be subject to the condition that, if, when and to the extent that the Reviewing Party determines that the Indemnitee would not be permitted to be so indemnified under applicable law, the Company shall be entitled to be reimbursed by the Indemnitee (who hereby agrees to reimburse the Company) for all such amounts theretofore paid; provided, however, that if the Indemnitee has commenced legal proceedings in a court of competent jurisdiction pursuant to Section 5 below to secure a determination that the Indemnitee should be indemnified under applicable law, any determination made by the Reviewing Party that the Indemnitee would not be permitted to be indemnified under applicable law shall not be binding and the Indemnitee shall not be required to reimburse the Company for any Expense Advance until a final judicial determination is made with respect thereto (as to which all rights of appeal therefrom have been exhausted or have lapsed). The Indemnitee's obligation to reimburse the Company for Expense Advances pursuant to this Section 4 shall be unsecured and no interest shall be charged thereon. The Reviewing Party shall be selected by the Board, unless there has been a Change in Control, other than a Change in Control which has been approved by a majority of the Company's Board who were directors immediately prior to such Change in Control, in which case the Reviewing Party shall be the special independent counsel referred to in Section 6 hereof. 5. Enforcement of Indemnification Rights. If the Reviewing Party determines that the Indemnitee substantively would not be permitted to be indemnified in whole or in part under applicable law, or if the Indemnitee has not otherwise been paid in full pursuant to Sections 2 and 3 above within 30 days after a written demand has been received by the Company, the Indemnitee shall have the right to commence litigation in any court in the State of Delaware having subject matter jurisdiction thereof and in which venue is proper to recover the unpaid amount of the demand (an " Enforcement Proceeding ") and, if successful in whole or in part, the Indemnitee shall be entitled to be paid any and all Expenses in connection with such Enforcement Proceeding. The Company hereby consents to service of process for such Enforcement Proceeding and to appear in any such Enforcement Proceeding. Any determination by the Reviewing Party otherwise shall be conclusive and binding on the Company and the Indemnitee. 3  6. Change in Control. The Company agrees that if there is a Change in Control of the Company, other than a Change in Control which has been approved by a majority of the Company's Board who were directors immediately prior to such Change in Control, then with respect to all matters thereafter arising concerning the rights of the Indemnitee to indemnity payments and Expense Advances under this Agreement or any other agreement or under applicable law or the Company's Certificate of Incorporation or Bylaws now or hereafter in effect relating to indemnification for Indemnifiable Events, the Company shall seek legal advice only from special independent counsel selected by the Indemnitee and approved by the Company, which approval shall not be unreasonably withheld. Such special independent counsel shall not have otherwise performed services for the Company or the Indemnitee, other than in connection with such matters, within the last five years. Such independent counsel shall not include any person who, under the applicable standards of professional conduct then prevailing, would have a conflict of interest in representing either the Company or the Indemnitee in an action to determine the Indemnitee's rights under this Agreement. Such counsel, among other things, shall render its written opinion to the Company and the Indemnitee as to whether and to what extent the Indemnitee would be permitted to be indemnified under applicable law. The Company agrees to pay the reasonable fees of the special independent counsel referred to above and to indemnify fully such counsel against any and all expenses (including attorneys' fees), claims, liabilities and damages arising out of or relating to this Agreement or the engagement of special independent counsel pursuant to this Agreement. 7. Partial Indemnity. If the Indemnitee is entitled under any provision of this Agreement to indemnification by the Company for some or a portion of the Expenses and Liabilities, but not, however, for all of the total amount thereof, the Company shall nevertheless indemnify the Indemnitee for the portion thereof to which the Indemnitee is entitled. Moreover, notwithstanding any other provision of this Agreement, to the extent that the Indemnitee has been successful on the merits or otherwise in defense of any or all Proceedings relating in whole or in part to an Indemnifiable Event or in defense of any issue or matter therein, including dismissal without prejudice, the Indemnitee shall be indemnified against all Expenses incurred in connection therewith. In connection with any determination by the Reviewing Party or otherwise as to whether the Indemnitee is entitled to be indemnified hereunder, the burden of proof shall be on the Company to establish that the Indemnitee is not so entitled. 8. Non-exclusivity. The rights of the Indemnitee hereunder shall be in addition to any other rights the Indemnitee may have under any statute, provision of the Company's Certificate of Incorporation or Bylaws, vote of stockholders or disinterested directors or otherwise, both as to action in an official capacity and as to action in another capacity while holding such office. To the extent that a change in the DGCL permits greater indemnification by agreement than would be afforded currently under the Company's Certificate of Incorporation and Bylaws and this Agreement, it is the intent of the parties hereto that the Indemnitee shall enjoy by this Agreement the greater benefits so afforded by such change. 