Edgar Filing: Leidos Holdings, Inc.

LDOS Q3 FY2015 Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_____________________________________________________________

Form 10-Q

_____________________________________________________________

(Mark One)



ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 31, 2014



¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

_____________________________________________________________



Commission File Number	Exact Name of Registrant as Specified in its Charter, Address of Principal Executive Offices and Telephone Number	State or other jurisdiction of incorporation or organization	I.R.S. Employer Identification No.
001-33072	Leidos Holdings, Inc.	Delaware	20-3562868
	11951 Freedom Drive, Reston, Virginia 20190
	(571) 526-6000
000-12771	Leidos, Inc.	Delaware	95-3630868
	11951 Freedom Drive, Reston, Virginia 20190
	(571) 526-6000

_____________________________________________________________

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.



Leidos Holdings, Inc.	Yes x No o
Leidos, Inc.	Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).



Leidos Holdings, Inc.	Yes x No o
Leidos, Inc.	Yes x No o

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



Leidos Holdings, Inc.	Large accelerated filer	ý	Accelerated filer	¨	Non-accelerated filer	¨	Smaller reporting company	¨

Leidos, Inc.	Large accelerated filer	¨	Accelerated filer	¨	Non-accelerated filer	ý	Smaller reporting company	¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).



Leidos Holdings, Inc.	Yes o No x
Leidos, Inc.	Yes o No x

The number of shares issued and outstanding of each issuer’s classes of common stock as of November 24, 2014 was as follows:



Leidos Holdings, Inc.	74,066,871 shares of common stock ($.0001 par value per share)
Leidos, Inc.	5,000 shares of common stock ($.01 par value per share) held by Leidos Holdings, Inc.

Explanatory Note

This Quarterly Report on Form 10-Q is a combined report being filed by Leidos Holdings, Inc. ("Leidos") and Leidos, Inc. Leidos is a holding company and Leidos, Inc. is a direct, 100%-owned subsidiary of Leidos. Each of Leidos and Leidos, Inc. is filing on its own behalf all of the information contained in this report that relates to such company. Where information or an explanation is provided that is substantially the same for each company, such information or explanation has been combined in this report. Where information or an explanation is not substantially the same for each company, separate information and explanation has been provided. In addition, separate condensed consolidated financial statements for each company, along with combined notes to the condensed consolidated financial statements, are included in this report. Unless indicated otherwise, references in this report to the “Company,” “we,” “us,” and “our” refer collectively to Leidos, Leidos, Inc., and its consolidated subsidiaries.

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements.

LEIDOS HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)



	October 31, 2014			January 31, 2014
	(in millions)
ASSETS
Current assets:
Cash and cash equivalents	$	418		$	430
Receivables, net	1,021			1,082
Inventory, prepaid expenses and other current assets	228			256
Assets of discontinued operations	8			39
Total current assets	1,675			1,807
Property, plant and equipment (less accumulated depreciation and amortization of $311 million and $341 million at October 31, 2014 and January 31, 2014, respectively)	360			482
Intangible assets, net	39			93
Goodwill	1,207			1,693
Deferred income taxes	18			15
Other assets	99			72
	$	3,398		$	4,162
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	704		$	716
Accrued payroll and employee benefits	287			285
Notes payable and long-term debt, current portion	2			2
Liabilities of discontinued operations	8			6
Total current liabilities	1,001			1,009
Notes payable and long-term debt, net of current portion	1,227			1,331
Other long-term liabilities	194			227
Commitments and contingencies (Notes 12 and 13)
Stockholders’ equity:
Preferred stock, $.0001 par value, 10 million shares authorized and no shares issued and outstanding at October 31, 2014 and January 31, 2014	—			—
Common stock, $.0001 par value, 500 million shares authorized, 74 million and 80 million shares issued and outstanding at October 31, 2014 and January 31, 2014, respectively	—			—
Additional paid-in capital	1,435			1,576
Accumulated (deficit) earnings	(453		)	25
Accumulated other comprehensive loss	(6		)	(6		)
Total stockholders’ equity	976			1,595
	$	3,398		$	4,162

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)



	Three Months Ended						Nine Months Ended
	October 31, 2014			November 1, 2013			October 31, 2014			November 1, 2013
	(in millions, except per share amounts)
Revenues	$	1,276		$	1,414		$	3,894		$	4,464
Costs and expenses:
Cost of revenues	1,115			1,219			3,375			3,885
Selling, general and administrative expenses	72			113			239			343
Bad debt expense	—			43			3			45
Goodwill impairment charges	—			—			486			—
Intangible asset impairment charges	17			19			41			51
Separation transaction and restructuring expenses	—			25			1			58
Operating income (loss)	72			(5		)	(251		)	82
Non-operating income (expense):
Interest income	—			5			1			15
Interest expense	(18		)	(21		)	(58		)	(59		)
Other income, net	—			2			1			3
Income (loss) from continuing operations before income taxes	54			(19		)	(307		)	41
Income tax (expense) benefit	(16		)	11			(49		)	(4		)
Income (loss) from continuing operations	38			(8		)	(356		)	37
Discontinued operations:
(Loss) income from discontinued operations before income taxes	(1		)	19			(12		)	144
Income tax (expense) benefit	(3		)	(14		)	1			(61		)
(Loss) income from discontinued operations	(4		)	5			(11		)	83
Net income (loss)	$	34		$	(3	)	$	(367	)	$	120
Earnings (loss) per share:
Basic:
Income (loss) from continuing operations	$	0.52		$	(0.10	)	$	(4.75	)	$	0.40
(Loss) income from discontinued operations	(0.05		)	0.06			(0.14		)	0.99
	$	0.47		$	(0.04	)	$	(4.89	)	$	1.39
Diluted:
Income (loss) from continuing operations	$	0.51		$	(0.10	)	$	(4.75	)	$	0.40
(Loss) income from discontinued operations	(0.05		)	0.06			(0.14		)	0.99
	$	0.46		$	(0.04	)	$	(4.89	)	$	1.39
Cash dividends declared per share	$	0.32		$	0.32		$	0.96		$	5.28

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(UNAUDITED)



	Three Months Ended					Nine Months Ended
	October 31, 2014		November 1, 2013			October 31, 2014			November 1, 2013
	(in millions)
Net income (loss)	$	34	$	(3	)	$	(367	)	$	120
Other comprehensive income, net of tax	—		—			—			—
Comprehensive income (loss)	$	34	$	(3	)	$	(367	)	$	120

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(UNAUDITED)



	Shares of common stock		Additional paid-in capital			Accumulated earnings (deficit)			Accumulated other comprehensive loss			Total
	(in millions, except for share amounts)
Balance at January 31, 2014	80		$	1,576		$	25		$	(6	)	$	1,595
Net loss	—		—			(367		)	—			(367		)
Other comprehensive income, net of tax	—		—			—			—			—
Issuances of stock, net of cancellations	—		9			—			—			9
Shares repurchased and retired or withheld for tax withholdings on equity awards	(6	)	(176		)	(37		)	—			(213		)
Dividends of $0.96 per share	—		—			(74		)	—			(74		)
Adjustments for income tax benefits (deficiency)from stock-based compensation	—		(5		)	—			—			(5		)
Stock-based compensation	—		33			—			—			33
Other	—		(2		)	—			—			(2		)
Balance at October 31, 2014	74		$	1,435		$	(453	)	$	(6	)	$	976

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



	Nine Months Ended
	October 31, 2014			November 1, 2013
	(in millions)
Cash flows from operations:
Net (loss) income	$	(367	)	$	120
Loss (income) from discontinued operations	11			(83		)
Adjustments to reconcile net (loss) income to net cash provided by operations:
Depreciation and amortization	50			64
Stock-based compensation	33			43
Goodwill impairment charges	486			—
Intangible asset impairment charges	41			51
Bad debt expense	3			45
Restructuring charges, net	1			18
Other	3			(3		)
Change in assets and liabilities, net of effects of acquisitions and dispositions:
Receivables	29			(142		)
Inventory, prepaid expenses and other current assets	2			27
Deferred income taxes	46			20
Other assets	(2		)	3
Accounts payable and accrued liabilities	(11		)	(7		)
Accrued payroll and employee benefits	3			(46		)
Income taxes receivable/payable	(22		)	(14		)
Other long-term liabilities	(12		)	(14		)
Total cash flows provided by operating activities of continuing operations	294			82
Cash flows from investing activities:
Expenditures for property, plant and equipment	(26		)	(31		)
Proceeds from sale of assets	—			65
Proceeds from U.S. Treasury cash grant	80			—
Net proceeds of cost method investments	—			12
Dividend received from the separation of New SAIC	—			295
Contribution paid related to the separation of New SAIC	—			(26		)
Other	—			(3		)
Total cash flows provided by investing activities of continuing operations	54			312
Cash flows from financing activities:
Payments of notes payable and long-term debt	(104		)	(1		)
Payments of deferred financing costs	—			(5		)
Payments from New SAIC for deferred financing costs	—			5
Proceeds from real estate financing transaction	—			38
Proceeds from debt issuance	—			500
Distribution of debt to New SAIC	—			(500		)

