Hughes Communications 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
For the Transition Period from ____ to____
Commission file number: 001-33040
(Exact Name of Registrant as Specified in Its Charter)
11717 Exploration Lane, Germantown, Maryland 20876
(Address of Principal Executive Offices and Zip Code)
(Registrant’s Telephone Number, Including Area Code)
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 x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check one):
Indicate by check mark whether the company is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of the registrant’s common stock outstanding as of May 5, 2008 was 19,189,128.
CONDENSED CONSOLIDATED BALANCE SHEETS
See accompanying Notes to the Condensed Consolidated Financial Statements.
HUGHES COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share amounts)
See accompanying Notes to the Condensed Consolidated Financial Statements.
HUGHES COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying Notes to the Condensed Consolidated Financial Statements.
HUGHES COMMUNICATIONS, INC.
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Hughes Communications, Inc. (“HCI” and, together with its consolidated subsidiaries, the “Company” or “we”) was formed as a Delaware corporation on June 23, 2005. The Company is a publicly-traded company, and its stock trades on the National Association of Securities Dealers Automated Quotations System—Global Select Market under the symbol “HUGH.” We operate our business primarily through our wholly-owned subsidiary, Hughes Network Systems, LLC (“HNS”), a telecommunications company.
We are a provider of satellite based communications services and equipment that utilize very small aperture terminals (“VSAT”) to distribute signals via satellite as a means of connecting participants in private and shared data networks. VSAT networks are typically used by enterprises with a large number of geographically dispersed locations to provide reliable, scalable, and cost-effective applications, such as credit card verification, inventory tracking and control and broadcast video. Our broadband satellite network services and systems are provided to the international and domestic enterprise markets, and our satellite Internet access is provided to North American consumers which we refer to as the Consumer market. We also provide managed services to enterprises that combine the use of satellite and terrestrial alternatives, thus offering solutions that are tailored and cost optimized to the specific customer requirements.
In addition, we provide networking systems solutions to customers for mobile satellite, telematics and wireless backhaul systems. These services are generally provided on a contract or project basis and may involve the use of proprietary products engineered by us.
In August 2007, we launched our SPACEWAYTM 3 satellite (“SPACEWAY 3”) to support the growth of our North American Consumer and Enterprise businesses and introduced service in North America on the SPACEWAY system in April 2008. The launch of service on the SPACEWAY system will enable us to expand our business by increasing our addressable markets in North America.
Basis of Presentation
The accompanying condensed consolidated financial statements have been prepared in accordance with: (i) generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information; (ii) the instructions to Form 10-Q; and (iii) the guidance of Rule 10-01 of Regulation S-X under the Securities and Exchange Act of 1934, as amended, for financial statements required to be filed with the Securities and Exchange Commission (“SEC”). They include the assets, liabilities, results of operations and cash flows of the Company, including its domestic and foreign subsidiaries that are more than 50% owned or otherwise controlled by the Company. As permitted under such rules, certain notes and other financial information normally required by GAAP have been condensed or omitted. Management believes the accompanying condensed consolidated financial statements reflect all normal and recurring adjustments necessary for a fair presentation of the Company’s financial position, results of operations, and cash flows as of and for the periods presented herein. Our results of operations for the three months ended March 31, 2008 may not be indicative of our future results. These condensed consolidated financial statements are unaudited and should be read in conjunction with our audited consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007.
All intercompany balances and transactions with subsidiaries and other consolidated entities have been eliminated.
Use of Estimates in the Preparation of the Condensed Consolidated Financial Statements
The preparation of the condensed consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions that affect amounts reported herein. Management bases its estimates and assumptions on historical experience and on various other factors that are believed to be reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods may be affected by changes in those estimates.
Goodwill is the excess of purchase price over the fair value of identified net assets of businesses acquired. Goodwill is accounted for under the Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible
Assets.” Under the provisions of this statement, the Company’s goodwill is tested for impairment on an annual basis during the fourth quarter and whenever events and circumstances occur indicating that goodwill might be impaired.
New Accounting Pronouncements
In March 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of SFAS No. 133.” The objective of this Statement is to enhance disclosure requirements in the current disclosure framework of SFAS No. 133 with the intent to provide users of financial statements with an enhanced understanding of: (i) how and why an entity uses derivative instruments; (ii) how derivative instruments and related hedged items are accounted for under SFAS No. 133 and its related interpretations; and (iii) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This Statement encourages, but does not require, comparative disclosures for earlier periods at initial adoption. As of March 31, 2008, the Company has not determined the impact of SFAS No. 161 on its financial position, results of operations or cash flows.
