Management's Discussion and Analysis of Financial Condition and Results of Operations
In 2010 Unisys reported improved operating income on lower revenue, as the company benefited from an ongoing program to enhance its financial results and strengthen its balance sheet. The program, announced at the beginning of 2009, is based upon the following business priorities:
- Concentrate the company's investments and resources on business opportunities in fewer, more profitable markets in the information technology (IT) marketplace;
- Create clearly differentiated value propositions in its focused markets and solution offerings;
- Enhance the cost-efficiency of its services labor delivery model to drive gross margin expansion; and
- Reduce overhead expense by simplifying its business, streamlining reporting lines and processes, and creating clear lines of accountability for results.
During the year, the company continued to take actions related to these priorities, including divesting a number of non-core businesses, streamlining its geographic presence, strengthening its portfolio of solutions, increasing its use of lower-cost labor pools, and further reducing expenses and debt.
Reflecting the benefits of these and other actions, the company reported improved full-year 2010 operating income of $375.7 million, up 14 percent compared with operating income of $330.0 million in 2009. Operating profit margin improved to 9.3% in 2010 compared with 7.5% in 2009. After a tax provision of $58.8 million, the company reported net income attributable to Unisys Corporation of $236.1 million, or $5.45 per diluted share, for 2010. This compared with 2009 net income attributable to Unisys Corporation of $189.3 million, or $4.75 per diluted share, which included a tax provision of $42.3 million. The results for 2010 include income of $77.2 million from discontinued operations, net of tax, related to the sale of the company's health information management (HIM) business and the UK-based Unisys Insurance Services Limited (UISL) business.
The company's revenue declined 8 percent to $4.02 billion in 2010 compared with revenue of $4.39 billion in 2009. The decline reflected lower demand for the company's project-based services, de-emphasis of lower-margin business and divestiture of the company's U.S. specialized technology check sorter equipment and related U.S. maintenance business. Foreign currency exchange rates had an approximately 1-percentage-point positive impact on revenue in 2010.
The company's contract with the U.S. Transportation Security Administration expired at the end of November 2010. In 2010, the company recognized revenue of approximately $117 million related to this contract compared to $150 million in 2009 and $189 million in 2008.
Cash provided by operating activities was $336.8 million in 2010, which included a $100.0 million reduction in utilization under the company's U.S. accounts receivable securitization facility. Cash provided by operating activities in 2009 was $396.8 million, which included a $41.0 million reduction in utilization under the facility. The company's 2010 year-end cash balance increased $181 million to $828 million and exceeded the 2010 year-end debt balance of $824 million.
Effective January 1, 2011, the company reinstated a company match to its U.S. 401(k) Savings Plan which had been suspended effective January 1, 2009. The company expects to fund the match with the company's common stock and estimates the cost of such match will be approximately $14 million in 2011.
Results of operations
Revenue for 2010 was $4.02 billion compared with 2009 revenue of $4.39 billion, a decrease of 8%. Approximately 2 percentage points of the revenue decline was due to the divestiture of the company's U.S. specialized technology check sorter equipment and related U.S. maintenance business. Foreign currency had a 1-percentage-point positive impact on revenue in 2010 compared with 2009.
Services revenue in 2010 decreased by 10% (2 percentage points of the decline were due to divested businesses). Technology revenue in 2010 was flat compared with 2009. Adjusting for divested businesses, Technology revenue in 2010 would have increased by an additional 4 percentage points.
Revenue for 2009 was $4.39 billion compared with 2008 revenue of $4.95 billion, a decrease of 11%. Services revenue in 2009 decreased by 12% and Technology revenue declined by 11%. Foreign currency had a 4-percentage-point negative impact on revenue in 2009 compared with 2008. Revenue from international operations in 2010, 2009 and 2008 was $2.29 billion, $2.38 billion and $2.81 billion, respectively. Foreign currency had a 2-percentage-point positive impact on international revenue in 2010 compared with 2009. Revenue from U.S. operations was $1.73 billion in 2010, $2.01 billion in 2009 and $2.14 billion in 2008.
Gross profit percent was 26.7% in 2010, 25.4% in 2009 and 21.9% in 2008. The increase in gross profit percent in 2010 compared with 2009 principally reflects a stronger mix of high-end enterprise server sales as well as the benefits derived from improved cost efficiencies in services delivery. Gross profit percent in 2009 compared with 2008 reflects the improved cost efficiencies in services delivery and the benefits from expense reductions.
Selling, general and administrative expenses were $617.1 million in 2010 (15.4% of revenue), $681.1 million in 2009 (15.5% of revenue) and $955.3 million in 2008 (19.3% of revenue). The decline in selling, general and administrative expenses in 2010 and in 2009 reflect the benefits from cost reduction actions. Included in 2008 were cost reduction charges of $49.0 million.
Research and development (R&D) expenses in 2010 were $78.9 million compared with $101.9 million in 2009 and $129.0 million in 2008. The decrease in R&D expenses principally reflects changes in the company's development model as the company has focused its investments on operating system software development while leveraging commodity components and offshore resources.
In 2010, the company reported an operating profit of $375.7 million compared with $330.0 million in 2009 and $2.1 million in 2008.
Pension income for 2010 was $2.9 million compared with pension income of $23.6 million in 2009 and pension income of $51.3 million in 2008. For 2011, the company expects to recognize pension expense of approximately $36 million. The company records pension income or expense, as well as other employee-related costs such as payroll taxes and medical insurance costs, in operating income in the following income statement categories: cost of revenue; selling, general and administrative expenses; and research and development expenses. The amount allocated to each category is based on where the salaries of active employees are charged. Effective January 1, 2011, the company reinstated a company match to its U.S. 401(k) Savings Plan, which had been suspended effective January 1, 2009. The company will match 50 percent of the first 6 percent of eligible pay contributed by participants to the plan on a before-tax basis (subject to IRS limits). The company expects to fund the match with the company's common stock and estimates the cost of such match will be approximately $14 million in 2011. The charge to income related to the company match for the years ended December 31, 2010, 2009 and 2008 was zero, zero, and $47.5 million, respectively.
During 2009, the company recorded a benefit of $11.2 million (a $5.4 million benefit in other income, a $6.1 million benefit in cost of revenue and an expense of $0.3 million in selling, general and administrative expense related to legal fees) related to a 2009 change in Brazilian law involving a gross receipts tax.
Interest expense was $101.8 million in 2010, $95.2 million in 2009 and $85.1 million in 2008. The increases in interest expense were primarily due to higher interest rates associated with the debt issued in connection with the debt exchange discussed below.