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS [CONTINUED]

(UNAUDITED)



	Nine Months Ended
	October 31, 2014			November 1, 2013
	(in millions)
Sales of stock and exercises of stock options	6			11
Repurchases of stock	(213		)	(17		)
Dividend payments	(72		)	(452		)
Other	1			2
Total cash flows used in financing activities of continuing operations	(382		)	(419		)
Decrease in cash and cash equivalents from continuing operations	(34		)	(25		)
Cash flows from discontinued operations:
Cash (used in) provided by operating activities of discontinued operations	(5		)	121
Cash provided by (used in) investing activities of discontinued operations	27			(17		)
Increase in cash and cash equivalents from discontinued operations	22			104
Total (decrease) increase in cash and cash equivalents	(12		)	79
Cash and cash equivalents at beginning of period	430			735
Cash and cash equivalents at end of period	$	418		$	814

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)



	October 31, 2014			January 31, 2014
	(in millions)
ASSETS
Current assets:
Cash and cash equivalents	$	418		$	430
Receivables, net	1,021			1,082
Inventory, prepaid expenses and other current assets	228			256
Assets of discontinued operations	8			39
Total current assets	1,675			1,807
Property, plant and equipment (less accumulated depreciation and amortization of $311 million and $341 million at October 31, 2014 and January 31, 2014, respectively)	360			482
Intangible assets, net	39			93
Goodwill	1,207			1,693
Deferred income taxes	18			15
Other assets	99			72
Note receivable from Leidos Holdings, Inc.	1,394			1,137
	$	4,792		$	5,299
LIABILITIES AND STOCKHOLDER'S EQUITY
Current liabilities:
Accounts payable and accrued liabilities	$	704		$	716
Accrued payroll and employee benefits	287			285
Notes payable and long-term debt, current portion	2			2
Liabilities of discontinued operations	8			6
Total current liabilities	1,001			1,009
Notes payable and long-term debt, net of current portion	1,227			1,331
Other long-term liabilities	194			227
Commitments and contingencies (Notes 12 and 13)
Stockholder's equity:
Common stock, $.01 par value, 10,000 shares authorized, 5,000 shares issued and outstanding at October 31, 2014 and January 31, 2014	—			—
Additional paid-in capital	207			207
Accumulated earnings	2,169			2,531
Accumulated other comprehensive loss	(6		)	(6		)
Total stockholder's equity	2,370			2,732
	$	4,792		$	5,299

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(UNAUDITED)



	Three Months Ended						Nine Months Ended
	October 31, 2014			November 1, 2013			October 31, 2014			November 1, 2013
	(in millions)
Revenues	$	1,276		$	1,414		$	3,894		$	4,464
Costs and expenses:
Cost of revenues	1,115			1,219			3,375			3,885
Selling, general and administrative expenses	72			113			239			343
Bad debt expense	—			43			3			45
Goodwill impairment charges	—			—			486			—
Intangible asset impairment charges	17			19			41			51
Separation transaction and restructuring expenses	—			25			1			58
Operating income (loss)	72			(5		)	(251		)	82
Non-operating income (expense):
Interest income	3			5			9			15
Interest expense	(18		)	(21		)	(58		)	(59		)
Other income, net	—			2			1			3
Income (loss) from continuing operations before income taxes	57			(19		)	(299		)	41
Income tax (expense) benefit	(17		)	11			(52		)	(4		)
Income (loss) from continuing operations	40			(8		)	(351		)	37
Discontinued operations:
(Loss) income from discontinued operations before income taxes	(1		)	19			(12		)	144
Income tax (expense) benefit	(3		)	(14		)	1			(61		)
(Loss) income from discontinued operations	(4		)	5			(11		)	83
Net income (loss)	$	36		$	(3	)	$	(362	)	$	120

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(UNAUDITED)



	Three Months Ended					Nine Months Ended
	October 31, 2014		November 1, 2013			October 31, 2014			November 1, 2013
	(in millions)
Net income (loss)	$	36	$	(3	)	$	(362	)	$	120
Other comprehensive income, net of tax	—		—			—			—
Comprehensive income (loss)	$	36	$	(3	)	$	(362	)	$	120

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDER’S EQUITY

(UNAUDITED)



	Shares of common stock	Additional paid-in capital		Accumulated earnings			Accumulated other comprehensive loss			Total
	(in millions, except for share amounts)
Balance at January 31, 2014	5,000	$	207	$	2,531		$	(6	)	$	2,732
Net loss	—	—		(362		)	—			(362		)
Other comprehensive income, net of tax	—	—		—			—			—
Balance at October 31, 2014	5,000	$	207	$	2,169		$	(6	)	$	2,370

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)



	Nine Months Ended
	October 31, 2014			November 1, 2013
	(in millions)
Cash flows from operations:
Net (loss) income	$	(362	)	$	120
Loss (income) from discontinued operations	11			(83		)
Adjustments to reconcile net (loss) income to net cash provided by operations:
Depreciation and amortization	50			64
Stock-based compensation	33			43
Goodwill impairment charges	486			—
Intangible asset impairment charges	41			51
Bad debt expense	3			45
Restructuring charges, net	1			18
Other	(2		)	(3		)
Change in assets and liabilities, net of effects of acquisitions and dispositions:
Receivables	29			(142		)
Inventory, prepaid expenses and other current assets	2			27
Deferred income taxes	46			20
Other assets	(2		)	3
Accounts payable and accrued liabilities	(11		)	(7		)
Accrued payroll and employee benefits	3			(46		)
Income taxes receivable/payable	(22		)	(14		)
Other long-term liabilities	(12		)	(14		)
Total cash flows provided by operating activities of continuing operations	294			82
Cash flows from investing activities:
Proceeds on obligations of Leidos Holdings, Inc.	82			—
Payments on obligations of Leidos Holdings, Inc.	(360		)	—
Expenditures for property, plant and equipment	(26		)	(31		)
Proceeds from sale of assets	—			65
Proceeds from U.S. Treasury cash grant	80			—
Net proceeds of cost method investments	—			12
Contribution paid related to the separation of New SAIC	—			(26		)
Other	—			(3		)
Total cash flows (used in) provided by investing activities of continuing operations	(224		)	17
Cash flows from financing activities:
Proceeds on obligations of Leidos Holdings, Inc.	—			11
Payments on obligations of Leidos Holdings, Inc.	—			(442		)
Payments of notes payable and long-term debt	(104		)	(1		)
Payments of deferred financing costs	—			(5		)
Payments from New SAIC for deferred financing costs	—			5

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS [CONTINUED]

(UNAUDITED)



	Nine Months Ended
	October 31, 2014			November 1, 2013
	(in millions)
Proceeds from real estate financing transaction	—			38
Other	—			2
Total cash flows used in financing activities of continuing operations	(104		)	(392		)
Decrease in cash and cash equivalents from continuing operations	(34		)	(293		)
Cash flows from discontinued operations:
Cash (used in) provided by operating activities of discontinued operations	(5		)	121
Cash provided by (used in) investing activities of discontinued operations	27			(17		)
Increase in cash and cash equivalents from discontinued operations	22			104
Total decrease in cash and cash equivalents	(12		)	(189		)
Cash and cash equivalents at beginning of period	430			735
Cash and cash equivalents at end of period	$	418		$	546

See accompanying combined notes to condensed consolidated financial statements.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 1—Summary of Significant Accounting Policies:

Nature of Operations and Basis of Presentation

Leidos Holdings, Inc. ("Leidos") is a holding company whose direct 100%-owned subsidiary is Leidos, Inc., a company focused on delivering science and technology solutions and services primarily in the areas of national security, health and engineering to agencies of the U.S. Department of Defense ("DoD"), the intelligence community, the U.S. Department of Homeland Security and other U.S. Government civil agencies, state and local government agencies, foreign governments, and customers across a variety of commercial markets. Unless indicated otherwise, references to the "Company," "we," "us," and "our" refer collectively to Leidos, Leidos, Inc., and its consolidated subsidiaries.

On September 27, 2013 (the "Distribution Date"), Leidos completed the spin-off of its technical services and enterprise information technology services business into an independent, publicly traded company named Science Applications International Corporation (“New SAIC”). The separation was effected through a tax-free distribution to Leidos' stockholders of 100% of the shares of New SAIC's common stock. On the Distribution Date, New SAIC's common stock was distributed, on a pro rata basis, to Leidos' stockholders of record as of the close of business on September 19, 2013, the record date. Each holder of Leidos common stock received one share of New SAIC common stock for every seven shares of Leidos common stock held on the record date. Prior to the Distribution Date, Leidos Holdings, Inc. was named SAIC, Inc. and Leidos, Inc. was named Science Applications International Corporation.

As a result of the spin-off, the assets, liabilities, results of operations, and cash flows of New SAIC have been classified as discontinued operations for all periods presented. References to financial data are to the Company’s continuing operations, unless otherwise noted. See Note 2–Dispositions for further information.