On February 4, 2008, we completed the acquisition of Helius, Inc. (“Helius”) pursuant to the merger agreement that we entered into on December 21, 2007 (the “Merger Agreement”). Pursuant to the Merger Agreement, we paid $10.5 million, after certain adjustments, at the closing of the acquisition. Immediately after the acquisition of Helius, we transferred our ownership of Helius to HNS, along with the remaining contractual obligation for contingent consideration of up to $20.0 million (the “Contingent Payment”) as additional purchase price, if any, to be payable in April 2010 by us or Helius, as the surviving corporation, subject to Helius achieving the post-closing performance goals (the “Performance Goals”). Since it is not certain that Helius will achieve the Performance Goals, we have not recognized the liability on the Contingent Payment according to SFAS No. 141, "Business Combinations." However, when it is probable that Helius will achieve the Performance Goals set pursuant to the Merger Agreement, we will recognize the Contingent Payment as additional goodwill.
We believe that the goodwill resulting from the Helius acquisition reflects the expected synergies that will generate long-term revenue growth, expansion of customer services and improvement of customer retention rates as we combine Helius' customer base and skills as a recognized leader in the internet protocol television solutions business with our extensive broadband networking experience and customer base. Due to the nature of Helius’ business activities, its customer base and other similarities with our North America enterprise business, Helius operates within our North America VSAT segment. For financial statements for periods beginning on or after the closing date of the acquisition, Helius’ results have been consolidated into our results of operations, and the basis of Helius’ acquired assets and assumed liabilities were adjusted to their preliminary estimated fair values in accordance with SFAS No. 141. Management determined the estimated fair value after considering a number of factors. The excess of the total acquisition costs of $10.8 million over the estimated fair value of the net assets acquired has been reflected as goodwill and intangible assets in accordance with SFAS No. 141.
The estimated fair value is preliminary and subject to revision, including the finalization of the valuation of property and equipment and intangible assets and evaluation of the Company’s other long lived assets and non-current liabilities, which is expected to be completed in the second half of 2008. The final valuation will be based on the actual assets acquired and liabilities assumed at the acquisition date and management’s determination of fair value. Although the final determination may result in asset and liability fair values that are different than the preliminary estimates of these amounts included herein, it is not expected that those differences will be material to an understanding of the impact of this transaction to the Company. The following table summarizes the estimated fair values of the assets acquired, less the excess of fair value over acquisition cost, and liabilities assumed as of February 4, 2008; however the allocation is subject to refinement. Based on the preliminary valuation, the purchase price has been estimated as follows (in thousands):
The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the acquisition date. The Company is in the process of determining the fair value of certain intangible assets, thus the allocation of the purchase price is subject to refinement (in thousands):
Based on the preliminary valuation of Helius’ intangible assets, using an income approach, the fair values of the intangible assets are as follows (in thousands):
The weighted average amortization period for the intangible assets is approximately 10.1 years. The total amount of goodwill is expected to be deductible for tax purposes.
Pro forma financial statements are not presented for Helius because the Company believes that the pro forma amount will be immaterial to the financial statements.
The amortized cost basis and estimated fair values of available-for-sale marketable securities are summarized as follows (in thousands):
The unrealized gains at March 31, 2008 were attributable to changes in interest rates of these investments. The Company has the intent and ability to hold these securities until the securities mature.
Receivables, net consisted of the following (in thousands):
Trade receivables included $4.1 million and $2.7 million of amounts due from affiliates at March 31, 2008 and December 31, 2007, respectively.
Advances and progress billings offset against contracts in process amounted to $23.6 million and $27.0 million at March 31, 2008 and December 31, 2007, respectively. The Company expects to collect the $31.3 million, $2.6 million, $2.3 million and $2.0 million in 2008, 2009, 2010 and 2011, respectively, of contracts in process recorded at March 31, 2008.
Inventories consisted of the following (in thousands):
Inventories are carried at the lower of cost or market, principally using standard costs adjusted to reflect actual based on variance analyses performed throughout the year. Inventories are adjusted to net realizable value using management’s best estimates of future use. In making its assessment of future use or recovery, management considers the aging and composition of inventory balances, the effects of technological and/or design changes, forecasted future product demand based on firm or near-firm customer orders and alternative means of disposition of excess or obsolete items.
Property, net consisted of the following (dollars in thousands):
SPACEWAY 3 is a next generation broadband satellite system, with a unique architecture for broadband data communications. Designed for operational flexibility, the system will greatly enhance data communication capacity and efficiencies. In August 2007, we launched our SPACEWAY 3 satellite and introduced service in North America on the SPACEWAY system in April 2008. For the three months ended March 31, 2008 and 2007, we capitalized $4.8 million and $1.3 million, respectively, of interest related to the construction of the SPACEWAY 3 satellite.
Intangible assets, net consisted of the following (dollars in thousands):
We amortize the recorded values of our intangible assets over their estimated useful lives. As a result of the application of SFAS No. 109, “Accounting for Income Taxes,” we reduced the cost basis of our intangible assets at March 31, 2008 by approximately $0.2 million, on a pro-rata basis. This reduction relates to the reversal of our German subsidiary’s valuation allowance associated with the utilization of the net operating loss (“NOL”) carry-forwards acquired in the acquisition of HNS which reduces the basis of our intangible assets. Intangible assets may be subject to additional reductions to the extent the acquired NOL carry-forwards of our German and United Kingdom (“U.K.”) subsidiaries are utilized during 2008. See Note 11—Income Taxes for further detail.