9. Liability Insurance. To the extent the Company maintains an insurance policy or policies providing directors' and officers' liability insurance, the Indemnitee shall be covered by such policy or policies, in accordance with its or their terms, to the maximum extent of the coverage available for any director or officer of the Company. 10. Settlement of Claims. The Company shall not be liable to indemnify the Indemnitee under this Agreement (a) for any amounts paid in settlement of any action or claim effected without the Company's written consent, which consent shall not be unreasonably withheld; or (b) for any judicial award if the Company was not given a reasonable and timely opportunity, at its expense, to participate in the defense of such action. 4  11. No Presumption. For purposes of this Agreement, to the fullest extent permitted by law, the termination of any Proceeding, action, suit or claim, by judgment, order, settlement (whether with or without court approval) or conviction, or upon a plea of nolo contendere, or its equivalent, shall not create a presumption that the Indemnitee did not meet any particular standard of conduct or have any particular belief or that a court has determined that indemnification is not permitted by applicable law. 12. Period of Limitations. No legal action shall be brought and no cause of action shall be asserted by or on behalf of the Company or any affiliate of the Company against the Indemnitee, the Indemnitee's spouse, heirs, executors or personal or legal representatives after the expiration of two years from the date of accrual of such cause of action, or such longer period as may be required by state law under the circumstances, and any claim or cause of action of the Company or its affiliate shall be extinguished and deemed released unless asserted by the timely filing of a legal action within such period; provided, however, that if any shorter period of limitations is otherwise applicable to any such cause of action, such shorter period shall govern. 13. Consent and Waiver by Third Parties. The Indemnitee hereby represents and warrants that he or she has obtained all waivers and/or consents from third parties which are necessary for his or her employment with the Company on the terms and conditions set forth herein and to execute and perform this Agreement without being in conflict with any other agreement, obligation or understanding with any such third party. The Indemnitee represents that he or she is not bound by any agreement or any other existing or previous business relationship which conflicts with, or may conflict with, the performance of his or her obligations hereunder or prevent the full performance of his or her duties and obligations hereunder. 14. Amendment of this Agreement. No supplement, modification or amendment of this Agreement shall be binding unless executed in writing by both of the parties hereto. No waiver of any of the provisions of this Agreement shall be deemed or shall constitute a waiver of any other provisions hereof (whether or not similar), nor shall such waiver constitute a continuing waiver. Except as specifically provided herein, no failure to exercise or any delay in exercising any right or remedy hereunder shall constitute a waiver thereof. 15. Subrogation. In the event of payment under this Agreement, the Company shall be subrogated to the extent of such payment to all of the rights of recovery of the Indemnitee [(other than against the Other Indemnitors)], who shall execute all papers required and shall do everything that may be necessary to secure such rights, including the execution of such documents necessary to enable the Company effectively to bring suit to enforce such rights. 16. No Duplication of Payments. The Company shall not be liable under this Agreement to make any payment in connection with any claim made against Indemnitee to the extent the Indemnitee has otherwise actually received payment (under any insurance policy, Bylaw, vote, agreement or otherwise) of the amounts otherwise indemnifiable hereunder. 17. Binding Effect. This Agreement shall be binding upon and inure to the benefit of and be enforceable by the parties hereto and their respective successors, assigns, including any direct or indirect successor by purchase, merger, consolidation or otherwise to all or substantially all of the business and/or assets of the Company, spouses, heirs, and personal and legal representatives. The Company shall require and cause any successor (whether direct or indirect by purchase, merger, consolidation or otherwise) to all, substantially all, or a substantial part, of the business and/or assets of the Company, by written agreement in form and substance satisfactory to the Indemnitee, expressly to assume and agree to perform this Agreement in the same manner and to the same extent that the Company would be required to perform if no such succession had taken place. This Agreement shall continue in effect regardless of whether the Indemnitee continues to serve as a director or officer of the Company or of any other enterprise at the Company's request. 