Immediately following the spin-off, Leidos effectuated a one-for-four reverse stock split of its shares of common stock, so that every four shares of Leidos common stock issued and outstanding were combined and converted into one share of Leidos common stock. Each reference to the number of shares outstanding or per share amounts has been adjusted to reflect the reverse stock split for all periods presented.

The condensed consolidated financial statements of Leidos include the accounts of its majority-owned and 100%-owned subsidiaries, including Leidos, Inc. The condensed consolidated financial statements of Leidos, Inc. include the accounts of its majority-owned and 100%-owned subsidiaries. Leidos does not have separate operations, assets or liabilities independent of Leidos, Inc., except for a note with Leidos, Inc. (the “related party note”), on which interest is recognized. From time to time, Leidos issues stock to employees of Leidos, Inc. and its subsidiaries, which is reflected in Leidos’ Condensed Consolidated Statement of Stockholders’ Equity and results in an increase to the related party note. All intercompany transactions and accounts have been eliminated in consolidation.

The accompanying financial information has been prepared by the Company pursuant to the rules and regulations of the U.S. Securities and Exchange Commission ("SEC") and accounting principles generally accepted in the United States of America ("GAAP"). Certain disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and combined notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 31, 2014. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingencies at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting periods. Estimates have been prepared by management on the basis of the most current and best available information at the time of estimation and actual results could differ from those estimates.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

In the opinion of management, the financial information as of October 31, 2014 and for the three and nine months ended October 31, 2014 and November 1, 2013 reflects all adjustments, which consist of normal recurring adjustments, necessary for a fair presentation thereof. Operating results for the three and nine months ended October 31, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending January 30, 2015, or any future period.

Unless otherwise noted, references to fiscal years are to fiscal years ended the Friday closest to January 31. Fiscal 2015 began on February 1, 2014 and ends on January 30, 2015. The third quarter of fiscal 2015 ended on October 31, 2014.

Separation Transaction and Restructuring Expenses

In anticipation of the spin-off of New SAIC from the Company, the Company initiated a program to align the Company’s cost structure for post-spin-off. In fiscal 2014 the Company reduced headcount, which resulted in severance costs, and reduced its real estate footprint by vacating facilities that are not necessary for its future requirements, which resulted in lease termination and facility consolidation expenses.

Separation transaction and restructuring expenses related to New SAIC, exclusive of any tax impacts, of $20 million and $55 million for the three and nine months ended November 1, 2013, respectively, were reclassified as discontinued operations.

The separation transaction and restructuring expenses for continuing operations were as follows:



	Three Months Ended					Nine Months Ended
	October 31, 2014		November 1, 2013			October 31, 2014		November 1, 2013
	(in millions)
Strategic advisory services	$	—	$	5		$	—	$	7
Legal and accounting services	—		1			—		1
Lease termination and facility consolidation expenses	—		17			1		40
Severance costs	—		2			—		10
Separation transaction and restructuring expenses in operating income (loss)	—		25			1		58
Less: income tax benefit	—		(10		)	—		(23		)
Separation transaction and restructuring expenses, net of tax	$	—	$	15		$	1	$	35

During the nine months ended October 31, 2014, the lease termination and facility consolidation expenses related to an adjustment to the reserve established for loss on leases in connection with revised sublease income assumptions.

For the nine months ended October 31, 2014 and November 1, 2013, all separation transaction and restructuring expenses for continuing operations were recorded in the Corporate and Other segment.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The following table represents the restructuring liability balance as of October 31, 2014 and summarizes the changes during the period attributable to costs incurred and charged to expense, costs paid or otherwise settled, and any adjustments to the liability:



	Severance Costs			Lease Termination and Facility Consolidation Expenses			Total
	(in millions)
Balance as of January 31, 2014	$	1		$	20		$	21
Charges	—			1			1
Cash payments	(1		)	(11		)	(12		)
Balance as of October 31, 2014	$	—		$	10		$	10

Receivables

The Company’s accounts receivable include both amounts billed and currently due from customers, and unbilled receivables consisting of costs and fees billable upon contract completion or the occurrence of a specified event, substantially all of which are expected to be billed and collected within one year. Unbilled receivables are stated at estimated realizable value. Since the Company’s receivables are primarily with the U.S. Government, the Company does not have a material credit risk exposure. Contract retentions are billed when the Company has negotiated final indirect rates with the U.S. Government and, once billed, are subject to audit and approval by government representatives. Consequently, the timing of collection of retention balances is outside the Company’s control. Based on the Company’s historical experience, the majority of retention balances are expected to be collected beyond one year and write-offs of retention balances have not been significant.

The Company has extended deferred payment terms with contractual maturities that may exceed one year to commercial customers related to certain construction projects. As of October 31, 2014, the Company had outstanding receivables of $28 million, net of allowance of $7 million, related to one construction project with deferred payment terms, which have not been paid in accordance with the initial payment terms established with the customer. The Company has filed a legal claim to enforce the payment terms as established in the contract. Based on these events, the Company has determined that the receivables are not expected to be collected within the next 12 months. Accordingly, the receivables are classified as non-current in “Other Assets” on the condensed consolidated balance sheet as of October 31, 2014.

When events or conditions indicate that amounts outstanding from customers may become uncollectible, an allowance is estimated and recorded.

Fair Value Measurements

The accounting standard for fair value measurements establishes a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: observable inputs such as quoted prices in active markets (Level 1); inputs other than the quoted prices in active markets that are observable either directly or indirectly (Level 2); and unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions (Level 3).

The fair value of financial instruments is determined based on quoted market prices, if available, or management’s best estimate. It is management’s belief that the carrying amounts of the Company’s financial instruments other than derivatives (see below), which include cash equivalents and long-term investments in private equity securities are reasonable estimates of their related fair values.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Cash equivalents are recorded at historical cost which equals fair value based on quoted market prices (Level 1 input). The Company’s cash equivalents were primarily comprised of investments in several large institutional money market funds and bank deposits. There are no restrictions on the withdrawal of the Company’s cash and cash equivalents.

Management evaluates its investments for other-than-temporary impairment at each balance sheet date. When testing long-term investments for recovery of carrying value, the fair value of long-term investments in private equity securities is determined using various valuation techniques and factors, such as market prices of comparable companies (Level 2 input), discounted cash flow models (Level 3 input) and recent capital transactions of the portfolio companies being valued (Level 3 input). If management determines that an other-than-temporary decline in the fair value of an investment has occurred, an impairment loss is recognized to reduce the investment to its estimated fair value (Level 2 input). The fair value of long-term debt is determined based on current interest rates available for debt with terms and maturities similar to the Company’s existing debt arrangements (Level 2).

The carrying value of accounts receivable, accounts payable, and accrued expenses approximate their fair value.

Financial Instruments

The Company is exposed to certain market risks which are inherent in certain transactions entered into during the normal course of business. These transactions include sales or purchase contracts denominated in foreign currencies, investments in equity securities and exposure to changing interest rates. The Company uses a risk management policy to assess and manage cash flow and fair value exposure. The policy permits the use of derivative instruments with certain restrictions.

The Company uses interest rate swaps to hedge its fixed rate debt against changes in fair value due to variability in interest rates. The Company is party to interest rate swap agreements that have been designated as fair value hedges and are recorded at fair value on the condensed consolidated balance sheet. The fair value of the interest rate swaps are determined based on observed values for underlying interest rates on the LIBOR yield curve (Level 2).

The Company does not hold derivative instruments for trading or speculative purposes.

Changes in Estimates on Contracts

Changes in estimates related to certain types of contracts accounted for using the percentage of completion method of accounting are recognized in the period in which such changes are made for the inception-to-date effect of the changes. Changes in these estimates can routinely occur over the contract performance period for a variety of reasons, including changes in contract scope, changes in contract cost estimates due to unanticipated cost growth or retirements of risk for amounts different than estimated and changes in estimated incentive or award fees. Aggregate changes in contract estimates resulted in an increase to operating income of $6 million and an increase of $0.05 per diluted share for the three months ended October 31, 2014, and an increase to operating income of $24 million and an increase of $0.20 per diluted share for the nine months ended October 31, 2014. Aggregate changes in contract estimates resulted in a decrease to operating income of $1 million and a decrease of $0.02 per diluted share for the three months ended November 1, 2013, and a decrease to operating income of $29 million and a decrease of $0.22 per diluted share for the nine months ended November 1, 2013.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Goodwill and Intangible Assets

Goodwill

Goodwill represents purchase consideration paid in a business combination that exceeds the values assigned to the net assets of acquired businesses. Goodwill is not amortized, but instead is tested for impairment at the reporting unit level annually, at the beginning of the fourth quarter and during interim periods whenever events or circumstances indicate that the carrying value may not be recoverable. Goodwill is evaluated for impairment either under a qualitative assessment option or a two-step quantitative approach depending on facts and circumstances of a reporting unit, including the excess of fair value over carrying amount in previous assessments and changes in business environment.