Other income (expense), net was expense of $51.0 million in 2010, compared with expense of $16.6 million in 2009 and expense of $14.6 million in 2008. Included in 2010 were foreign exchange losses of $43.4 million (including $19.9 million related to the Venezuelan devaluation, discussed below). Included in 2009 was income of $5.4 million related to the Brazilian law change discussed above and foreign exchange losses of $12.5 million.
Income (loss) from continuing operations before income taxes in 2010 was income of $222.9 million compared with income of $218.2 million in 2009 and a loss of $97.6 million in 2008.
The provision for income taxes in 2010, 2009 and 2008 was $58.8 million, $42.3 million and $40.9 million, respectively. The 2010, 2009 and 2008 income tax provisions include benefits due to changes in judgment about the company's ability to realize deferred tax assets in future years resulting in a net decrease in valuation allowances of $13.2 million, $28.7 million and $9.7 million, respectively. The 2009 income tax provision includes an $11.1 million benefit related to provisions in the Housing and Economic Recovery Act of 2008 (the Act) permitting certain research and alternative minimum tax (AMT) credit carryforwards to be refundable and a tax benefit of $7.7 million related to prior year tax adjustments. The 2008 income tax provision includes a $7.8 million benefit related to the Act and a tax benefit of $8.7 million related to prior year tax adjustments.
The company evaluates quarterly the realizability of its deferred tax assets by assessing its valuation allowance and by adjusting the amount of such allowance, if necessary. The company will record a tax provision or benefit for those international subsidiaries that do not have a full valuation allowance against their deferred tax assets. Any profit or loss recorded for the company's U.S. continuing operations will have no provision or benefit associated with it due to its full valuation allowance, except with respect to benefits related to income from discontinued operations. As a result, the company's provision or benefit for taxes will vary significantly period to period depending on the geographic distribution of income. Due to its full valuation allowance in the U.S., the health care legislation enacted during 2010 had no impact on the company's U.S. deferred tax assets.
The realization of the company's net deferred tax assets of approximately $185 million as of December 31, 2010 is primarily dependent on forecasted future taxable income within certain foreign jurisdictions. Any reduction in estimated forecasted future taxable income may require the company to record an additional valuation allowance against the remaining deferred tax assets. Any increase or decrease in the valuation allowance would result in additional or lower income tax expense in such period and could have a significant impact on that period's earnings.
Net income (loss) from continuing operations attributable to Unisys Corporation for 2010 was income of $158.9 million, or $3.67 per diluted share, compared with income of $172.2 million, or $4.32 per diluted share, in 2009 and a loss of $150.9 million, or a loss of $4.20 per diluted share, in 2008.
Income from discontinued operations for 2010 was $77.2 million, or $1.78 per diluted share, compared with income of $17.1 million, or $0.43 per diluted share, in 2009 and income of $20.8 million, or $0.58 per diluted share in 2008. See Note 3 of the Notes to Consolidated Financial Statements.
Due to cumulative inflation of approximately 100 percent or more over the last 3-year period, the company's Venezuelan subsidiary has applied highly inflationary accounting beginning January 1, 2010. For those international subsidiaries operating in highly inflationary economies, the U.S. dollar is the functional currency, and as such, nonmonetary assets and liabilities are translated at historical exchange rates, and monetary assets and liabilities are translated at current exchange rates. Exchange gains and losses arising from translation are included in other income (expense), net. Effective January 11, 2010, the Venezuelan government devalued the Bolivar Fuerte by 50 percent by resetting the official exchange rate from 2.15 to the U.S. dollar to 4.30 to the U.S. dollar. As a result, the company recorded a foreign exchange loss in the first quarter of 2010 of approximately $20 million. The company has used and continues to use the official exchange rate for translation purposes. At December 31, 2010, the company's operations in Venezuela had net monetary assets denominated in local currency of approximately $20 million.
The company has two business segments: Services and Technology. Revenue classifications by segment are as follows: Services -- systems integration and consulting, outsourcing, infrastructure services and core maintenance; Technology -- enterprise-class servers and other technology. The accounting policies of each business segment are the same as those followed by the company as a whole. Intersegment sales and transfers are priced as if the sales or transfers were to third parties. Accordingly, the Technology segment recognizes intersegment revenue and manufacturing profit on hardware and software shipments to customers under Services contracts. The Services segment, in turn, recognizes customer revenue and marketing profit on such shipments of company hardware and software to customers. The Services segment also includes the sale of hardware and software products sourced from third parties that are sold to customers through the company's Services channels. In the company's consolidated statements of income, the manufacturing costs of products sourced from the Technology segment and sold to Services customers are reported in cost of revenue for Services.
Also included in the Technology segment's sales and operating profit are hardware and software sold to the Services segment for internal use in Services agreements. The amount of such profit included in operating income of the Technology segment for the years ended December 31, 2010, 2009 and 2008 was $7.2 million, $14.8 million and $38.5 million, respectively. The profit on these transactions is eliminated in Corporate.
The company evaluates business segment performance on operating income exclusive of cost-reduction charges and unusual and nonrecurring items, which are included in Corporate. All other corporate and centrally incurred costs are allocated to the business segments, based principally on revenue, employees, square footage or usage. Therefore, the segment comparisons below exclude the cost-reduction charges mentioned above. See Note 15 of the Notes to Consolidated Financial Statements.
Customer revenue by classes of similar products or services, by segment, for 2010, 2009 and 2008 is presented below:
|Year ended December 31 (millions)||
2010||2009||Percent Change||2008||Percent Change|
|Services|| || || || || |
|Systems integration and consulting||
|Technology|| || || || || |
Information by business segment for 2010, 2009 and 2008 is presented below:
|(millions of dollars)||Total||Eliminations||Services||Technology|
2010|| || || || |
|Customer revenue||$4,019.6|| ||$3,457.4||$562.2|
|Gross profit percent||26.7%|| ||20.1%||55.1%|
|Operating income percent||9.3%|| ||6.7%||21.6%|
2009|| || || || |
|Customer revenue||$4,385.7|| ||$3,824.9||$560.8|
|Gross profit percent||25.4%|| ||19.2%||49.6%|
|Operating income percent||7.5%|| ||6.2%||12.4%|
2008|| || || || |
|Customer revenue||$4,954.9|| ||$4,325.3||$629.6|
|Gross profit percent||21.9%|| ||18.3%||43.5%|
|Operating income percent||0.0%|| ||2.3%||4.1%|
Gross profit percent and operating income percent are as a percent of total revenue.
In the Services segment, customer revenue was $3.46 billion in 2010, $3.82 billion in 2009 and $4.33 billion in 2008. Approximately 2 percentage points of the decline in 2010 compared with 2009 were due to divestitures of businesses. Foreign currency had about a 1-percentage-point positive impact on Services revenue in 2010 compared with 2009.