In addition, our intangible assets at March 31, 2008 included $8.9 million related to the preliminary estimate of intangible assets as a result of the Helius acquisition. See Note 2—Acquisition of Helius, Inc. for further detail.
For the three months ended March 31, 2008 and 2007, we recorded $1.6 million and $1.5 million, respectively, of amortization expense related to intangible assets. Estimated future amortization expense at March 31, 2008 was as follows (in thousands):
Short-term borrowings and current portion of long-term debt consisted of the following (dollars in thousands):
At March 31, 2008, HNS had outstanding revolving bank borrowings of $3.5 million, which had a weighted average variable interest rate of 11.46%. These borrowings were obtained by HNS’ subsidiary in India under revolving lines of credit with several local banks. There is no requirement for compensating balances for these borrowings. The total amount available for borrowing by the Indian subsidiary under the revolving lines of credit was $1.5 million at March 31, 2008.
Long-term debt consisted of the following (dollars in thousands):
HNS’ $450 million of 9 1/2% senior notes (the “Senior Notes”) mature on April 15, 2014. Interest on the Senior Notes is paid semi-annually in arrears on April 15 and October 15. At March 31, 2008 and 2007, interest accrued on the Senior Notes was $19.7 million.
HNS has a secured $50 million revolving credit facility (the “Revolving Credit Facility”), which matures on April 22, 2011. As of March 31, 2008, the total outstanding letters of credit under the Revolving Credit Facility was $11.5 million. As a result, the available borrowing capacity under the Revolving Credit Facility as of March 31, 2008 was $38.5 million.
In February 2007, HNS borrowed $115 million from a syndicate of banks (the “Term Loan Facility”). The interest on the Term Loan Facility is paid quarterly at Adjusted LIBOR (as defined in the Term Loan Facility and existing Revolving Credit Facility) plus 2.50%. To mitigate the variable interest rate risk associated with the Term Loan Facility, HNS entered into a swap agreement to swap the variable LIBOR based interest for a fixed interest rate of 5.12% per annum
(the “Swap Agreement”). At March 31, 2008 and 2007, interest accrued based on the Swap Agreement and the Term Loan Facility was $0.8 million.
The indenture governing the Senior Notes, the agreement governing the amended Revolving Credit Facility and the agreement governing the Term Loan Facility require HNS to comply with certain covenants: (i) in the case of the indenture, for so long as any Senior Notes are outstanding; (ii) in the case of the amended Revolving Credit Facility, so long as the amended revolving credit agreement is in effect, and (iii) in the case of the Term Loan Facility, for so long as the Term Loan Facility remains outstanding. Negative covenants contained in these agreements include limitations on the ability of HNS and/or certain of its subsidiaries to incur additional indebtedness; issue redeemable stock and subsidiary preferred stock; incur liens; pay dividends or distributions or redeem or repurchase capital stock; prepay, redeem or repurchase debt; make loans and investments; enter into agreements that restrict distributions from HNS’ subsidiaries; sell assets and capital stock of HNS’ subsidiaries; enter into certain transactions with affiliates; consolidate or merge with or into, or sell substantially all of HNS’ assets to, another person; and enter into new lines of business. In addition to these negative covenants, the amended Revolving Credit Facility, the indenture governing the Senior Notes and/or the agreement governing the Term Loan Facility contain affirmative covenants that require HNS to: (i) preserve its businesses and properties; (ii) maintain insurance over its assets; (iii) pay and discharge all material taxes when due; and (iv) furnish the lenders’ administrative agent its financial statements for each fiscal quarter and fiscal year, certificates from a financial officer certifying that no Event of Default or Default has occurred during the fiscal period being reported; and as to matters, including but not limited to, litigation and other notices, compliance with laws, maintenance of records and other such customary covenants. HNS and its subsidiaries comprise a substantial portion of the Company’s net assets and results of operations since January 1, 2006. There are certain restrictions on the net assets of HNS. At March 31, 2008 and December 31, 2007, HNS’ consolidated net assets were $244.0 million and $247.5 million, respectively. HNS was in compliance with all of its debt covenants at March 31, 2008.
Interest Rate Swap
To mitigate the variable interest rate risk associated with the Term Loan Facility, HNS entered into the Swap Agreement to swap the variable LIBOR based interest for a fixed interest rate of 5.12% per annum. During the three months ended March 31, 2008, HNS recorded an increase in other comprehensive loss of $5.3 million associated with the fair market valuation of the interest rate swap. The net interest payments based on the Swap Agreement and the Term Loan Facility are paid quarterly starting on May 29, 2007 and estimated to be approximately $8.8 million for each of the years ended December 31, 2008 through 2013 and $3.3 million for the year ended December 31, 2014.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements, but does not require any new fair value measurements.
SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (exit price) in an orderly transaction between market participants at the measurement date. The principal market, as prescribed by SFAS No. 157, is the market in which the reporting entity would sell the asset or transfer the liability with the greatest volume and level of activity for the asset or liability. If there is no principal market, the most advantageous market is used. This is the market in which the reporting entity would sell the asset or transfer the liability with the price that maximizes the amount that would be received for the asset or minimizes the amount that would be paid to transfer the liability. SFAS No. 157 clarifies that fair value should be based on assumptions market participants would make in pricing the asset or liability. Where available, fair value is based on observable quoted market prices or derived from observable market data. Where observable prices or inputs are not available, valuation models are used (i.e. Black-Scholes or a binomial model).
Effective January 1, 2008, financial assets and liabilities recorded at fair value on a recurring basis on our condensed consolidated balance sheet were categorized based on the priority of the inputs used in the valuation technique to measure fair value. SFAS No.157 established a three level fair value hierarchy to classify the inputs used in measuring fair value as follows:
Level 1-Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.
Level 2-Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other then quoted prices that are observable, and inputs derived from or corroborated by observable market data.
Level 3-Inputs are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.
As of March 31, 2008, our financial assets consist of marketable securities. These are all valued based on observable quoted market prices. The Company has revolving bank facilities at its subsidiary in India, which bear interest at observable interest rates. The Company also has a revolving credit facility which is subject to variable interest rates based on observable interest rates; however, there were no borrowings under this facility as of March 31, 2008. Our Term Loan Facility is a variable interest rate loan based on observable interest rates; however, the Company entered into the Swap Agreement to swap the variable LIBOR based interest for a fixed interest rate of 5.12% per annum. The Company adjusts the value of the interest rate swap on a quarterly basis.
The following table summarizes the financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2008 and the level they fall within the fair value hierarchy (in thousands):
On February 12, 2008, the FASB issued FASB Staff Position No. 157-2, which delays the effective date of SFAS No. 157 for nonfinancial assets and liabilities to fiscal years beginning after November 15, 2008. With this deferral, we have not applied the provisions of SFAS No. 157 to goodwill and intangible assets. We are still assessing the impact the adoption of SFAS No. 157 for non-financial assets and liabilities will have on our consolidated financial statements.
On February 21, 2006, SkyTerra distributed (the “Distribution”) all of our outstanding shares of common stock to the common, non-voting common and preferred stockholders and Series 1-A and 2-A warrant holders of SkyTerra Communications, Inc. (“SkyTerra”), which separated SkyTerra into two publicly traded companies. For U.S. federal income tax purposes, the Company’s results through the date of the Distribution were included in the consolidated returns filed by SkyTerra. Prior to the Distribution, SkyTerra had unused NOL carry-forwards of approximately $227.2 million expiring in 2008 through 2025 and capital loss carry-forwards of approximately $93.3 million expiring in 2006 through 2010. Following the issuance of a private letter ruling by the Internal Revenue Service with respect to whether an “ownership change” as defined by Section 382 of the Internal Revenue Code (the “Code”) occurred during a period from 1999 through 2004, SkyTerra expects that its carry-forwards will not be subject to such limitation, as included in Section 382 of the Code, and, therefore, will be available to offset future taxable income unless subject to other limitations.
Following the Distribution, a portion of the unused SkyTerra NOL and capital loss carry-forwards were retained by the Company. The Company estimates that its share of the NOL carry-forwards was approximately $119.3 million and its share of the capital loss carry-forwards was approximately $3.3 million at the date of the Distribution. As of March 31, 2008, the Company estimates that its NOL carry-forwards are approximately $129.7 million and will expire, if unused, between the years 2020 and 2027 and its capital loss carry-forwards of approximately $3.3 million will expire, if unused, in 2010.
Prior to the year ended December 31, 2005, due to SkyTerra’s operating losses and the uncertainty surrounding the ability of SkyTerra to realize its deferred tax assets, a full valuation allowance was established related to the NOL and capital loss carry-forwards. As the Distribution did not qualify as a tax-free spin-off, SkyTerra generated significant taxable income in 2006 for income tax purposes. As the Company is the accounting successor to SkyTerra, the taxes associated with the
Distribution were included in the Company’s results. In addition, due to the tax sharing agreement between SkyTerra and the Company (the “Tax Sharing Agreement”), the Company will be responsible for all tax liabilities associated with the Distribution. According to Skyterra’s 2006 income tax returns, the existing NOL and capital loss carry-forwards were sufficient to offset any income taxes payable on the gain from the Distribution, other than alternative minimum taxes (“AMT”) of $1.1 million.
The Company had previously estimated that AMT, in the amount of $1.4 million, would be payable by SkyTerra as a result of the gain from the Distribution. In accordance with the Tax Sharing Agreement, the Company is currently entitled to the amount paid to SkyTerra in excess of SkyTerra’s AMT liability and will be entitled to the remaining $1.1 million reimbursement from SkyTerra at such time as SkyTerra realizes the benefit of the alternative minimum tax credit. This estimated reimbursement has been reflected on the Company’s books as a non-current receivable from SkyTerra.