When performing a qualitative assessment, the Company considers factors including, but not limited to, current macroeconomic conditions, industry and market conditions, cost factors, financial performance and other events relevant to the entity or reporting unit under evaluation to determine whether it is more likely or not that the fair value of a reporting unit is less than its carrying amount. If the Company determines that it is more likely than not that a reporting unit’s fair value is less than its carrying amount, a quantitative two-step goodwill impairment test is performed.

In evaluating the first step of the two-step quantitative goodwill impairment test, the estimated fair value of each reporting unit is compared to its carrying value, which includes the allocated goodwill. If the estimated fair value of a reporting unit is more than its carrying value, including allocated goodwill, no further analysis is required. If the estimated fair value of a reporting unit is less than its carrying value, including allocated goodwill, a second step is performed to compute the amount of the impairment by determining an implied fair value of goodwill. The implied fair value of goodwill is the residual fair value derived by deducting the fair value of a reporting unit’s identifiable assets and liabilities from its estimated fair value calculated in the first step. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then the Company records an impairment charge equal to the difference.

The Company estimates the fair value of each reporting unit using both market and income approaches (Level 3) when a quantitative analysis is required.

The market approach consists of the guideline public company method which is a valuation technique where the fair value is calculated based on market prices obtained from a detailed market analysis of publicly traded companies that provide a reasonable basis of comparison for each reporting unit. Valuation ratios are selected that relate market prices to selected financial metrics from comparable companies. These ratios are applied after consideration of adjustments and weightings related to financial position, growth, volatility, working capital movement, and other factors. Due to the fact that stock prices of comparable companies represent minority interests the Company also considers an acquisition control premium to reflect the impact of additional value associated with a controlling interest.

The income approach is a valuation technique where the fair value is calculated based on forecasted future cash flows within the projection period discounted back to the present value with appropriate risk adjusted discount rates, which represent the weighted-average cost of capital ("WACC") for each reporting unit. This includes assessing the cost of equity and debt capital as of the valuation date. In addition, a terminal value is developed for forecasted future cash flows beyond the projection period discounted back to the present value. The forecasts used in the Company’s estimation of fair value are developed by management based on known business and market considerations.

The goodwill impairment test process and valuation model is based upon certain key assumptions that require the exercise of significant judgment including judgments for the use of appropriate financial projections, economic expectations, discount rates and WACC as well as using available market data.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

An interim goodwill impairment evaluation was performed during the second quarter of fiscal 2015 and resulted in goodwill impairment charges of $486 million for the three months ended August 1, 2014. See Note 4–Goodwill and Intangible Assets for further information.

Intangible assets

Intangible assets with finite lives are amortized using the method that best reflects how their economic benefits are utilized or, if a pattern of economic benefits cannot be reliably determined, on a straight-line basis over their estimated useful lives.

Intangible assets with finite lives are assessed for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. See Note 4–Goodwill and Intangible Assets for impairment charges taken during the period. Intangible assets with indefinite lives are not amortized but are assessed for impairment at the beginning of the fourth quarter and whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

Supplementary Cash Flow Information

Supplementary cash flow information, including non-cash investing and financing activities, for the periods presented was as follows:



	Nine Months Ended
	October 31, 2014		November 1, 2013
	(in millions)
Vested stock issued as settlement of annual bonus accruals	$	1	$	2
Stock issued in lieu of cash dividends	$	2	$	17
Fair value of assets acquired in acquisitions	$	—	$	259
Cash paid in acquisitions	$	—	$	(1	)
Forgiveness of accounts receivable to acquire equity interest in business combination	$	—	$	(105	)
Accrued liability for acquisition of business	$	—	$	(5	)
Liabilities assumed in acquisitions	$	—	$	(148	)
Cash paid for interest (including discontinued operations)	$	41	$	37
Cash paid for income taxes, net of refunds (including discontinued operations)	$	22	$	62

Accounting Standards Updates Adopted

In February 2013, the Financial Accounting Standards Board ("FASB") issued ASU 2013-04: Liabilities (Topic 405): Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date. This standard requires an entity to measure obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance is fixed at the reporting date, as the sum of the amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors and any additional amount the reporting entity expects to pay on behalf of its co-obligors. The guidance also requires an entity to disclose the nature and amount of the obligation as well as other information about those obligations. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of the provisions of ASU 2013-04 did not have a material effect on the Company's consolidated financial position, results of operations, or cash flows.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

In March 2013, the FASB issued ASU No. 2013-05, Foreign Currency Matters (Topic 830): Parent’s Accounting for the Cumulative Translation Adjustment upon Derecognition of Certain Subsidiaries or Groups of Assets within a Foreign Entity or of an Investment in a Foreign Entity. This standard applies to the release of the cumulative translation adjustment into net income when a parent either sells a part of or all of its investment in a foreign entity or no longer holds a controlling financial interest in a subsidiary or group of assets that is a nonprofit activity or a business within a foreign entity. In addition, the amendments resolve the diversity in practice for the treatment of business combinations achieved in stages (i.e., step acquisitions) involving a foreign entity. The amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of the provisions of ASU 2013-05 did not have a material effect on the Company's consolidated financial position, results of operations, or cash flows.

In June 2014, the FASB issued ASU No. 2014-12, Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period. This standard was issued to provide guidance on share based payment awards in which a performance target may be achieved after an employee completes the requisite service period to achieve the award. In some instances, this has led to a performance award being granted subsequent to the employee no longer rendering services to the issuing company. Previously, no guidance had been included in the codification on how to account for these transactions. The amendments require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. The amendments in this ASU are effective for all entities for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted. The amendments may be adopted prospectively or retrospectively. The Company elected to early adopt the provisions of ASU No. 2014-12 and the standard did not have a material effect on the Company's financial position, results of operations, or cash flows.

During the quarter presented, the Company adopted various other accounting standards issued by the FASB, none of which had a material effect on the Company's consolidated financial position, results of operations, or cash flows.

Accounting Standards Updates Issued But Not Yet Adopted

In April 2014, the FASB issued ASU No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. The amendments in the ASU change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization’s operations and financial results. Examples include a disposal of a major geographic location, a major line of business or a major equity method investment. In addition, the new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income and expenses of discontinued operations. The new guidance also requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. This disclosure will provide users with information about the ongoing trends in a reporting organization’s results from continuing operations. The amendments in the ASU are effective in the first quarter of 2015 for public organizations with calendar year ends. Early adoption is permitted. The Company is still evaluating the provisions of ASU 2014-08 and its impact on the Company's consolidated financial position, results of operations, or cash flows.

In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of non-financial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts). This ASU will supersede the revenue recognition requirements in Topic 605, Revenue Recognition, and most industry-specific guidance throughout the Industry Topics of the codification. Additionally, this ASU supersedes some cost guidance included in Subtopic 605-35, Revenue Recognition-Construction-Type and Production-Type Contracts. The guidance's core principle is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In applying the revenue principles, an entity will identify the performance obligations, determine the transaction price, allocate the transaction price to the performance obligations and recognize revenue when the performance obligation is satisfied. The ASU further states that an entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The amendments in this ASU are effective for annual reporting periods (including interim reporting periods within those periods) beginning after December 15, 2016, for public companies. Early adoption is not permitted. The Company is still evaluating the provisions of ASU 2014-09 and its impact on the Company's consolidated financial position, results of operations, or cash flows.

Note 2—Dispositions:

Fiscal 2015 Discontinued Operations

In July 2014, the Company committed to plans to dispose of a business primarily focused on full service emergency management consulting for disaster preparedness, response, recovery, and mitigation historically included in the Company's Health and Engineering segment. The sale transaction was completed in the third quarter of fiscal 2015 with cash proceeds received of $19 million, resulting in an immaterial loss on sale.

Fiscal 2014 Discontinued Operations

Separation of New SAIC

As discussed in Note 1, the Company completed the spin-off of New SAIC on September 27, 2013. New SAIC was a subsidiary of Leidos prior to the separation date. At separation, New SAIC made a $295 million dividend payment to Leidos and reimbursed Leidos, Inc. $5 million for financing costs previously advanced to New SAIC to secure a revolving and term credit facility, and Leidos, Inc. made a $26 million capital contribution to New SAIC.

The spin-off was made pursuant to the terms of a Distribution Agreement and several other agreements entered into between the Company and New SAIC on September 25, 2013. These agreements set forth, among other things, the principal actions needed to be taken in connection with the separation and govern certain aspects of the relationship between the Company and New SAIC following the separation. These agreements generally provide, with certain exceptions, that each party is responsible for its respective assets, liabilities and obligations, including employee benefits, insurance and tax related assets and liabilities, whether accrued or contingent, except that unknown liabilities will be shared between the parties in certain circumstances. The agreements also describe the party’s commitments to provide each other with certain services for a limited time to help ensure an orderly transition. The agreements also include the treatment of existing contracts, proposals, and teaming arrangements where New SAIC will jointly perform work after separation on Leidos contracts. While the Company is a party to the Distribution Agreement and the ancillary agreements, the Company has determined that it does not have significant continuing involvement in the operations of New SAIC, nor does the Company expect significant continuing cash flows from New SAIC.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The operating results of New SAIC through the Distribution Date, which have been classified as discontinued operations, for the periods presented were as follows:



	Three Months Ended				Nine Months Ended
	October 31, 2014		November 1, 2013		October 31, 2014		November 1, 2013
	(in millions)
Revenues	$	8	$	598	$	34	$	2,712
Costs and expenses:
Cost of revenues	8		533		34		2,446
Selling, general and administrative expenses	—		22		—		42
Separation transaction and restructuring expenses	—		20		—		55
Operating income	$	—	$	23	$	—	$	169

Other Fiscal 2014 Discontinued Operations

Other fiscal 2014 non-strategic dispositions were historically included in the Company's National Security Solutions segment.