Reflecting lower demand for project-based services and the continued reshaping of the company's services portfolio, revenue from systems integration and consulting decreased 10.1% in 2010 compared with 2009, and 2009 declined 8.8% compared with 2008.
Outsourcing revenue decreased 3.8% in 2010 from 2009 reflecting a decline in business processing outsourcing (BPO) revenue as information technology outsourcing (ITO) revenue was flat in 2010 compared with 2009. Outsourcing revenue decreased 7.9% in 2009 from 2008, primarily reflecting declines in BPO revenue.
Infrastructure services revenue declined 16.2% in 2010 compared with 2009 and 23.3% in 2009 compared with 2008. The decline in both periods reflects the company's de-emphasis of lower-margin business, as well as the shift away from project work to managed outsourcing contracts. Approximately 4 percentage points of the decline in 2010 compared with 2009 were due to divestitures of businesses.
Core maintenance revenue declined 25.3% in 2010 compared with 2009. Approximately 12 percentage points of the decline were due to divestitures of businesses. Core maintenance revenue declined 16.9% in 2009 compared with 2008. The declines in both periods reflect the continuing secular decline of core maintenance.
Services gross profit percent was 20.1% in 2010, 19.2% in 2009 and 18.3% in 2008. Services operating income percent was 6.7% in 2010 compared with 6.2% in 2009 and 2.3% in 2008.
In the Technology segment, customer revenue was $562.2 million in 2010, $560.8 million in 2009 and $629.6 million in 2008. Foreign currency translation had a negligible impact on Technology revenue in 2010 compared with 2009. Adjusting for divested businesses, the growth rate in Technology revenue in 2010 would have been 4 percentage points higher. The decline in Technology revenue in 2009 compared with 2008 primarily reflected lower sales of ES7000 servers and specialized equipment.
Revenue for the company's enterprise-class servers was flat in 2010 compared with 2009 and declined 9.9% in 2009 compared with 2008. Technology sales in 2009 slowed as clients tightened spending on information technology projects due to economic concerns.
Revenue from other technology increased 3.6% in 2010 compared with 2009 and decreased 15.5% in 2009 compared with 2008. Adjusting for divested businesses, the growth rate in other technology revenue in 2010 would have been 19 percentage points higher.
Technology gross profit percent was 55.1% in 2010, 49.6% in 2009 and 43.5% in 2008. Technology operating income percent was 21.6% in 2010 compared with 12.4% in 2009 and 4.1% in 2008. The increase in gross profit margin and operating profit margin percents in both periods reflects a richer mix of higher margin enterprise servers.
New accounting pronouncements
See Note 5 of the Notes to Consolidated Financial Statements for a full description of recent accounting pronouncements, including the expected dates of adoption and estimated effects on results of operations and financial condition.
The company's principal sources of liquidity are cash on hand, cash from operations and its U.S. trade accounts receivable securitization facility (the A/R Facility), which is discussed below. The company's anticipated future cash expenditures are discussed below and include anticipated contributions to its defined benefit pension plans. The company believes that it will have adequate sources of liquidity to meet its expected 2011 cash requirements.
Cash and cash equivalents at December 31, 2010 were $828.3 million compared with $647.6 million at December 31, 2009. At December 31, 2010, the company had sold no receivables under the A/R Facility compared with $100 million as of December 31, 2009 and $141 million at December 31, 2008.
During 2010, cash provided by operations was $336.8 million compared with $396.8 million in 2009. The principal reason for the decline in cash provided from operations was the decrease in the utilization in the A/R Facility, discussed above. Cash expenditures related to restructuring actions (which are included in operating activities) in 2010 and 2009 were $22.4 million and $61.3 million, respectively. Cash expenditures for restructuring actions are expected to be approximately $5 million in 2011.
Cash used for investing activities in 2010 was $61.6 million compared with cash used of $271.3 million in 2009. The current year includes net proceeds of $117.2 million related to the sale of the company's HIM business, U.S. specialized technology check sorter and related U.S. maintenance business and UISL business (see Note 3 of the Notes to Consolidated Financial Statements). Items affecting cash used for investing activities were the following: Net proceeds from investments in 2010 were $0.9 million compared with net proceeds of $1.3 million in 2009. Proceeds from investments and purchases of investments represent derivative financial instruments used to manage the company's currency exposure to market risks from changes in foreign currency exchange rates. During the year ended December 31, 2010, the net change in restricted deposits resulted in cash provided of $23.4 million compared with a cash usage of $86.8 million in 2009. In addition, the investment in marketable software was $55.8 million in 2010 compared with $57.6 million in 2009, capital additions of properties were $64.1 million in 2010 compared with $45.9 million in 2009 and capital additions of outsourcing assets were $83.2 million in 2010 compared with $97.8 million in 2009. The increase in capital additions of properties was principally due to expenditures related to new leased facilities as part of the company's multi-year plan to reduce its square footage.
Cash used for financing activities during 2010 was $91.5 million compared with cash used of $46.1 million in 2009. The current-year period includes $92.8 million used to reduce long-term debt. Cash used during 2009 relates to the debt exchange discussed below.
At December 31, 2010, total debt was $824.0 million, a decrease of $87.7 million from December 31, 2009, principally due to the redemption at maturity of the remainder of the company's 6.875% senior notes and the call of the company's remaining 8.5% senior notes. In December 2010, the company called all $14.2 million outstanding of its 8.5% senior notes due October 15, 2015 and recognized a charge of $0.7 million in "Other income (expense), net".
On July 31, 2009, the company completed offers to exchange its 6.875% senior notes due 2010 (the 2010 Notes), its 8% senior notes due 2012 (the 2012 Notes), its 8.5% senior notes due 2015 (the 2015 Notes) and its 12.5% senior notes due 2016 (the 2016 Notes) in private placements for new 12.75% senior secured notes due 2014 (the First Lien Notes), new 14.25% senior secured notes due 2015 (the Second Lien Notes and, together with First Lien Notes, the New Secured Notes), shares of the company's common stock and cash. On that date, the company issued $385.0 million aggregate principal amount of First Lien Notes, $246.6 million aggregate principal amount of Second Lien Notes and 5.2 million shares of common stock and paid $30.0 million in cash in exchange for $235.1 million aggregate principal amount of 2010 Notes, $332.0 million aggregate principal amount of 2012 Notes, $134.0 million aggregate principal amount of 2015 Notes, and $59.4 million aggregate principal amount of 2016 Notes. The New Secured Notes, which are not registered with the Securities and Exchange Commission, are guaranteed by Unisys Holding Corporation, a wholly owned Delaware corporation that directly or indirectly holds the shares of substantially all of the company's foreign subsidiaries, and by certain of the company's other current and future U.S. subsidiaries. The First Lien Notes and Second Lien Notes are secured by first-priority liens and second-priority liens, respectively (in each case, subject to permitted prior liens) on substantially all of the company's assets, except (i) accounts receivable that are subject to one or more receivables facilities, (ii) real estate located outside the U.S., (iii) cash or cash equivalents securing reimbursement obligations under letters of credit or surety bonds and (iv) certain other excluded assets. In 2009, the company recognized a net gain of $0.5 million on the exchange in "Other income (expense), net".