For the three months ended March 31, 2008, the Company’s German subsidiary utilized $0.7 million of its NOL carry-forwards. Since it has not met the “more likely than not” criteria of SFAS No. 109, it maintains a full valuation allowance on its deferred tax assets as of March 31, 2008. As required by SFAS No. 109, paragraph 30, regarding accounting for business combinations, the 2008 reversal of the German valuation allowance associated with the utilization of its NOL carry-forwards reduces the basis of our intangible assets by approximately $0.2 million, on a pro-rata basis. Intangible assets may be subject to additional reductions to the extent the acquired NOL carry-forwards of our German and U.K. subsidiaries are utilized during 2008. Upon the Company’s adoption of SFAS No. 141(R), a revision of SFAS No. 141, on January 1, 2009, any benefit realized from the utilization of the German and U.K. NOL carry-forwards will be recorded as a reduction to income tax expense.
For the three months ended March 31, 2008 and 2007, the Company recorded income tax expense of $0.6 million and $0.5 million, respectively, which was attributable primarily to HNS’ foreign subsidiaries and the Company’s state income taxes.
The Company has identified $8.7 million in unrecognized tax benefits related to tax positions in prior periods. If recognized, the total unrecognized tax benefits would impact the Company’s effective tax rate. The company does not anticipate that unrecognized tax benefits will increase or decrease significantly within the next twelve months.
The Company recognizes interest accrued related to unrecognized tax benefits in operating expenses and penalties in income tax expense in the Condensed Consolidated Statements of Operations. As of March 31, 2008, the Company had not recorded any liability for the payment of interest or penalties associated with uncertain tax positions. The following is a description of the tax years that remain subject to examination by major tax jurisdictions:
2006 Equity and Incentive Plan
In January 2006, we adopted and our Board of Directors approved the 2006 Equity and Incentive Plan (the “Plan”). The Plan provides for the grant of equity-based awards, including restricted common stock, restricted stock units, stock options, stock appreciation rights and other equity-based awards, as well as cash bonuses and long-term cash awards to directors, officers, other employees, advisors and consultants of the Company and its subsidiaries who are selected by our Compensation Committee for participation in the Plan. For the three months ended March 31, 2008 and 2007, the Company recorded compensation expense related to the restricted stock awards, issued to members of our Board of Directors, our executives, a contractor and HNS’ employees, and restricted stock units, issued only to our international employees, after adjustment for forfeitures, of approximately $1.0 million and $0.9 million, respectively. As of March 31, 2008, the Company
had $8.5 million of unrecognized compensation expense related to the restricted stock awards and restricted stock units, which will be recognized over a weighted average life of 2.8 years.
Summaries of non-vested restricted stock awards and restricted units are as follows:
Restricted Stock Awards
Restricted Stock Units
HNS’ Bonus Unit Plan
In July 2005, HNS adopted an incentive plan (the “Bonus Unit Plan”) for certain of its employees. HNS recognized minimal expenses for each of the three months ended March 31, 2008 and 2007. The following table summarizes changes in the bonus units under the Bonus Unit Plan:
Class B Membership Interests
Class B membership interests in HNS were issued in April 2005 to certain members of HNS’ senior management, two of HNS’ former senior management and a director. Pursuant to SFAS No. 123, “Accounting for Stock-Based Compensation”, HNS determined that the Class B membership interests had nominal value at the date of grant and minimal compensation expense was recorded for each of the three months ended March 31, 2008 and 2007.
Long-Term Cash Incentive Plan
In connection with the April 22, 2005 transaction between DIRECTV Group (“DIRECTV”) and SkyTerra, HNS established the Long-Term Cash Incentive Plan (the “Retention Plan”), a one-time employee retention plan, which was designed to retain a select group of employees chosen by the HNS’ senior management over a four year vesting period. The Retention Plan provides that participants will receive a cash payout equal to each participant’s individual target bonus amount if (i) the individual remains employed by HNS on the vesting date of April 22, 2009 and (ii) HNS successfully attains its earnings goal for 2008.