In August 2013, the Company committed to plans to dispose of a business primarily focused on technology used to detect if an individual is concealing explosive devices or other hidden weapons. In the first quarter of fiscal 2015, the Company adjusted the carrying values of the business's assets to their fair value based on the estimated selling price of the business. The carrying value exceeded the fair value which resulted in approximately $12 million of impairment charges recorded in discontinued operations, of which $9 million related to fixed assets and inventory and the remainder related to intangible assets. The sale transaction was completed in the second quarter of fiscal 2015 with insignificant cash proceeds received, resulting in an immaterial loss on sale.

In November 2013, the Company sold a certain component of the Company's business focused on machine language translation with insignificant cash proceeds received, resulting in an immaterial gain on sale.

In January 2014, the Company committed to plans to dispose of Cloudshield Technologies, Inc. ("Cloudshield"), previously acquired in fiscal 2011, which is focused on producing a suite of cybersecurity hardware and associated software and services.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The pre-sale operating results through the date of disposal of the Company’s discontinued operations discussed above, not including the separation of New SAIC, for the periods presented were as follows:



	Three Months Ended						Nine Months Ended
	October 31, 2014			November 1, 2013			October 31, 2014			November 1, 2013
	(in millions)
Revenues	$	5		$	7		$	25		$	25
Costs and expenses:
Cost of revenues	2			10			19			27
Selling, general and administrative expenses (including impairment charges of $9 million for the nine months ended October 31, 2014)	5			1			24			20
Intangible asset impairment charges	—			—			3			2
Operating loss	$	(2	)	$	(4	)	$	(21	)	$	(24	)
Non-operating income (expense)	$	1		$	—		$	9		$	(1	)
Total loss from discontinued operations before income taxes	$	(1	)	$	(4	)	$	(12	)	$	(25	)

Note 3—Acquisitions:

Plainfield Renewable Energy Holdings LLC

On October 11, 2013, the Company and Plainfield Renewable Energy Owner, LLC (“project owner”) entered into a consensual foreclosure agreement pursuant to which the project owners agreed to transfer 100% of the equity interest of Plainfield Renewable Energy Holdings, LLC (“PRE Holdings”) to an indirect wholly-owned subsidiary of Leidos in full satisfaction of certain secured obligations owed by the project owner to the Company. Plainfield Renewable Energy LLC or "Plainfield" was a wholly-owned subsidiary of PRE Holdings. As a result of the entry into the foreclosure agreement, the Company determined that it has the power to direct the activities of the VIE and has the right to receive benefits from or the obligation to absorb the losses of the VIE. Accordingly, the Company was deemed the primary beneficiary of the VIE, resulting in the consolidation of Plainfield as of October 11, 2013 (the "transaction"). The Company also determined that Plainfield met the definition of a business and as such gained control of 100% of PRE Holdings equity through the consensual foreclosure agreement which constituted a change in control accounted for as a business combination.

The Plainfield Renewable Energy Project involves the design, construction, and financing of a 37.5 megawatt biomass-fueled power plant in Plainfield, Connecticut (the "plant"). Connecticut Light & Power will purchase approximately 80% of the power produced by the plant based on a 15-year off-take agreement, utilizing the plant's status as a renewable power source. In addition, there are fuel supply agreements with initial terms of 5 to 15 years and minimum purchase requirements either at prevailing market prices or a set price plus a CPI index.

At the time the Company became the primary beneficiary of Plainfield, the Company measured the assets acquired and liabilities assumed at their fair values. The difference between the estimated fair value of the plant in comparison to the carrying value of the Company's deferred payment term receivables forgiven as of the date of the transaction resulted in a $32 million loss as bad debt expense in the Company's condensed consolidated statements of income during the three months ended November 1, 2013. In addition as part of the transaction, contingent consideration of approximately $3 million remains to be paid as of October 31, 2014, of which $2 million will be paid on the earlier of November 2015 or the successful sale of the plant, and the remainder of which will be paid solely upon the successful sale of the plant.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

In July 2014, the Company received a cash grant of $80 million from the U.S. Treasury Department, which was recorded as a reduction to the fixed asset basis of the plant on the condensed consolidated balance sheet, and will be recognized ratably over the life of the plant through reduced depreciation expense. For tax purposes, the tax basis of the plant was reduced by half of the amount of the cash grant. This difference between the excess tax basis of the plant over the book basis resulted in a $27 million deferred tax asset which was recorded as a reduction to the fixed asset basis of the plant. The U.S. Treasury grant also contains a recapture provision that could require the Company to repay funds to the Treasury in certain circumstances which the Company deems not probable.

The aggregate purchase consideration that the Company exchanged for PRE Holdings is as follows (in millions):



Forgiveness of accounts receivable (net of $32 million bad debt expense)	$	105
Contingent consideration	6
Total purchase consideration	$	111

The fair values of the assets acquired and liabilities assumed at the date of acquisition were as follows (in millions):



Property, plant and equipment	$	248
Other assets	8
Notes payable assumed (net of debt discount)	(148		)
Total identifiable net assets acquired	108
Intangible assets	3
Total purchase consideration	$	111

Note 4—Goodwill and Intangible Assets:

The Company's National Security Solutions ("NSS") and Health and Engineering ("HES") are the reportable segments that contain goodwill. Goodwill is tested for impairment at the reporting unit level annually, at the beginning of the fourth quarter, and during interim periods whenever events or circumstances indicate that the carrying value may not be recoverable. As disclosed in the Company's Annual Report on Form 10-K for the fiscal year ended January 31, 2014, the annual goodwill impairment assessment was completed in the fourth quarter fiscal 2014 and it was concluded that the estimated fair value of all of the Company's reporting units exceeded their carrying value. In the second quarter of fiscal 2015, as part of its normal quarterly procedures, the Company considered both qualitative and quantitative factors associated with each of the Company's reporting units and determined that there were indicators that the carrying values of the Health Solutions and Engineering reporting units may not be fully recoverable due to operating performance shortfalls and forecasted declines of revenues and operating income. The Company performed an interim evaluation for these reporting units that resulted in impairments of the goodwill carrying value.

The changes in the carrying value of goodwill for NSS and HES were as follows:



	NSS		HES			Total
	(in millions)
Goodwill at January 31, 2014	$	788	$	905		$	1,693
Goodwill impairment charges	—		(486		)	(486		)
Goodwill at October 31, 2014	$	788	$	419		$	1,207

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

During the second quarter of fiscal 2015, the Health Solutions reporting unit experienced a significant decline in both actual and forecasted revenue volumes primarily in the Company's commercial health consulting business resulting from a reduction in new project opportunities, delayed award decisions, and completion of several larger electronic health records ("EHR") implementation engagements that were not extended or replaced with other projects. The declines were also impacted by delays in legislative compliance deadlines (i.e., ICD-10 and Meaningful Use Stage 2). These events attributed to a significant reduction in the Company's sales pipeline, revenue, and operating income. The nature of the Company's commercial health consulting engagements are short term in nature and the aforementioned events transpired and became known during the second quarter of fiscal 2015 and triggered a revised and lower financial forecast.

During the second quarter of fiscal 2015, the Engineering reporting unit experienced delayed or lost award decisions and reductions in scope on several large engineering construction projects as clients shifted priorities and adjusted their capital expenditure plans that were anticipated to be awarded to the Company during the second quarter of fiscal 2015. The Engineering reporting unit was also impacted by significant reduction in scope of services with an existing client. These events culminated in a significant reduction in the Company's sales pipeline, revenue, and operating income. The aforementioned events transpired and became known during the second quarter of fiscal 2015 and triggered a revised and lower financial forecast.

Based on the unexpected impacts and other unanticipated factors discussed above, the Company conducted an interim goodwill impairment test using the two-step quantitative approach.

As described in Note 1, the Company utilized both the market and income approach as part of the first step of the two-step quantitative goodwill impairment test to determine the estimated fair value of both the Health Solutions and Engineering reporting units.

The Company performed the market approach, guideline public company method, by applying pricing multiples derived from publicly traded guideline companies that are comparable to the reporting units to determine their fair values. The Company utilized enterprise/earnings before interest, taxes, depreciation, and amortization ("EBITDA") multiples and enterprise/revenue multiples which averaged 6.0 and 0.5, respectively, for the Health Solutions reporting unit, and 6.8 and 0.4, respectively, for the Engineering reporting unit. In addition, the fair value under the guideline public company method included a control premium of 20%, which was determined based on a review of comparable market transactions.