The company and certain international subsidiaries have access to uncommitted lines of credit from various banks.
In May 2008, the company entered into the A/R Facility. Under this three-year facility, the company has agreed to sell, on an ongoing basis, through Unisys Funding Corporation I, a wholly owned subsidiary, up to $150 million of interests in eligible U.S. trade accounts receivable. Under the A/R Facility, receivables are sold at a discount that reflects, among other things, a yield based on LIBOR subject to a minimum rate. The A/R Facility includes customary representations and warranties, including no material adverse change in the company's business, assets, liabilities, operations or financial condition. It also requires the company to maintain a minimum fixed charge coverage ratio and requires the maintenance of certain ratios related to the sold receivables. Other termination events include failure to perform covenants, materially incorrect representations and warranties, change of control and default under debt aggregating at least $25 million. As discussed in Note 5 of the Notes to Consolidated Financial Statements, effective January 1, 2010, the company adopted a new accounting standard whereby the A/R Facility no longer meets the requirements to be treated as a sale, and therefore any sales under the facility will be accounted for as a secured borrowing. At December 31, 2010 and December 31, 2009, the company had sold zero and $100 million, respectively, of eligible receivables. At December 31, 2009, the receivables sold under the facility of $100 million were treated as a sale and therefore removed from the accompanying consolidated balance sheet.
At December 31, 2010, the company has met all covenants and conditions under its various lending and funding agreements. The company expects to continue to meet these covenants and conditions.
As described more fully in Notes 9 and 11 of the Notes to Consolidated Financial Statements, at December 31, 2010, the company had certain cash obligations, which are due as follows:
|(millions of dollars)||Total||Less than 1 year||1-3 years ||4-5 years ||After 5 years |
|Interest payments on long-term debt||481.4||107.2||209.0||155.8||9.4|
|Minimum purchase obligations||126.3||32.1||63.0||31.2||-- |
As described in Note 16 of the Notes to Consolidated Financial Statements, in 2011 the company expects to make cash contributions of approximately $115 million to its worldwide defined benefit pension plans, principally international plans. In accordance with regulations governing contributions to U.S. defined benefit pension plans, the company is not required to fund its U.S. qualified defined benefit pension plan in 2011. Based on current legislation, recent interest rates and expected returns for 2011, the company currently expects that it will be required to make a contribution of approximately $100 million in 2012 to this plan.
At December 31, 2010, the company had outstanding standby letters of credit and surety bonds of approximately $268 million related to performance and payment guarantees. On the basis of experience with these arrangements, the company believes that any obligations that may arise will not be material.
The company may, from time to time, redeem, tender for, or repurchase its securities in the open market or in privately negotiated transactions depending upon availability, market conditions and other factors. The company has on file with the Securities and Exchange Commission an effective registration statement covering $1.1 billion of debt or equity securities, which enables the company to be prepared for future market opportunities.
Stockholders' deficit decreased $337.9 million during 2010, principally reflecting consolidated net income of $236.1 million, share-based compensation and share issuances of $9.7 million, currency translation gains of $25.7 million, an increase in the funded status of the company's defined benefit plans of $59.5 million and an increase in noncontrolling interest of $6.9 million.
Goodwill is reviewed annually for impairment and whenever events or circumstances occur indicating that goodwill may be impaired. The company performed its annual impairment test in the fourth quarter of 2010, which indicated that goodwill was not impaired. At December 31, 2010, the company does not have any reporting units that are at risk of failing the company's goodwill impairment review.
The company has exposure to interest rate risk from its short-term and long-term debt. In general, the company's long-term debt is fixed rate and, to the extent it has any, its short-term debt is variable rate. See Note 9 of the Notes to Consolidated Financial Statements for components of the company's long-term debt. The company believes that the market risk assuming a hypothetical 10% increase in interest rates would not be material to the fair value of these financial instruments, or the related cash flows, or future results of operations.
The company is also exposed to foreign currency exchange rate risks. The company is a net receiver of currencies other than the U.S. dollar and, as such, can benefit from a weaker dollar, and can be adversely affected by a stronger dollar relative to major currencies worldwide. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, may adversely affect consolidated revenue and operating margins as expressed in U.S. dollars. To minimize currency exposure gains and losses, the company enters into forward exchange contracts and has natural hedges by purchasing components and incurring expenses in local currencies. The company uses derivative financial instruments to reduce its exposure to market risks from changes in foreign currency exchange rates. The derivative instruments used are foreign exchange forward contracts. See Note 12 of the Notes to Consolidated Financial Statements for additional information on the company's derivative financial instruments.
The company has performed a sensitivity analysis assuming a hypothetical 10% adverse movement in foreign currency exchange rates applied to these derivative financial instruments described above. As of December 31, 2010 and 2009, the analysis indicated that such market movements would have reduced the estimated fair value of these derivative financial instruments by approximately $3 million and $4 million, respectively. Based on changes in the timing and amount of interest rate and foreign currency exchange rate movements and the company's actual exposures and hedges, actual gains and losses in the future may differ from the above analysis.
Critical accounting policies
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates, judgments and assumptions that affect the amounts reported in the financial statements and accompanying notes. Certain accounting policies, methods and estimates are particularly important because of their significance to the financial statements and because of the possibility that future events affecting them may differ from management's current judgments. The company bases its estimates and judgments on historical experience and on other assumptions that it believes are reasonable under the circumstances; however, to the extent there are material differences between these estimates, judgments and assumptions and actual results, the financial statements will be affected. Although there are a number of accounting policies, methods and estimates affecting the company's financial statements as described in Note 1 of the Notes to Consolidated Financial Statements, the following critical accounting policies reflect the significant estimates, judgments and assumptions. The development and selection of these critical accounting policies have been determined by management of the company and the related disclosures have been reviewed with the Audit Committee of the Board of Directors.