In accordance with the Retention Plan, HNS established the earnings goal in March 2008, which is equivalent to HNS' planned 2008 Adjusted EBITDA. Adjusted EBITDA is defined as EBITDA further adjusted to exclude certain adjustments consistent with the definitions used in calculating HNS’ covenant compliance under its credit agreements and the indenture governing the Senior Notes. EBITDA is defined as earnings (losses) before interest, income taxes, depreciation, amortization and equity incentive compensation. As of March 31, 2008, the Retention Plan had 88 participants and a maximum payout (if all participants remain employed and the Adjusted EBITDA goal is achieved) of approximately $14.2 million. If HNS successfully attains 100% of its Adjusted EBITDA goal for 2008, each participant who remains continuously employed by HNS will be paid in the form of a lump-sum cash award on or about April 22, 2009. If HNS misses the goal by up to 15%, a pro-rated portion of a participant’s bonus would still be paid. If HNS misses its goal by more than 15%, no payout will be made. On the basis that a goal had been established for 2008, management assessed the probability of achieving the Adjusted EBITDA goal and recorded an accrued liability of $8.5 million at March 31, 2008, related to the estimated payout for the Retention Plan after giving effect for the vesting period for the Retention Plan. The liability is based on management’s current assessment of the probability of achieving a profitability goal and continued employment by the participants through April 22, 2009 after giving effect to the vesting period. Management will continue to assess this liability and will accrue the balance as appropriate through the vesting period. Management currently estimates that the payout will be $11.4 million.
In the ordinary course of its operations, the Company enters into transactions with related parties to purchase and/or sell telecommunications services, equipment and inventory. Our related parties include Apollo Management, L.P. and its affiliates (collectively “Apollo”).
Hughes Systique Corporation ("Hughes Systique")
HNS has contracted with Hughes Systique for software development services. The founders of Hughes Systique include Pradman Kaul, our CEO and President, and certain former employees of the Company, including Pradeep Kaul, who is the CEO and President of Hughes Systique, our former Executive Vice President and the brother of our CEO and President. On January 9, 2008, HCI invested an additional $1.5 million in the common equity of Hughes Systique. At March 31, 2008, on an undiluted basis, the Company owned approximately 32.2% of the outstanding shares of Hughes Systique and our CEO and President and his brother owned an aggregate of approximately 17.5% of the outstanding shares of Hughes Systique. In addition, our CEO and President and a member of our Board of Directors and HNS’ Board of Managers serve on the board of directors of Hughes Systique.
On February 8, 2008, the Company and another significant shareholder of Hughes Systique agreed to make available to Hughes Systique a term loan facility of up to $3.0 million. Under that facility, Hughes Systique may make borrowing requests of at least $1.0 million to be funded equally by the Company and the other shareholder. The loan bears interest at 6%, payable annually, and is convertible into shares of Hughes Systique upon non-payment or an event of default. On February 11, 2008, Hughes Systique made an initial draw of $1.0 million, and we funded $0.5 million for our share of the initial draw.
Intelsat Holdings Limited
The Company and its subsidiaries lease satellite transponder capacity from Intelsat. In addition, our Italian subsidiary, Hughes Network Systems, S.r.L., entered into a cooperation agreement with Intelsat, Telespazio and Telecom Italia. Under this agreement, the parties are cooperating to provide broadband satellite services for Italian businesses operating in Eastern Europe and North Africa. Effective February 4, 2008, Apollo divested its entire ownership interest in Intelsat, and as a result, Intelsat is no longer a related party.
Agreement with 95 West Co., Inc.
In July 2006, HNS entered into an agreement with 95 West Co., Inc. (“95 West Co.”) and its parent, Miraxis License Holdings, LLC (“MLH”), pursuant to which 95 West Co. and MLH agreed to provide a series of coordination agreements which allow HNS to operate its SPACEWAY 3 satellite at an orbital position where such parties have higher-priority rights.
The related parties are controlled by an affiliate of Apollo. A member of our Board of Directors and HNS’ Board of Managers is the managing director of one of the related parties, the CEO and President of the other related party and also owns a small interest in each. Another member of HNS’ Board of Managers and a member of our Board of Directors is also a director of MLH. As part of the agreement, HNS agreed to pay $9.3 million, in annual installments of $0.3 million in 2006, $0.75 million in each year between 2007 and 2010 and $1.0 million in each year between 2011 and 2016 for the use of the orbital position, subject to conditions in the agreement, which include our ability to operate SPACEWAY 3.
Agreement with Hughes Telematics, Inc.
In July 2006, HNS granted a limited license to Hughes Telematics, Inc. (“HTI”) allowing HTI to use the HUGHES trademark. The license is limited in that HTI may use the HUGHES mark only in connection with its business of automotive telematics and only in combination with the TELEMATICS name. As partial consideration for the license, the agreement provides that HNS will be HTI’s preferred engineering services provider. The license is royalty-free, except that HTI has agreed to commence paying a royalty to HNS in the event HTI no longer has a commercial or affiliated relationship with HNS. As contemplated by the license terms, HNS has commenced providing development services and equipment to HTI.
In October 2007, HNS entered into an agreement with HTI and a customer of HTI, whereby HNS agreed to assume the rights and performance obligations of HTI under that agreement in the event that HTI fails to perform its obligations due to a fundamental cause such as bankruptcy or the cessation of its telematics business. In connection with that agreement, HNS and HTI have entered into a letter agreement pursuant to which HTI has agreed to take certain actions to enable HNS to assume HTI’s obligations in the event that such action is required. HNS’ management does not believe that this agreement with HTI and HTI’s customer, together with the letter agreement with HTI, will have a significant negative impact, if any, on HNS and its financial position, results of operations or cash flows.