The income approach was performed by calculating the fair value based on forecasted future cash flows discounted back to the present value, including significant judgments related to the risk adjusted discount rates, terminal growth rates, and weighted-average cost of capital ("WACC"). The projected cash flows were developed by management for planning purposes based on current known business and market conditions as well as future anticipated industry trends. The method included certain cost adjustments that a market participant buyer would not incur to operate the respective reporting units. A terminal value growth rate of 3% and 2% and WACC of 12% and 14% (which includes a specific company risk premium of 2%) were used for the Health Solutions and Engineering reporting units, respectively.

Based on the first step of the two-step quantitative goodwill impairment test, the Company determined that the fair values of the Health Solutions and Engineering reporting units were 62% and 91% of their carrying values, respectively. Due to the fact that indicators of impairment existed, the second step of the two-step quantitative goodwill impairment test was performed to determine the implied fair value of goodwill and the impairment amount of the respective reporting units.

As a result of the second step evaluation, the Company recorded goodwill impairment charges in the Health Solutions and Engineering reporting units of $369 million and $117 million, respectively, for the three months ended August 1, 2014, which represents the difference between the carrying value and the implied fair value. There were

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COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

no other goodwill impairment charges recorded for the remaining reporting units. There were no goodwill impairments during the three months ended October 31, 2014.

Intangible assets consisted of the following:



	October 31, 2014							January 31, 2014
	Gross carrying value		Accumulated amortization			Net carrying value		Gross carrying value		Accumulated amortization			Net carrying value
	(in millions)
Finite-lived intangible assets:
Customer relationships	$	70	$	(56	)	$	14	$	94	$	(47	)	$	47
Software and technology	52		(40		)	12		65		(36		)	29
Other	—		—			—		4		(1		)	3
Total finite-lived intangible assets	122		(96		)	26		163		(84		)	79
Indefinite-lived intangible assets:
In-process research and development	9		—			9		10		—			10
Trade names	4		—			4		4		—			4
Total indefinite-lived intangible assets	13		—			13		14		—			14
Total intangible assets	$	135	$	(96	)	$	39	$	177	$	(84	)	$	93

Amortization expense related to amortizable intangible assets was $3 million and $13 million for the three and nine months ended October 31, 2014, respectively, and $7 million and $29 million for the three and nine months ended November 1, 2013, respectively.

The Company recognized impairment charges for intangible assets of $17 million and $41 million during the three and nine months ending October 31, 2014, respectively, and $19 million and $51 million for the three and nine months ended November 1, 2013, respectively.

The Company determined that certain intangible assets consisting of software and technology, associated with the acquisition of Reveal Imaging Technologies, Inc. in fiscal 2011, were not recoverable due to lower projected revenue levels from the associated products and customers. As a result, the Health and Engineering reportable segment recognized impairment charges of $14 million and $30 million during the third quarter of fiscal 2015 and the second quarter of fiscal 2014, respectively, to reduce the carrying value of these intangible assets to their estimated fair values. Fair value was estimated using the income approach based on management's forecast of future cash flows to be derived from the assets' use.

The Company determined that certain customer relationship intangible assets associated with the acquisitions of Vitalize and maxIT in fiscal 2012 and 2013, respectively, were not recoverable due to lower projected revenue and operating income levels from the associated customers. As a result, the Health and Engineering reportable segment recognized impairment charges of $24 million and $19 million during the second quarter of fiscal 2015 and the third quarter of 2014, respectively, to reduce the carrying value of these intangible assets to their estimated fair values. Fair value was estimated using the income approach based on management’s forecast of future cash flows to be derived from the assets’ use (Level 3).

During the third quarter of fiscal 2015, the Company determined that certain intangible assets associated with fuel supply contracts obtained through the Plainfield Renewable Energy Project foreclosure were not recoverable due to changes in the Company's fuel supply strategy and newly identified requirements to operate the plant which impacted expected benefits from the related fuel supply arrangements. As a result, the Health and Engineering

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

reportable segment recognized an impairment charge of $3 million to write-off the carrying value associated with the intangible assets of three fuel supply agreements.

The estimated annual amortization expense related to finite-lived intangible assets as of October 31, 2014 was as follows:



Fiscal Year Ending January 31
	(in millions)
2015 (remainder of the fiscal year)	$	2
2016	8
2017	7
2018	5
2019	3
2020 and thereafter	1
	$	26

Actual amortization expense in future periods could differ from these estimates as a result of future acquisitions, dispositions, impairments, the outcome and timing of completion of in-process research and development projects (the assets of which will become amortizable upon completion and placement into service, or will be impaired if abandoned), adjustments to preliminary valuations of intangible assets and other factors.

Note 5—Derivative Instruments and Hedging Activities:

During the third quarter of fiscal 2015, the Company entered into interest rate swap agreements to hedge the fair value with respect to all of the $450 million aggregate principal outstanding on the Company's fixed rate 4.45% notes maturing in December 2020 (the “Notes”). The objective of these instruments is to hedge the Notes against changes in fair value due to the variability in the six-month LIBOR rate (the benchmark interest rate), which effectively converted the debt into floating interest rate debt. Under the terms of the interest rate swap agreements, the Company will receive semi-annual interest payments at the coupon rate of 4.45% and will pay variable interest based on the six-month LIBOR rate. The counterparties to these agreements are financial institutions.

The interest rate swaps were accounted for as a fair value hedge of the Notes and qualified for the shortcut method of hedge accounting which allows for the assumption of no ineffectiveness reported in earnings. The resulting changes in the fair value of the interest rate swaps are fully offset by the changes in the fair value of the underlying debt (the hedged item).

The fair value of the Notes is stated at an amount that reflects changes in the benchmark interest rate subsequent to the inception of the interest rate swaps through the reporting date. The cash flows associated with the interest rate swaps are classified as operating activities in the condensed consolidated statement of cash flows.

The fair value of the interest rate swaps and their impact on the related fair value of the debt in the condensed consolidated balance sheet is as follows:



Interest rate swaps					Hedged items
Balance sheet line item	October 31, 2014		January 31, 2014		Balance sheet line item	October 31, 2014		January 31, 2014
(in millions)
Other assets	$	2	$	—	Notes payable and long-term debt, net of current portion	$	2	$	—

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 6—Debt:

Leidos has a revolving credit facility, which is fully and unconditionally guaranteed by Leidos, Inc. which had provided for $750 million in unsecured borrowing capacity at interest rates determined, at Leidos’ option, based on either LIBOR plus a margin or a defined base rate. During the three months ended October 31, 2014, the Company amended the credit facility to, among other things, change the ratio of consolidated funded debt to EBITDA that the Company is required to maintain. A pro-rata portion of the unamortized deferred costs related to the prior arrangement was written off at the time of the amendment. The remaining unamortized deferred costs relating to the prior arrangement and the immaterial fee paid to amend the credit facility which were deferred, will be amortized over the term of the amended credit facility. In connection with the amendment to the credit facility, the Company exercised its right under the credit agreement to voluntarily reduce the combined commitments of the lenders from $750 million to $500 million. The maturity date of the credit facility is March 2017. As of October 31, 2014 and January 31, 2014, there were no borrowings outstanding under the credit facility.

The credit facility contains certain customary representations and warranties, as well as certain affirmative and negative covenants. The financial covenants contained in the amended credit facility require that, for a period of four trailing fiscal quarters, the Company maintains a ratio of consolidated funded debt, including borrowings under this credit facility, to EBITDA (adjusted for certain items as defined in the credit facility) of not more than 4.0 to 1.0 until no later than January 29, 2016 and 3.75 to 1.0 thereafter, and a ratio of EBITDA (adjusted for certain items as defined in the credit facility) to interest expense of greater than 3.5 to 1.0. The Company was in compliance with these financial covenants as of October 31, 2014. A failure by the Company to meet these financial covenants in the future could eliminate the Company’s borrowing capacity under the credit facility.

The available borrowing capacity on the credit facility may vary each quarter based on the trailing four quarters of EBITDA. If the Company's trailing four quarters of EBITDA declines below a certain threshold in relation to outstanding debt, the borrowing capacity available under the credit facility is reduced. The available borrowing capacity based on the results of the Company's trailing four quarters of EBITDA as of October 31, 2014 was approximately $500 million.