Typically, the initial terms of the company's outsourcing contracts are between 3 and 5 years. In certain of these arrangements, the company hires certain of the customers' employees and often becomes responsible for the related employee obligations, such as pension and severance commitments. In addition, system development activity on outsourcing contracts often requires significant upfront investments by the company. The company funds these investments, and any employee-related obligations, from customer prepayments and operating cash flow. Also, in the early phases of these contracts, gross margins may be lower than in later years when the work force and facilities have been rationalized for efficient operations, and an integrated systems solution has been implemented.
Revenue under these contracts is recognized when the company performs the services or processes transactions in accordance with contractual performance standards. Customer prepayments (even if nonrefundable) are deferred (classified as a liability) and recognized systematically as revenue over the initial contract term.
Costs on outsourcing contracts are charged to expense as incurred. However, direct costs incurred related to the inception of an outsourcing contract are deferred and charged to expense over the initial contract term. These costs consist principally of initial customer setup and employment obligations related to employees hired under terms of the outsourcing contracts. In addition, the costs of equipment and software, some of which are internally developed, are capitalized and depreciated over the shorter of their life or the initial contract term.
Recoverability of outsourcing assets is subject to various business risks, including the timely completion and ultimate cost of the outsourcing solution, and realization of expected profitability of existing outsourcing contracts. The company quarterly compares the carrying value of the outsourcing assets with the undiscounted future cash flows expected to be generated by the outsourcing assets to determine if there is an impairment. If impaired, the outsourcing assets are reduced to an estimated fair value on a discounted cash flow approach. The company prepares its cash flow estimates based on assumptions that it believes to be reasonable but are also inherently uncertain. Actual future cash flows could differ from these estimates. At December 31, 2010 and 2009, the net capitalized amount related to outsourcing contracts was $162.3 million and $213.7 million, respectively.
The majority of the company's sales agreements contain standard business terms and conditions; however, some agreements contain multiple elements or non-standard terms and conditions. As discussed in Note 1 of the Notes to Consolidated Financial Statements, the company enters into multiple-element arrangements, which may include any combination of hardware, software or services. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple-element arrangement should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the price should be allocated among the elements and when to recognize revenue for each element. The company recognizes revenue on delivered elements only if: (a) any undelivered products or services are not essential to the functionality of the delivered products or services, (b) the company has an enforceable claim to receive the amount due in the event it does not deliver the undelivered products or services, (c) there is evidence of the fair value for each undelivered product or service, and (d) the revenue recognition criteria otherwise have been met for the delivered elements. Otherwise, revenue on delivered elements is recognized as the undelivered elements are delivered. For arrangements with multiple elements where software is more than incidental to the arrangement, fair value of undelivered products or services is determined by "vendor-specific objective evidence," which is based upon normal pricing and discounting practices for those products and services when sold separately. The company's continued ability to determine vendor-specific objective evidence of fair value will depend on continued sufficient volumes and sufficient consistent pricing of stand-alone sales of such undelivered elements. In addition, the company's revenue recognition policy states that revenue is not recognized until collectibility is deemed probable. Changes in judgments on these assumptions and estimates could materially impact the timing of revenue recognition.
For long-term fixed price systems integration contracts, the company recognizes revenue and profit as the contracts progress using the percentage-of-completion method of accounting, which relies on estimates of total expected contract revenues and costs. The company follows this method because reasonably dependable estimates of the revenue and costs applicable to various elements of a contract can be made. The financial reporting of these contracts depends on estimates, which are assessed continually during the term of the contracts and therefore, recognized revenues and profit are subject to revisions as the contract progresses to completion. Revisions in profit estimates are reflected in the period in which the facts that give rise to the revision become known. Accordingly, favorable changes in estimates result in additional revenue and profit recognition, and unfavorable changes in estimates result in a reduction of recognized revenue and profit. When estimates indicate that a loss will be incurred on a contract upon completion, a provision for the expected loss is recorded in the period in which the loss becomes evident. As work progresses under a loss contract, revenue continues to be recognized, and a portion of the contract costs incurred in each period is charged to the contract loss reserve. For other systems integration projects, the company recognizes revenue when the services have been performed.
Accounting rules governing income taxes require that deferred tax assets and liabilities be recognized using enacted tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. These rules also require that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or the entire deferred tax asset will not be realized. In 2005, the company recorded a noncash charge of $1.6 billion to increase the valuation allowance against deferred taxes.
At December 31, 2010 and 2009, the company had deferred tax assets in excess of deferred tax liabilities of $2,612 million and $2,656 million, respectively. For the reasons cited below, at December 31, 2010 and 2009, management determined that it is more likely than not that $185 million and $173 million, respectively, of such assets will be realized, resulting in a valuation allowance of $2,427 million and $2,483 million, respectively.
The company evaluates the realizability of its deferred tax assets by assessing its valuation allowance and by adjusting the amount of such allowance, if necessary. The factors used to assess the likelihood of realization are the company's historical profitability, forecast of future taxable income and available tax-planning strategies that could be implemented to realize the net deferred tax assets. The company uses tax-planning strategies to realize or renew net deferred tax assets to avoid the potential loss of future tax benefits.
Failure to achieve forecasted taxable income might affect the ultimate realization of the net deferred tax assets. Factors that may affect the company's ability to achieve sufficient forecasted taxable income include, but are not limited to, the following: increased competition, a decline in sales or margins, loss of market share, delays in product availability or technological obsolescence. See "Factors that may affect future results."
Internal Revenue Code Sections 382 and 383 provide annual limitations with respect to the ability of a corporation to utilize its net operating loss and tax credit carryforwards, respectively, against future U.S. taxable income, if the corporation experiences an "ownership change." Based on currently available information, the company believes that an ownership change occurred as of January 2011 for purposes of the rules described above. See Note 7 of the Notes to Consolidated Financial Statements.
The company's provision for income taxes and the determination of the resulting deferred tax assets and liabilities involve a significant amount of management judgment and are based on the best information available at the time. The company operates within federal, state and international taxing jurisdictions and is subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. As a result, the actual income tax liabilities in the jurisdictions with respect to any fiscal year are ultimately determined long after the financial statements have been published.
Accounting rules governing income taxes also prescribe a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The company maintains reserves for estimated tax exposures including penalties and interest. Income tax exposures include potential challenges of research and development credits and intercompany pricing. Exposures are settled primarily through the settlement of audits within these tax jurisdictions, but can also be affected by changes in applicable tax law or other factors, which could cause management of the company to believe a revision of past estimates is appropriate. Management believes that an appropriate liability has been established for estimated exposures; however, actual results may differ materially from these estimates. The liabilities are reviewed quarterly for their adequacy and appropriateness. See Note 7 of the Notes to Consolidated Financial Statements.