In January 2008, HNS entered into an agreement with HTI, pursuant to which HNS is developing an overall automotive telematics system for HTI, comprising the telematics system hub and the Telematics Control Unit (“TCU”), which will serve as the user appliance in the telematics system. The agreement also provides that, subject to certain specified performance conditions, HNS will serve as the exclusive manufacturer and supplier of TCU’s for HTI. The total development phase of the agreement is currently valued at approximately $38.5 million, $20.0 million of which was subject to the authorization to proceed previously issued by HTI for such development work through December 31, 2007.
HTI is controlled by an affiliate of Apollo. Apollo is our controlling stockholder. A member of HNS’ Board of Managers and our Board of Directors is the CEO and a director of HTI and owns approximately 1.0% of HTI’s equity as of March 31, 2008. In addition, a member of HNS’ Board of Managers and our Board of Directors is a director of HTI and a senior partner of Apollo.
Certain members of our Board of Directors and officers serve on the board of directors of some of our affiliates, including Hughes Systique. In some cases, such directors and officers have received stock-based compensation from such affiliates for their service. In those cases, the amount of stock-based compensation received by the directors and officers is comparable to stock-based compensation awarded to other non-executive members of the affiliates’ board of directors.
Related Party Transactions
Sales and purchase transactions with related parties are as follows (in thousands):
* For the first quarter of 2008, purchases represented activities for the month of January 2008.
Assets and liabilities resulting from transactions with related parties are as follows (in thousands):
Our operations have been classified into four business segments: (i) the North America VSAT segment; (ii) the International VSAT segment; (iii) the Telecom Systems segment; and (iv) the Corporate and Other segment. The North America VSAT segment consists of the Consumer group and the Network Equipment and Services group. The International VSAT segment consists of the Network Equipment and Services group. The Telecom Systems segment consists of the Mobile Satellite Systems group, including development services and equipment provided to a related party, Hughes Telematics, Inc., and the Terrestrial Microwave group. The Corporate and Other includes various minority investments held by the Company, our corporate offices and assets not specifically related to another business segment.
Selected financial information for our operating segments is as follows (in thousands):
Comprehensive income (loss) is as follows (in thousands):
The Company is periodically involved in litigation in the ordinary course of its business involving claims regarding intellectual property infringement, product liability, property damage, personal injury, contracts, employment and worker’s compensation. We do not believe that there are any such pending or threatened legal proceedings, including ordinary litigation incidental to the conduct of our business and the ownership of our properties that, if adversely determined, would have a material adverse effect on our business, financial condition, results of operations or liquidity.
On June 28, 2007, HNS initiated an arbitration proceeding against Sea Launch Limited Partnership and Sea Launch Company, LLC (collectively, “Sea Launch”) with the American Arbitration Association seeking a refund of $44.4 million in payments made to Sea Launch under a Launch Services Agreement (“LSA”). This dispute stems from the material failure of a Sea Launch rocket that occurred on January 30, 2007. Sea Launch was scheduled to launch HNS’ SPACEWAY 3 satellite in May 2007; however, following the January 30, 2007 rocket failure, there was substantial uncertainty about when Sea Launch would return to flight. As a result, HNS made alternative arrangements with another launch services provider to launch SPACEWAY 3 in August 2007. In accordance with the LSA, HNS sent a notice of termination to Sea Launch and
was entitled to a refund of the $44.4 million in payments made to Sea Launch in anticipation of the SPACEWAY 3 launch. Sea Launch refused to refund HNS’ payments and alleged that HNS breached the LSA by entering into a contract with another launch services provider and that the January 30, 2007 explosion of a Sea Launch rocket constituted an “excusable delay” under the LSA. HNS’ arbitration filing is based on breach of contract and a violation of the California statute prohibiting unlawful and unfair business practices. HNS believes that Sea Launch's purported justifications for refusing to refund its $44.4 million are without merit and that HNS is contractually entitled to a full refund of its payments under the express terms of the LSA. As a result, HNS intends to vigorously pursue the recovery of its $44.4 million in payments as well as any other relief to which it may be entitled as a consequence of Sea Launch's wrongful refusal to refund HNS’ payments. HNS has recorded a deposit, included in Other assets in the accompanying Condensed Consolidated Balance Sheets, in anticipation of the refund from Sea Launch.
It is the opinion of management that such litigation is not expected to have a material adverse effect on the Company’s financial position, results of operations or cash flows.
The Company is contingently liable under standby letters of credit and bonds in the aggregate amount of $31.6 million that were undrawn at March 31, 2008. Of this amount, $11.5 million were issued under the Revolving Credit Facility; $4.3 million was secured by restricted cash; $0.2 million related to an insurance bond; and $15.6 million were secured by letters of credit issued under credit arrangements available to our Indian and Brazilian subsidiaries. Certain of the letters of credit issued by our Indian subsidiaries are secured by those entities’ assets. As of March 31, 2008, these obligations were scheduled to expire as follows: $9.5 million in 2008; $15.1 million in 2009; $0.8 million in 2010; minimal amount in 2011; and $6.2 million in 2012 and thereafter.