Other covenants in the credit facility restrict certain of the Company’s activities, including, among other things, its ability to create liens, dispose of certain assets and merge or consolidate with other entities. The credit facility also contains certain customary events of default, including, among others, defaults based on certain bankruptcy and insolvency events, nonpayment, cross-defaults to other debt, breach of specified covenants, Employee Retirement Income Security Act (ERISA) events, material monetary judgments, change of control events, and the material inaccuracy of the Company’s representations and warranties. In addition, the Company's ability to declare and pay future dividends on Leidos stock may be restricted by the provisions of Delaware law and covenants in the revolving credit facility.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

The Company’s notes payable and long-term debt consisted of the following:



	Stated interest rate		Effective interest rate		October 31, 2014		January 31, 2014
	(dollars in millions)
Leidos Holdings, Inc. senior unsecured notes:
$450 million notes, which mature in December 2020 ⁽¹⁾	4.45	%	4.53	%	$	451	$	449
$300 million notes, which mature in December 2040	5.95	%	6.03	%	291		300
Leidos, Inc. senior unsecured notes:
$250 million notes, which mature in July 2032	7.13	%	7.43	%	248		248
$300 million notes, which mature in July 2033	5.50	%	5.83	%	201		296
Capital leases and other notes payable due on various dates through fiscal 2021	0%-3.7%		Various		38		40
Total notes payable and long-term debt					$	1,229	$	1,333
Less current portion					2		2
Total notes payable and long-term debt, net of current portion					$	1,227	$	1,331
Fair value of notes payable and long-term debt					$	1,228	$	1,350


(1)	As a result of executing the interest rate swap agreements, the carrying value of $451 million includes a fair value adjustment of $2 million attributable to changes in the benchmark interest rate, the six-month LIBOR rate, from the inception of the interest rate swap agreements to October 31, 2014.

The fair value of long-term debt is determined based on current interest rates available for debt with terms and maturities, and credit risk similar to the Company’s existing debt arrangements.

During the third quarter of fiscal 2015, the Company repurchased in the open market and retired principal amounts of $9 million on its $300 million 5.95% notes issued by Leidos Holdings, Inc. maturing in December 2040 and $96 million on its $300 million 5.50% notes issued by Leidos, Inc. maturing in July 2033. The Company recorded an immaterial loss on extinguishment of debt for the Leidos Holdings, Inc. notes and an immaterial gain for the Leidos, Inc. notes as part of the partial repayment of the respective notes. The net combined gain represents the difference between the repurchase price of $102 million and the net carrying amount of the notes repurchased less the write-off of a portion of the unamortized debt discount and deferred financing costs on a pro-rata basis to the reduction of debt. The Company recorded the gain (loss) on extinguishment of debt in Other income, net in the Company’s condensed consolidated statements of income.

The senior unsecured notes contain customary restrictive covenants, including, among other things, restrictions on the Company’s ability to create liens and enter into sale and leaseback transactions under certain circumstances. The Company was in compliance with all covenants as of October 31, 2014.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 7—Related Party Transactions:

Leidos, Inc. has fully and unconditionally guaranteed the obligations of Leidos under its $450 million 4.45% notes and $300 million 5.95% notes. These notes have been reflected as debt of Leidos, Inc. in these condensed consolidated financial statements. Leidos, Inc. has fully and unconditionally guaranteed any borrowings under Leidos’ amended and restated revolving credit facility maturing in fiscal 2018. Leidos has fully and unconditionally guaranteed the obligations of Leidos, Inc. under its $300 million 5.50% notes and $250 million 7.13% notes.

Leidos and Leidos, Inc. have a related party note in connection with a loan of cash between the entities, which is adjusted to reflect issuances of stock by Leidos to employees of Leidos, Inc. and its subsidiaries and Leidos Inc.’s payment of certain obligations on behalf of Leidos. The related party note bears interest based on LIBOR plus a market-based premium. Portions of the related party note may be repaid at any time. The note automatically extends for successive one-year periods unless either Leidos or Leidos, Inc. provides prior notice to the other party. As of October 31, 2014, the note receivable from Leidos Holdings, Inc. to Leidos, Inc. was $1.4 billion. The note receivable also includes the distribution of the assets and liabilities of New SAIC of $736 million that occurred at the time of the separation in September 2013.

Note 8—Accumulated Other Comprehensive Loss:

The components of accumulated other comprehensive loss were as follows:



	October 31, 2014			January 31, 2014
	(in millions)
Foreign currency translation adjustments, net of taxes of $(1) million as of October 31, 2014 and January 31, 2014	$	2		$	2
Unrecognized net loss on settled derivative instruments associated with outstanding debt, net of taxes of $3 million as of October 31, 2014 and January 31, 2014	(5		)	(5		)
Unrecognized net loss on defined benefit plan, net of taxes of $2 million as of October 31, 2014 and January 31, 2014	(3		)	(3		)
Total accumulated other comprehensive loss, net of taxes of $4 million as of October 31, 2014 and January 31, 2014	$	(6	)	$	(6	)

Reclassifications from other comprehensive income to net income, relating to foreign currency translation adjustments, unrecognized gain (loss) on settled derivative instruments and the unrecognized net gain (loss) on the defined benefit plan for the three and nine months ended October 31, 2014, were not material. Reclassifications for foreign currency translation adjustments and unrecognized gain (loss) on settled derivative instruments are recorded in other income, net, and reclassifications for the unrecognized net gain (loss) on the defined benefit plan is recorded in selling, general, and administrative expenses.

Note 9—Earnings (Loss) Per Share (EPS):

The Company is required to allocate a portion of its earnings to its unvested stock awards containing nonforfeitable rights to dividends or dividend equivalents (participating securities) in calculating EPS using the two-class method.

Unvested stock awards granted prior to fiscal 2013 are participating securities requiring application of the two-class method. In fiscal 2013, the Company began issuing unvested stock awards that have forfeitable rights to dividends or dividend equivalents. These stock awards are not participating securities requiring application of the two-class method, but are dilutive common share equivalents subject to the treasury stock method. Basic EPS is computed by dividing income less earnings allocable to participating securities by the basic weighted average number of shares outstanding. Diluted EPS is computed similar to basic EPS, except the weighted average number of shares outstanding is increased to include the dilutive effect of outstanding stock options and other stock-based awards.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

A reconciliation of the income (loss) used to compute basic and diluted EPS for the periods presented was as follows:



	Three Months Ended					Nine Months Ended
	October 31, 2014		November 1, 2013			October 31, 2014			November 1, 2013
	(in millions)
Basic EPS:
Income (loss) from continuing operations, as reported	$	38	$	(8	)	$	(356	)	$	37
Less: allocation of distributed and undistributed earnings to participating securities	—		—			—			(3		)
Income (loss) from continuing operations, for computing basic EPS	$	38	$	(8	)	$	(356	)	$	34
Net income (loss), as reported	$	34	$	(3	)	$	(367	)	$	120
Less: allocation of distributed and undistributed earnings to participating securities	—		—			—			(3		)
Net income (loss), for computing basic EPS	$	34	$	(3	)	$	(367	)	$	117
Diluted EPS:
Income (loss) from continuing operations, as reported	$	38	$	(8	)	$	(356	)	$	37
Less: allocation of distributed and undistributed earnings to participating securities	—		—			—			(3		)
Income (loss) from continuing operations, for computing diluted EPS	$	38	$	(8	)	$	(356	)	$	34
Net income (loss), as reported	$	34	$	(3	)	$	(367	)	$	120
Less: allocation of distributed and undistributed earnings to participating securities	—		—			—			(3		)
Net income (loss), for computing diluted EPS	$	34	$	(3	)	$	(367	)	$	117

The following table provides a reconciliation of the weighted average number of shares outstanding used to compute basic and diluted EPS for the periods presented. The presentation for the three and nine months ended November 1, 2013 gives effect to the one-for-four reverse stock split which occurred after market close on September 27, 2013.



	Three Months Ended		Nine Months Ended
	October 31, 2014	November 1, 2013	October 31, 2014	November 1, 2013
	(in millions)
Basic weighted average number of shares outstanding	73	84	75	84
Dilutive common share equivalents—stock options and other stock awards	1	—	—	—
Diluted weighted average number of shares outstanding	74	84	75	84

For the nine months ended October 31, 2014, all outstanding common stock equivalents were excluded in the computation of diluted income (loss) per share because their effect would have been anti-dilutive due to the net loss for the period.

For the three months ended November 1, 2013, all outstanding common stock equivalents were excluded in the computation of diluted income (loss) per share because their effect would have been anti-dilutive due to the net loss for the quarter. For the nine months ended November 1, 2013, the declared dividends exceeded current period earnings. Therefore, the Company was in a loss position for computing diluted income (loss) per share and all

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

outstanding common stock equivalents were excluded in the computation because their effect would have been anti-dilutive.

The following anti-dilutive stock-based awards were excluded from the weighted average number of shares outstanding used to compute basic and diluted EPS for the periods presented:



	Three Months Ended		Nine Months Ended
	October 31, 2014	November 1, 2013	October 31, 2014	November 1, 2013
	(in millions)
Stock options	2	5	4	5
Vesting stock awards	—	3	3	3

In December 2013, the Company entered into an Accelerated Share Repurchase ("ASR") agreement with a financial institution to repurchase shares of its outstanding common stock for an aggregate purchase price of $300 million. During the fourth quarter of fiscal 2014, the Company paid $300 million to the financial institution and received an initial delivery of 5.6 million shares of its outstanding shares of common stock for an aggregate value of $255 million. The final delivery of approximately 1.0 million shares for a total value of $45 million under the program was completed during the first quarter of fiscal 2015. The purchase was allocated between additional paid in capital and retained earnings. All shares delivered were immediately retired.