5  18. Severability. The provisions of this Agreement shall be severable in the event that any of the provisions hereof (including any provision within a single section, paragraph or sentence) is held by a court of competent jurisdiction to be invalid, void or otherwise unenforceable, and the remaining provisions shall remain enforceable to the fullest extent permitted by law. Furthermore, to the fullest extent possible, the provisions of this Agreement (including, without limitation, each portion of this Agreement containing any provision held to be invalid, void or otherwise unenforceable, that is not itself invalid, void or unenforceable) shall be construed so as to give effect to the intent manifested by the provision held invalid, illegal or unenforceable. 19. Governing Law. This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of Delaware applicable to contracts made and to be performed in such State without giving effect to the principles of conflicts of laws. 20. Counterparts. This Agreement may be executed in one or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. 21. Notices. All notices, demands, and other communications required or permitted hereunder shall be made in writing and shall be deemed to have been duly given if delivered by hand, against receipt, or mailed, postage prepaid, certified or registered mail, return receipt requested, and addressed to the Company at: and to the Indemnitee at: Notice of change of address shall be effective only when done in accordance with this Section. All notices complying with this Section shall be deemed to have been received on the date of delivery or on the third business day after mailing. 6  IN WITNESS WHEREOF, the parties hereto have duly executed and delivered this Agreement as of the day first set forth above. 7 THE COMPANY: KRATOS DEFENSE & SECURITY SOLUTIONS, INC. By: Name: Title: INDEMNITEE: Signature Print Name:  QuickLinks EXHIBIT 10.6  QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We have issued our reports dated March 9, 2009, with respect to the consolidated financial statements and internal control over financial reporting included in the Annual Report of Kratos Defense & Security Solutions Inc. and subsidiaries on Form 10-K for the year ended December 28, 2008. We hereby consent to the incorporation by reference of said reports in the Registration Statements of Kratos Defense & Security Solutions, Inc. and subsidiaries on Forms S-3 (File No. 333-53014, effective December 29, 2000, File No. 333-71618, effective October 15, 2001, File No. 333-74108, effective November 28, 2001, and File No. 333-112956, effective February 19, 2004), on Form S-4 (File No. 333-112957, effective February 19, 2004, File No. 333-150165, effective April 10, 2008, and File No. 333-155604, effective November 24, 2008) and on Forms S-8 (File No. 333-90455, effective November 5, 1999, File No. 333-54818, February 1, 2001, File No. 333-71702, effective October 17, 2001, File No. 333-91852, effective July 2, 2002, File No. 333-116903, effective June 28, 2004, No. 333-124957, effective May 16, 2005, File No. 333-127060, effective August 1, 2005 and File No. 333-155317, effective November 12, 2008). /s/GRANT THORNTON LLP San Diego, CA March 9, 2009  QuickLinks EXHIBIT 23.1 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 31.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Eric M. DeMarco, certify that: 1. I have reviewed this annual report on Form 10-K of Kratos Defense & Security Solutions, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 10, 2009 /s/ ERIC M. DEMARCO Eric M. De Marco Chief Executive Officer and President (Principal Executive Officer)  QuickLinks EXHIBIT 31.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002  QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 31.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002 I, Deanna H. Lund, certify that: 1. I have reviewed this annual report on Form 10-K of Kratos Defense & Security Solutions, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-(f))for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing similar functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: March 10, 2009 /s/ DEANNA H. LUND Deanna H. Lund Chief Financial Offer (Principal Financial Officer)  QuickLinks EXHIBIT 31.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002  QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 18 U.S.C SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Kratos Defense & Security Solutions, Inc. (the "Company") on Form 10-K for the fiscal year ended December 31, 2007 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Eric M. DeMarco, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that to my knowledge: 1. The Report fully complies with the requirements of Section 13(a) or 15(d), of the Securities Exchange Act of 1934; and 2. That the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 10, 2009 KRATOS DEFENSE & SECURITY SOLUTIONS, INC. /s/ ERIC M. DEMARCO Chief Executive Officer  QuickLinks EXHIBIT 32.1 CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 18 U.S.C SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002  QuickLinks -- Click here to rapidly navigate through this document EXHIBIT 32.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 18 U.S.C SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report of Kratos Defense & Security Solutions, Inc. (the "Company") on Form 10-K for the fiscal year ended December 31, 2007 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Deanna H. Lund, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: 1. The Report fully complies with the requirements of Section 13(a) or 15(d), of the Securities Exchange Act of 1934; and 2. That the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. Date: March 10, 2009 KRATOS DEFENSE & SECURITY SOLUTIONS, INC. /s/ DEANNA H. LUND Chief Financial Officer  QuickLinks EXHIBIT 32.2 CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 18 U.S.C SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 

Continue reading text version or see original annual report in PDF format above