Accounting rules governing defined benefit pension plans require that amounts recognized in financial statements be determined on an actuarial basis. The measurement of the company's pension obligations, costs and liabilities is dependent on a variety of assumptions selected by the company and used by the company's actuaries. These assumptions include estimates of the present value of projected future pension payments to plan participants, taking into consideration the likelihood of potential future events such as salary increases and demographic experience. The assumptions used in developing the required estimates include the following key factors: discount rates, salary growth, retirement rates, inflation, expected return on plan assets and mortality rates.
As permitted for purposes of computing pension expense, the company uses a calculated value of plan assets (which is further described below). This allows that the effects of the performance of the pension plan's assets and changes in pension liability discount rates on the company's computation of pension income (expense) be amortized over future periods. A substantial portion of the company's pension plan assets and liabilities relates to its qualified defined benefit plan in the United States.
A significant element in determining the company's pension income (expense) is the expected long-term rate of return on plan assets. The company sets the expected long-term rate of return based on the expected long-term return of the various asset categories in which it invests. The company considers the current expectations for future returns and the actual historical returns of each asset class. Also, because the company's investment policy is to actively manage certain asset classes where the potential exists to outperform the broader market, the expected returns for those asset classes are adjusted to reflect the expected additional returns. For 2011 and 2010, the company has assumed that the expected long-term rate of return on U.S. plan assets will be 8.75%. A change of 25 basis points in the expected long-term rate of return for the company's U.S. and principal non-U.S. pension plans causes a change of approximately $10 million and $4 million, respectively, in pension expense. The assumed long-term rate of return on assets is applied to a calculated value of plan assets, which recognizes changes in the fair value of plan assets in a systematic manner over four years. This produces the expected return on plan assets that is included in pension income (expense). The difference between this expected return and the actual return on plan assets is deferred. The net deferral of past asset gains (losses) affects the calculated value of plan assets and, ultimately, future pension income (expense). At December 31, 2010, for the company's U.S. qualified defined benefit pension plan, the calculated value of plan assets was $4.07 billion and the fair value was $3.90 billion.
At the end of each year, the company determines the discount rate to be used to calculate the present value of plan liabilities. The discount rate is an estimate of the current interest rate at which the pension liabilities could be effectively settled at the end of the year. In estimating this rate, the company looks to rates of return on high-quality, fixed-income investments that (a) receive one of the two highest ratings given by a recognized ratings agency and (b) are currently available and expected to be available during the period to maturity of the pension benefits. At December 31, 2010, the company determined this rate to be 5.68% for its U.S. defined benefit pension plans, a decrease of 43 basis points from the rate used at December 31, 2009. A change of 25 basis points in the U.S. and principal non-U.S. discount rates causes a change in pension expense of approximately zero and $3 million, respectively, and a change of approximately $113 million and $68 million, respectively, in the benefit obligation. The net effect of changes in the discount rate, as well as the net effect of other changes in actuarial assumptions and experience, has been deferred, as permitted.
Gains and losses are defined as changes in the amount of either the projected benefit obligation or plan assets resulting from experience different from that assumed and from changes in assumptions. Because gains and losses may reflect refinements in estimates as well as real changes in economic values and because some gains in one period may be offset by losses in another and vice versa, the accounting rules do not require recognition of gains and losses as components of net pension cost of the period in which they arise.
As a minimum, amortization of an unrecognized net gain or loss must be included as a component of net pension cost for a year if, as of the beginning of the year, that unrecognized net gain or loss exceeds 10 percent of the greater of the projected benefit obligation or the calculated value of plan assets. If amortization is required, the minimum amortization is that excess above the 10 percent divided by the average remaining life expectancy of the plan participants. For the company's U.S. defined benefit pension plan, that period is approximately 21 years. At December 31, 2010, based on the calculated value of plan assets, the estimated unrecognized loss was $2.11 billion.
For the year ended December 31, 2010, the company recognized consolidated pretax pension income of $2.9 million, compared with pretax pension income of $23.6 million for the year ended December 31, 2009. For 2011, the company expects to recognize pension expense of approximately $36 million. See Note 16 of the Notes to Consolidated Financial Statements.
During 2010, the company made cash contributions to its worldwide defined benefit pension plans (principally international plans) of $81.5 million and expects to make cash contributions of approximately $115 million during 2011. In accordance with regulations governing contributions to U.S. defined benefit pension plans, the company is not required to fund its U.S. qualified defined benefit pension plan in 2011. Based on current legislation, recent interest rates and expected returns for 2011, the company currently expects that it will be required to make a contribution of approximately $100 million in 2012 to this plan.
In recent years, the company engaged in actions associated with cost reduction initiatives. The company's cost-reduction actions require significant estimates including (a) expenses for severance and other employee separation costs, (b) remaining lease obligations, including sublease income, and (c) other exit costs. The company has accrued amounts that it believes are its best estimates of the obligations it expects to incur in connection with these actions, but these estimates are subject to change due to market conditions and final negotiations. Should the actual amounts differ from the estimated amounts, the charges could be materially impacted.
Factors that may affect future results
From time to time, the company provides information containing "forward-looking" statements, as defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements provide current expectations of future events and include any statement that does not directly relate to any historical or current fact. Words such as "anticipates," "believes," "expects," "intends," "plans," "projects" and similar expressions may identify such forward-looking statements. All forward-looking statements rely on assumptions and are subject to risks, uncertainties and other factors that could cause the company's actual results to differ materially from expectations. Factors that could affect future results include, but are not limited to, those discussed below. Any forward-looking statement speaks only as of the date on which that statement is made. The company assumes no obligation to update any forward-looking statement to reflect events or circumstances that occur after the date on which the statement is made.
Factors that could affect future results include the following:
Future results will depend in part on the company's ability to drive profitable growth in consulting and systems integration. The company's ability to grow profitably in this business will depend on the level of demand for systems integration projects and the portfolio of solutions the company offers for specific industries. It will also depend on an improvement in the utilization of services delivery personnel. In addition, profit margins in this business are largely a function of the rates the company is able to charge for services and the chargeability of its professionals. If the company is unable to attain sufficient rates and chargeability for its professionals, profit margins will suffer. The rates the company is able to charge for services are affected by a number of factors, including clients' perception of the company's ability to add value through its services; introduction of new services or products by the company or its competitors; pricing policies of competitors; and general economic conditions. Chargeability is also affected by a number of factors, including the company's ability to transition employees from completed projects to new engagements, and its ability to forecast demand for services and thereby maintain an appropriate headcount.
The company's future results will depend in part on its ability to take on, successfully implement and grow outsourcing operations. The company's outsourcing contracts are multiyear engagements under which the company takes over management of a client's technology operations, business processes or networks. In a number of these arrangements, the company hires certain of its clients' employees and may become responsible for the related employee obligations, such as pension and severance commitments. In addition, system development activity on outsourcing contracts may require the company to make significant upfront investments. The company will need to have available sufficient financial resources in order to take on these obligations and make these investments.