In March 2014, the Company entered into a second Accelerated Share Repurchase agreement with a different financial institution to repurchase shares of its outstanding common stock for an aggregate purchase price of $200 million. During the first quarter of fiscal 2015, the Company paid $200 million to the financial institution and received an initial delivery of 4.5 million shares of its outstanding shares of common stock for an aggregate value of approximately $168 million. The final delivery of approximately 0.8 million shares for a total value of approximately $32 million under the program was completed during the second quarter of fiscal 2015. The purchase was allocated between additional paid in capital and retained earnings. All shares delivered were immediately retired.

The delivery of 6.3 million shares of Leidos common stock for both ASR purchases for the nine months ended October 31, 2014 reduced the Company's outstanding shares used to determine the weighted average shares outstanding for purposes of calculating basic and diluted EPS for the periods presented.

Note 10—Stock-Based Compensation:

Plan Summaries: At October 31, 2014, the Company had stock-based compensation awards outstanding under the following plans: the 2006 Equity Incentive Plan, the Management Stock Compensation Plan, the Stock Compensation Plan, and the 2006 Employee Stock Purchase Plan (ESPP). Leidos issues new shares upon the issuance of stock awards or exercise of stock options under these plans.

The 2006 Equity Incentive Plan provides the Company's and its affiliates' employees, directors, and consultants the opportunity to receive various types of stock-based compensation and cash awards. The Company has issued stock options, vested stock awards, restricted stock awards including stock units (vesting stock), performance-based awards, and cash awards under this plan.

Stock awards granted under the plan prior to fiscal 2015 generally vest or became exercisable 20% a year for the first three years and 40% in the fourth year. In fiscal 2015, the Company has begun granting awards that generally vest or become exercisable 25% a year over four years.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Total Stock-Based Compensation. Total stock-based compensation expense and related tax benefits recognized for the periods presented was as follows:



	Three Months Ended				Nine Months Ended
	October 31, 2014		November 1, 2013		October 31, 2014		November 1, 2013
	(in millions)
Stock-based compensation expense:
Stock options	$	1	$	4	$	4	$	9
Vesting stock awards	9		10		27		35
Vested stock awards	—		—		2		—
Total stock-based compensation expense recorded in continuing operations	$	10	$	14	$	33	$	44
Total stock-based compensation expense recorded in discontinued operations	$	—	$	6	$	—	$	21
Tax benefits recognized from stock-based compensation	$	4	$	5	$	13	$	17

New SAIC Separation Adjustments. As a result of the separation of New SAIC, effective September 27, 2013, all outstanding equity awards related to New SAIC employees were assumed by New SAIC. Also in connection with the separation, adjustments were made to the share amounts and exercise prices of all remaining outstanding Leidos stock options, and the share amounts for vesting stock awards and performance-based stock awards as of the Distribution Date such that the adjustments were generally made to preserve the aggregate intrinsic value at the distribution date pursuant to the terms of the stock based compensation plans under which they were issued. Taking into account the change in the value of the Company’s common stock as a result of the distribution of the New SAIC shares, the conversion ratio applied to all outstanding equity awards at the distribution date was 1.4523. In addition, all outstanding equity awards reflected the Company’s one-for-four reverse stock split.

Stock Options

Stock options granted during the nine months ended October 31, 2014 and November 1, 2013 have terms of seven years and a vesting period of four years based upon required service conditions, except for stock options granted to the Company’s outside directors, which have a vesting period of one year.

The fair value of the Company’s stock option awards is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted average grant date fair value and assumptions used to determine the fair value of stock options granted for the periods presented were as follows:



	Nine Months Ended
	October 31, 2014			October 2013 Grants			2013 Grants Before Spin
Options granted (in millions)	0.6			0.1			1.4			*
Weighted average grant-date fair value	$	6.14		$	9.48		$	6.96		*
Expected term (in years)	4.7			5.0			5.0
Expected volatility	25.1		%	30.0		%	25.0		%
Risk-free interest rate	1.6		%	1.4		%	0.8		%
Dividend yield	2.9		%	2.8		%	3.8		%

*Adjusted for additional awards granted for the $4.00 special cash dividend

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

In March 2013, Leidos' board of directors declared a special cash dividend of $4.00 per share of Leidos common stock and paid an aggregate $342 million on June 28, 2013 to stockholders of record on June 14, 2013. In connection with the special cash dividend, anti-dilutive adjustments were made to all outstanding stock options on the dividend record date to preserve their value following the special cash dividend, as required by the Company's 2006 Equity Incentive Plan. The modifications were made to reduce the exercise prices of the outstanding stock options and to increase the number of shares issuable upon the exercise of each option such that the aggregate difference between the market price and exercise price times the number of shares issuable upon exercise was substantially the same immediately before and after the payment of the special dividend. These adjustments did not result in additional share-based compensation expense, as the fair value of the outstanding options immediately following the payment of the special cash dividend was equal to the fair value immediately prior to such distribution.

As of October 31, 2014, compensation cost related to unvested stock options not yet recognized in the income statement was $7 million and is expected to be recognized over an average period of 1.6 years.

Vesting Stock

Compensation expense is measured at the grant date fair value and generally vests over a four-year vesting period, or seven-years for certain stock awards, based upon required service conditions and in some cases performance conditions. The grant date fair value is based on the closing price of the Company's common stock generally on the day before the date of grant.

During the nine months ended October 31, 2014, the Company granted 0.7 million shares of vesting stock at a weighted average grant date fair value of $36.92.

As of October 31, 2014, compensation cost related to unvested shares not yet recognized in the income statement was $55 million and is expected to be recognized over an average period of 1.7 years.

Performance-Based Awards

The Company grants performance-based stock awards to certain officers and key employees of the Company under the 2006 Equity Incentive Plan. The Company’s performance-based stock awards vest and the stock is issued at the end of a three-year period based upon the achievement of specific performance criteria, with the number of shares ultimately awarded, if any, ranging up to 150% of the specified target awards. If performance is below the threshold level of performance, no shares will be issued. The performance period for performance-based stock awards granted in fiscal 2013 was deemed completed as of the last fiscal quarter prior to the separation of New SAIC with the target shares prorated for the completed period earned. For all of the remaining target shares in the original award, the performance condition was removed and the awards are subject to vesting based on continued employment through the original performance period.

During the nine months ended October 31, 2014, the Company granted approximately 50 thousand shares of performance based awards at a weighted average grant date fair value of $36.88.

There were no performance-based stock awards granted in fiscal 2014. For the fiscal 2015 awards granted, one-third of the target number of shares of stock granted under the awards will be allocated to each fiscal year over the three-year performance period and the actual number of shares to be issued with respect to each fiscal year will be based upon the achievement of that fiscal year’s performance criteria.

As of October 31, 2014, compensation cost related to unvested performance-based awards not yet recognized in the income statement was $1 million and is expected to be recognized over an average period of 2.0 years.

LEIDOS HOLDINGS, INC.

LEIDOS, INC.

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

Note 11—Business Segment Information:

The Company defines its reportable segments based on the way the chief operating decision maker ("CODM"), currently its chief executive officer, manages the operations of the Company for purposes of allocating resources and assessing performance.

The Company's reportable segments are as follows: National Security Solutions, Health and Engineering, and Corporate and Other.

National Security Solutions provides solutions and systems for air, land, sea, space, and cyberspace for the U.S. intelligence community, the DoD, the military services, and the U.S. Department of Homeland Security. The Company's solutions deliver technology, large scale intelligence systems, data analytics, cyber solutions, logistics, and intelligence analysis and operations support to critical missions around the world. Major customers of National Security Solutions include national and military intelligence agencies and other federal, civilian, and commercial customers in the national security complex.

Health and Engineering provides health systems integration services to implement and optimize the use of electronic health records, apply data analytics and behavioral health research to help enable customers to improve healthcare quality and patient outcomes, detect and prevent diseases, enhance scientific discovery, and reduce costs to the healthcare system. Health and Engineering also provides engineering services and solutions focused on solving energy, environmental, and infrastructure challenges. These include products and solutions in energy generation, efficiency and management, environmental services, securing critical infrastructure, and designing and building construction projects. Major customers of Health and Engineering primarily include the U.S. federal government, state and local governmental agencies, foreign governments, and commercial enterprises in various industries.

Corporate and Other includes the operations of the Company’s internal real estate management subsidiary, various corporate activities, certain corporate expense items that are not reimbursed by the Company’s U.S. Government customers and certain revenue and expense items excluded from the CODM’s evaluation of a reportable segment’s performance.

The segment information for the periods presented was as follows:

Three Months Ended

Nine Months Ended

October 31,
2014

November 1,
2013

October 31,
2014

November 1,
2013

(in millions)

Revenues:

National Security Solutions

906