Pursuant to the terms of a contribution agreement among HNS, SkyTerra, DIRECTV and DTV Networks, Inc. entered into in December 2004, HNS has limited rights with respect to its investment in the common stock of an unconsolidated affiliate carried in Other assets prior to June 30, 2007. The investment is included in Prepaid expenses and other in the accompanying Condensed Consolidated Balance Sheets as of March 31, 2008. Among other things, the Company may not pledge or otherwise encumber these shares, and while it may sell the shares to an unaffiliated third party, it must deliver the net proceeds from such sale to DIRECTV. Accordingly, the Company recorded a corresponding liability for this investment, which is included in Accrued liabilities in the accompanying Condensed Consolidated Balance Sheets as of March 31, 2008. Prior to June 30, 2007, this commitment was included in Other liabilities in the accompanying Condensed Consolidated Balance Sheets. The Company expects to return the investment to DIRECTV in the second quarter of 2008.
In August 2007, we launched our SPACEWAY 3 satellite and introduced service in North America on the SPACEWAY system in April 2008. At March 31, 2008, the remaining purchase commitments relating to the satellite was approximately $10.3 million.
In July 2006, HNS entered into an agreement with 95 West Co. and its parent, MLH, pursuant to which 95 West Co. and MLH agreed to provide a series of coordination agreements allowing HNS to operate its SPACEWAY 3 satellite at the 95° West Longitude orbital slot where 95 West Co. and MLH have higher priority rights. Pursuant to the agreement, our remaining obligation with 95 West Co. at March 31, 2008 is a payment of $0.75 million for each of the year ended December 31, 2008 through 2010 and $1.0 million for each of the year ended December 31, 2011 through 2016.
On April 24, 2008, the Company adopted and the Compensation Committee approved the Employee Stock Option Program (the “Stock Option Program”), which provides for the issuance of non-qualified stock options for grant to employees of the Company and its subsidiaries. A total of 700,000 options (the “Option Pool”) have been authorized under the Stock Option Program for awards during the period of April 24, 2008 to December 31, 2009. The grant price and strike price will be the closing price for the Company’s stock on the date of the grant. Any forfeited or cancelled options before exercise will be deposited back into the Option Pool and will become available for award under the Stock Option Program. In accordance with the terms of the Stock Option Program, the Compensation Committee delegated to our CEO and President the authority to award options, at his discretion, to current and future employees of the Company and its subsidiaries. The option awards vest 50% on the second anniversary of the grant date and 25% on each of the third and fourth anniversaries of
the grant date and expire within ten years from the date of grant. The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option valuation model.
On April 24, 2008, the Company granted 557,400 options, with an exercise and fair value price of $54 to its employees. The total unrecognized compensation expense related to this award will be recognized on a straight-line basis over the four year vesting periods beginning in the second quarter of 2008.
On August 8, 2007, the Company filed a shelf registration statement on Form S-3, as amended on November 15, 2007, to register shares of our common stock, preferred stock, and warrants and debt securities and non-convertible debt securities of HNS and HNS Finance Corp., as co issuers. In connection with any future issuance of debt securities of HNS and HNS Finance Corp., we will, and one or more of our other subsidiaries may, on a joint and several basis, offer full and unconditional guarantees of the obligations of HNS and HNS Finance Corp. under such debt securities. The registration statement was declared effective by the SEC on November 19, 2007. To date, no securities have been issued under the registration statement.
In lieu of providing separate unaudited financial statements of HNS and HNS Finance Corp., as co-issuers and HNS’ guarantor subsidiaries, condensed financial statements prepared in accordance with Rule 3-10 and Rule 5-04 of Regulation S-X are presented below. The column marked “Parent” represents the Company’s results. The column marked “Subsidiary Issuer” represents the results of HNS. The column marked “Guarantor Subsidiaries” includes the results of HNS’ guarantor subsidiaries and the results of HNS Finance Corp, a finance subsidiary which is 100% owned by the Company and which had no assets, operations, revenues or cash flows for the periods presented, HNS and HNS Finance Corp., a co-issuer of HNS’ Senior Notes. The column marked “Non-Guarantor Subsidiaries” includes the results of the Company’s and HNS, non-guarantor subsidiaries. Eliminations necessary to arrive at the information for the Company on a consolidated basis for the periods presented are included in the column so labeled. Separate financial statements and other disclosures concerning HNS Finance Corp. and HNS’ guarantor subsidiaries are not presented because management has determined that they are not material to investors.
The following represents the supplemental condensed financial statements of the Company, HNS and the guarantor and non-guarantor subsidiaries. These condensed financial statements should be read in conjunction with our consolidated financial statements and notes thereto.