In this Annual Report on Form 10-K, the words “L-1” and the “Company” refer to L-1 Identity Solutions, Inc. and, except as otherwise specified herein, to L-1 subsidiaries. L-1’s fiscal year ended on December 31, 2009.

 

BUSINESS OVERVIEW

 

L-1 Identity Solutions, Inc. (“L-1” or the “Company”) is a provider of technology, products, systems and solutions, and services that protect and secure personal identities and assets. Through its divisions, L-1 delivers the full range of offerings required for solving complex problems associated with managing identity.

 

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

 

Solutions

 

The Solutions segment consists of the Secure Credentialing and Biometrics / Enterprise Access Divisions. Solutions from these divisions are marketed to Federal agencies, State and Local government agencies (including law enforcement and department of corrections), foreign governments, and commercial entities (such as financial and health care institutions and casinos).

 

Solutions revenue includes products and related services, which comprise hardware, components, consumables and software, as well as maintenance, consulting and training services.

 

Services

 

The Services segment includes the Enrollment Services Division and Government Consulting Services Group.

 

Enrollment Services perform fingerprinting and process background checks for civilians at centers across the U.S. and Canada.

Government Consulting Services includes the businesses of Advanced Concepts (Information Technology Solutions), McClendon (Engineering & Analytical Solutions), and SpecTal (Intelligence Services).

 

Government Consulting Services offer comprehensive consulting, program management, information analysis, training, security, technology development, and information technology solutions to the U.S. intelligence community.

 

Depending upon customer needs, L-1 services can be bundled with identity solutions, product and services offerings to create an integrated solution.

 

 

The L-1 Portfolio of Identity Management
Solutions and Services

SECURE CREDENTIALING SOLUTIONS

 

The Secure Credentialing division provides solutions that protect and secure identities and assets by helping customers produce the most secure credentials possible.

 

The division builds and maintains an end-to-end secure process for ID production starting with identity proofing, vetting, and enrollment; incorporating biometric-based recognition and identity database management; card design and production; and inspection and authentication.

 

There are more than 6,500 L-1 systems in more than 20 countries used for large-scale credentialing programs around the world. L-1 systems are used to produce more than 80 percent of U.S. driver’s licenses (including Enhanced Driver’s Licenses), the U.S. Passport, U.S. Passport Card and Border Crossing Card, and other citizen credentials such as National and Voter IDs, passports and more. More than two billion cards have been produced to date using L-1 solutions.

 

During 2009, L-1 was awarded 19 of 20 competitive credentialing procurements and booked approximately $289 million in global driver’s license extensions and new contracts. The contracts awarded in 2009 had a price-per-card increase on average of 50 percent over prior contracts due to the inclusion of more value-added services and security technologies as part of the credential issuance process.

 

L-1 believes that Department of Motor Vehicle bureaus across the U.S. are increasingly turning to L-1 to enhance their issuance systems and establish more secure end-to-end processes for license production.

This is evidenced by the following:

 

 

L-1 has introduced new self service kiosks and value-added services in 2009 which offer further opportunity for growth independent from, and additive to, that generated from State driver’s license production contracts.

 

At the Federal level, in 2009 the Department of State reiterated its commitment to L-1 with a five-year sole source contract award for U.S. Passport printing valued at up to $195.0 million and continued to enhance Passport Cards and Border Crossing Cards produced by L-1.

 

International demand continued to build with opportunities for large scale National and Voter ID programs in Latin America, Africa, India and the Middle East.

 

Finally, L-1 is expected to be the exclusive provider of secure credentialing services and technologies to Alclear LLC, the winning bidder, for the assets of Verified Identity Pass (VIP), a private Company which was engaged in the airport passcard program authorized by the TSA.

The Biometric Division of L-1 provides solutions that protect and secure personal identities and assets by providing state-of-the art technologies that capture, store, manage and distribute biometric data for positive, rapid ID and tracking of persons of interest as part of large-scale identity management programs.