Recoverability of outsourcing assets is dependent on various factors, including the timely completion and ultimate cost of the outsourcing solution, and realization of expected profitability of existing outsourcing contracts. These risks could result in an impairment of a portion of the associated assets, which are tested for recoverability quarterly.
As long-term relationships, outsourcing contracts provide a base of recurring revenue. However, outsourcing contracts are highly complex and can involve the design, development, implementation and operation of new solutions and the transitioning of clients from their existing business processes to the new environment. In the early phases of these contracts, gross margins may be lower than in later years when an integrated solution has been implemented, the duplicate costs of transitioning from the old to the new system have been eliminated and the work force and facilities have been rationalized for efficient operations. Future results will depend on the company's ability to effectively and timely complete these implementations, transitions and rationalizations.
Future results will also depend, in part, on market demand for the company's high-end enterprise servers and maintenance on these servers. The company continues to apply its resources to develop value-added software capabilities and optimized solutions for these server platforms which provide competitive differentiation. Future results will depend on the company's ability to maintain its installed base for ClearPath and to develop next-generation ClearPath products to expand the market.
The company faces aggressive competition in the information service sand technology marketplace, which could lead to reduced demand for the company's products and services and could have an adverse effect on the company's business. The information services and technology markets in which the company operates include a large number of companies vying for customers and market share both domestically and internationally. The company's competitors include consulting and other professional services firms, systems integrators, outsourcing providers, infrastructure services providers, computer hardware manufacturers and software providers. Some of the company's competitors may develop competing products and services that offer better price-performance or that reach the market in advance of the company's offerings. Some competitors also have or may develop greater financial and other resources than the company, with enhanced ability to compete for market share, in some instances through significant economic incentives to secure contracts. Some also may be better able to compete for skilled professionals. Any of these factors could lead to reduced demand for the company's products and services and could have an adverse effect on the company's business. Future results will depend on the company's ability to mitigate the effects of aggressive competition on revenues, pricing and margins and on the company's ability to attract and retain talented people.
The company's future results will depend on its ability to retain significant clients. The company has a number of significant long-term contracts with clients, including governmental entities, and its future success will depend, in part, on retaining its relationships with these clients. The company could lose clients for such reasons as contract expiration, conversion to a competing service provider, disputes with clients or a decision to in-source services, including for contracts with governmental entities as part of the rebid process. The company could also lose clients as a result of their merger, acquisition or business failure. The company may not be able to replace the revenue and earnings from any such lost client.
The company's future results will depend upon its ability to effectively anticipate and respond to volatility and rapid technological change in its industry. The company operates in a highly volatile industry characterized by rapid technological change, evolving technology standards, short product life cycles and continually changing customer demand patterns. Future success will depend in part on the company's ability to anticipate and respond to these market trends and to design, develop, introduce, deliver or obtain new and innovative products and services on a timely and cost-effective basis. The company may not be successful in anticipating or responding to changes in technology, industry standards or customer preferences, and the market may not demand or accept its services and product offerings. In addition, products and services developed by competitors may make the company's offerings less competitive.
The company's business can be adversely affected by global economic conditions, acts of war, terrorism or natural disasters. The company's financial results have been impacted by the global economic slowdown in recent years. If economic conditions worsen, the company could see reductions in demand and increased pressure on revenue and profit margins. The company could also see a further consolidation of clients, which could also result in a decrease in demand. The company's business could also be affected by acts of war, terrorism or natural disasters. Current world tensions could escalate, and this could have unpredictable consequences on the world economy and on the company's business.
The company has significant pension obligations and may be required to make significant cash contributions to its defined benefit pension plans. The company has unfunded obligations under its U.S. and non-U.S. defined benefit pension plans. In 2011, the company expects to make cash contributions of approximately $115 million to its worldwide, primarily non-U.S., defined benefit pension plans. In accordance with regulations governing contributions to U.S. defined benefit pension plans, the company is not required to fund its U.S. qualified defined benefit pension plan in 2011. Based on current legislation, recent interest rates and expected returns for 2011, the company currently expects that it will be required to make a contribution of approximately $100 million in 2012 to this plan.
Deterioration in the value of the company's worldwide defined benefit pension plan assets could require the company to make larger cash contributions to its defined benefit pension plans in the future. In addition, the funding of plan deficits over a shorter period of time than currently anticipated could result in making cash contributions to these plans on a more accelerated basis. Either of these events would reduce the cash available for working capital and other corporate uses and may have an adverse impact on the company's operations, financial condition and liquidity.
The company's future results will depend on the success of its program to reduce costs, focus its global resources and simplify its business structure. Over the past several years, the company has implemented significant cost-reduction measures and continues to focus on measures intended to further improve cost efficiency. In prior years, the company has incurred significant cost reduction charges in connection with these efforts. Future results will depend on the success of these efforts as well as on the success of the company's program to focus its global resources and simplify its business structure. This program is based on various assumptions, including assumptions regarding market segment growth, client demand, and the proper skill set of and training for sales and marketing management and personnel, all of which are subject to change. Furthermore, the company's institutional stockholders may attempt to influence these strategies.
The company's contracts with U.S. governmental agencies may subject the company to audits, criminal penalties, sanctions and other expenses and fines. The company frequently enters into contracts with governmental entities. U.S. government agencies, including the Defense Contract Audit Agency and the Department of Labor, routinely audit government contractors. These agencies review a contractor's performance under its contracts, cost structure and compliance with applicable laws, regulations and standards. The U.S. government also may review the adequacy of, and a contractor's compliance with contract terms and conditions, its systems and policies, including the contractor's purchasing, property, estimating, billing, accounting, compensation and management information systems. Any costs found to be overcharged or improperly allocated to a specific contract or any amounts improperly billed or charged for products or services will be subject to reimbursement to the government. In addition, government contractors, such as the company, are required to disclose credible evidence of certain violations of law and contract overpayments to the federal government. If the company is found to have participated in improper or illegal activities, the company may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines and suspension or prohibition from doing business with the U.S. government. Any negative publicity related to such contracts, regardless of the accuracy of such publicity, may adversely affect the company's business or reputation.
The company's contracts may not be as profitable as expected or provide the expected level of revenues . In a number of the company's long-term contracts for infrastructure services, outsourcing, help desk and similar services, the company's revenue is based on the volume of products and services provided. As a result, revenue levels anticipated at the contract's inception are not guaranteed. In addition, some of these contracts may permit termination at the customer's discretion before the end of the contract's term or may permit termination or impose other penalties if the company does not meet the performance levels specified in the contracts.