 

Customers include State, Local, Federal and international government agencies and ministries, and commercial businesses. The solutions are part of civilian and criminal identification management programs in border management, credentialing, law enforcement and military applications.

 

Solutions and products include multi-modal automated biometric identification and matching systems (ABIS), finger and palm print scanners, integrated multi-biometric (finger, face and iris) devices including HIIDE^tm and PIER^tm automated facial recognition systems both static (digital photo or mug shot) and dynamic (video) and automated iris recognition systems (AIRS). L-1 also manufactures multi-biometric-based readers used to secure buildings and restricted areas, available though more than 400 partners worldwide.

 

The division’s revenue in 2009 included more than $95 million of combined software and hardware solutions delivered to customers.

 

Development highlights in 2009 include:

 

 

At the Federal level, L-1’s facial recognition technology was incorporated into the U.S. Passport program in 2009, an extension beyond its current use in the U.S. Visa program (the largest facial database in the world with more than 80 million records). The Department of Defense (DoD) next generation ABIS system is running 28 times faster and finding hundreds of thousands more matches than the legacy DoD system according to DoD reports.

 

Internationally, a Middle Eastern customer expanded its contract with L-1 to take advantage today of system integration capabilities and customized functionality made possible through technological advances in HIIDE 5 due out in 2010. L-1 iris technology is performing nearly half a billion cross-comparisons per second on the largest iris database in the world.

 

Other new international contracts included facial recognition for customs police, narcotics and e-passport customers across Asia Pacific, and multi-modal search for civil and criminal applications in Canada, Qatar, Egypt, New Zealand, Mexico and the UK.

 

ENROLLMENT SERVICES

 

The Enrollment Services division provides services that protect and secure identities and assets by performing fingerprinting and processing background checks for civilians at centers across the U.S. and Canada.

 

With more than 1,000 locations today, L-1 believes it is the largest network of enrollment centers in the U.S. and Canada. The centers processed more than two million individuals in 2009.

 

The centers use enrollment stations, live scan systems and software to fingerprint and process background checks for civilian applications.

 

Enrollment Services revenue growth exceeded 47 percent for the year as compared to the prior year period. Growth is coming in part from new contracts, such as those in New York and Indiana, which encompass more than 170 sites and dozens of agencies. Growth is also occurring through the expansion of existing contracts such as in Texas where 688,000 applicants were printed in 2009.

 

Today the division has established a nationwide scalable network that L-1 believes is capable of expanding to capitalize on new revenue opportunities. These include:

 

 

The infrastructure behind L-1’s network enables the centers to support Local, State and Federal enrollments. This ranges from checks against a State AFIS (Automated Fingerprint Identification System) to processing directly through the FBI channel.

 

Approximately one-third of all L-1 centers process applicants for Federal programs (TWIC, HAZPRINT). L-1 also is one of only 15 approved FBI channels.

 

In 2009, the TWIC program was fully transitioned to L-1 from its partner at the end of 2009. L-1 expects the program to continue to grow as new initiatives are added to print other transportation-related employees.

 

 

The Government Consulting Services Group provides services that protect and secure personal identities and assets by providing highly specialized solutions and services that address critical concerns in national security and intelligence.

 

The group includes the businesses of Advanced Concepts (Information Technology), McClendon (Engineering & Analytical), and SpecTal (Intelligence Services).

 

Advanced Concepts (Information
Technology (IT))

 

Advanced Concepts delivers IT solutions and services that help customers assure information superiority over any enemy, help make critical information systems and infrastructure more secure, and ensure that Federal sector processes and transactions move at maximum speed.

 

Advanced Concepts’ core competencies include:

 

 

McClendon (Engineering & Analytical)

 

McClendon delivers engineering and analytical services to the Department of Defense and Intelligence Community. L-1 believes that McClendon is distinguished by highly qualified experts in the areas of its core competencies. When combined with proven procedures and best practices policies, McClendon (Engineering & Analytical) ensures prompt and quality work within budget.