The company's contracts with governmental entities are subject to the availability of appropriated funds. These contracts also contain provisions allowing the governmental entity to terminate the contract at the governmental entity's discretion before the end of the contract's term. In addition, if the company's performance is unacceptable to the customer under a government contract, the government retains the right to pursue remedies under the affected contract, which remedies could include termination.
Certain of the company's outsourcing agreements require that the company's prices be benchmarked if the customer requests it and provide that those prices may be adjusted downward if the pricing for similar services in the market has changed. As a result, revenues anticipated at the beginning of the terms of these contracts may decline in the future.
Some of the company's systems integration contracts are fixed-price contracts under which the company assumes the risk for delivery of the contracted services and products at an agreed-upon fixed price. At times the company has experienced problems in performing some of these fixed-price contracts on a profitable basis and has provided periodically for adjustments to the estimated cost to complete them. Future results will depend on the company's ability to perform these services contracts profitably.
The company may face damage to its reputation or legal liability if its clients are not satisfied with its services or products. The success of the company's business is dependent on strong, long-term client relationships and on its reputation for responsiveness and quality. As a result, if a client is not satisfied with the company's services or products, its reputation could be damaged and its business adversely affected. Allegations by private litigants or regulators of improper conduct, as well as negative publicity and press speculation about the company, whatever the outcome and whether or not valid, may harm its reputation. In addition to harm to reputation, if the company fails to meet its contractual obligations, it could be subject to legal liability, which could adversely affect its business, operating results and financial condition.
Future results will depend in part on the performance and capabilities of third parties with whom the company has commercial relationships. The company has commercial relationships with suppliers, channel partners and other parties that have complementary products, services or skills. Future results will depend, in part, on the performance and capabilities of these third parties, on the ability of external suppliers to deliver components at reasonable prices and in a timely manner, and on the financial condition of, and the company's relationship with, distributors and other indirect channel partners.
More than half of the company's revenue is derived from operations outside of the United States, and the company is subject to the risks of doing business internationally. More than half of the company's total revenue is derived from international operations. The risks of doing business internationally include foreign currency exchange rate fluctuations, currency restrictions and devaluations, changes in political or economic conditions, trade protection measures, import or export licensing requirements, multiple and possibly overlapping and conflicting tax laws, new tax legislation, weaker intellectual property protections in some jurisdictions and additional legal and regulatory compliance requirements applicable to businesses that operate internationally, including the Foreign Corrupt Practices Act and non-U.S. laws and regulations.
Financial market conditions may inhibit the company's ability to access capital and credit markets to address its liquidity needs. The capital and credit markets have experienced volatility and disruption. Financial market conditions may impact the company's ability to borrow, to refinance its outstanding debt, or to utilize surety bonds, letters of credit, foreign exchange derivatives and other financial instruments the company uses to conduct its business. Although the company intends to use cash on hand to address its liquidity needs, its ability to do so assumes that its operations will continue to generate sufficient cash.
The company's services or products may infringe upon the intellectual property rights of others. The company cannot be sure that its services and products do not infringe on the intellectual property rights of third parties, and it may have infringement claims asserted against it or against its clients. These claims could cost the company money, prevent it from offering some services or products, or damage its reputation.
Pending litigation could affect the company's results of operations or cash flow. There are various lawsuits, claims, investigations and proceedings that have been brought or asserted against the company, which arise in the ordinary course of business, including actions with respect to commercial and government contracts, labor and employment, employee benefits, environmental matters and intellectual property. See Note 14 of the Notes to Consolidated Financial Statements for more information on litigation. The company believes that it has valid defenses with respect to legal matters pending against it. Litigation is inherently unpredictable, however, and it is possible that the company's results of operations or cash flow could be affected in any particular period by the resolution of one or more of the legal matters pending against it.
The company could face business and financial risk in implementing future dispositions or acquisitions. As part of the company's business strategy, it may from time to time consider disposing of existing technologies, products and businesses that may no longer be in alignment with its strategic direction, including transactions of a material size, or acquiring complementary technologies, products and businesses. Potential risks with respect to dispositions include difficulty finding buyers or alternative exit strategies on acceptable terms in a timely manner; potential loss of employees; and dispositions at unfavorable prices or on unfavorable terms, including relating to retained liabilities. Any acquisitions may result in the incurrence of substantial additional indebtedness or contingent liabilities. Acquisitions could also result in potentially dilutive issuances of equity securities and an increase in amortization expenses related to intangible assets. Additional potential risks associated with acquisitions include integration difficulties; difficulties in maintaining or enhancing the profitability of any acquired business; risks of entering markets in which the company has no or limited prior experience; potential loss of employees or failure to maintain or renew any contracts of any acquired business; and expenses of any undiscovered or potential liabilities of the acquired product or business, including relating to employee benefits contribution obligations or environmental requirements. Further, with respect to both dispositions and acquisitions, management's attention could be diverted from other business concerns. Adverse credit conditions could also affect the company's ability to consummate dispositions or acquisitions. The risks associated with dispositions and acquisitions could have a material adverse effect upon the company's business, financial condition and results of operations. There can be no assurance that the company will be successful in consummating future dispositions or acquisitions on favorable terms or at all.
The company believes that its ability to use its U.S. federal net operating loss carryforwards and other tax attributes is limited. Internal Revenue Code Sections 382 and 383 provide annual limitations with respect to the ability of a corporation to utilize its net operating loss (as well as certain built-in losses) and tax credit carryforwards, respectively (Tax Attributes), against future U.S. taxable income, if the corporation experiences an "ownership change." In general terms, an ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. The company regularly monitors ownership changes (as calculated for purposes of Section 382). Based on currently available information, the company believes that an ownership change occurred as of January 2011 for purposes of the rules described above. Moreover, any future transaction or transactions and the timing of such transaction or transactions could trigger an additional ownership change under Section 382.
As a result of the ownership change, utilization of the company's Tax Attributes will be subject to an estimated overall annual limitation determined in part by multiplying the total aggregate market value of the company's common stock immediately preceding the ownership change by the applicable long-term tax-exempt rate (which is 4.10% for January 2011), possibly subject to increase based on the built-in gain if any, in the company's assets at the time of the ownership change. Any unused annual limitation may be carried over to later years. Future U.S. taxable income may not be fully offset by existing Tax Attributes, if such income exceeds the company's annual limitation. However, based on presently available information and the existence of tax planning strategies, currently the company does not expect to incur a cash tax liability in the near term. The company maintains a full valuation allowance against the realization of all U.S. deferred tax assets as well as certain foreign deferred tax assets in excess of deferred tax liabilities.