 

McClendon’s core competencies include:

 

 

SpecTal (Intelligence Services)

 

SpecTal provides government and corporate clients with specialized security and intelligence consulting, going beyond assessments to present results-oriented solutions. Building on its employees intelligence careers marked by achievement in demanding assignments, SpecTal offers clients a broad range of experience and expertise. L-1 believes that its results have earned the group a reputation for service, responsiveness, and integrity.

 

SpecTal’s core competencies include:

 

 

In 2009, Government Consulting Services group benefited from the emergence of cyber security related initiatives and renewed demand for counterterrorism technologies across the intelligence community.

 

L-1 is playing an important role in government contracts related to transportation issues and Homeland Security. In addition, the Government Consulting Services group is on several cybersecurity related task orders and provides direct support to customers under the Comprehensive National Cybersecurity Initiative (CNCI) and other established Information Assurance (IA) programs.

 

Resources continue to grow in all areas of cybersecurity, including operational Computer Security Incident Response Center (CSIRC)/Computer Emergency Response Team (CERT) analytic support, Computer Network Defense (CND) strategy & tactics, and IA architecture development and policy analysis.

INDUSTRY OVERVIEW

 

MARKETS AND TRENDS IN CREDENTIALING AND BIOMETRIC SOLUTIONS

 

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

 

A core element to the L-1 identity management value proposition is biometrics. Biometrics are unique, individual physiological or behavioral characteristics, such as fingerprints, palm prints, facial characteristics, iris and voice patterns, hand geometry and handwriting patterns, which can be used to determine or verify an individual’s identity. Technology digitally captures and encodes these individual biometric characteristics and then compares that uniquely personal characteristic against previously encoded biometric data to determine or validate an individual’s identity.

 

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

 

Governments and their agencies were the early adopters of biometrics and today remain the primary customers for the industry. For law

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

 

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

 

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

 

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

 

Automated Biometric Identification Systems (ABIS) and Live Scan Systems are the largest market space for biometrics. These are large scale and highly complex systems used in law enforcement, background checks, and civil identification programs. Live scans are deployed as a front end to most ABIS systems and include hardware and software that captures and processes fingerprint images prior to submission. The ABIS and Live Scan market is

considerably more mature than any other biometric market sector. Increasingly, multiple biometrics are also being incorporated into these systems, augmenting fingerprints with hand/palm prints, facial images and iris patterns.

 

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

 

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

 

MARKETS AND TRENDS FOR GOVERNMENT SERVICES

 

The Federal government is the largest consumer of information technology services and solutions in the United States. L-1 believes that the Federal government’s spending on information technology and services will continue to increase in the next several years, driven by the expansion of National Defense and Homeland Security programs, the continued need for sophisticated intelligence gathering and information sharing, increased reliance on technology service providers due to shrinking ranks of government employee technical professionals, and the continuing impact of Federal procurement reform and Office of Management and Budget mandates regarding IT spending. Federal government spending on information technology has consistently increased in each year since 1980.

 

L-1 believes the following trends will continue to impact spending and dependence on technology and support contractors among the Company’s core intelligence community customers.

 

The emphasis on counter-terrorism, irregular warfare, Homeland Defense, and combating the spread of weapons of mass destruction remain overarching guiding principles for current and out-year funding priorities. L-1 believes Intelligence Agencies will increase demand for data and text mining solutions to enable them to extract, analyze, and present data gathered from the massive volumes of information available through open sources such as the Internet. This increased focus on National Security, Homeland Security, and intelligence has also reinforced the need for interoperability among the many disparate information technology systems throughout the Federal government. L-1 believes the Department of Defense, Department of Homeland Security and the intelligence community will continue to be interested in systems that strengthen the coordination within and among agencies and departments.

 

Demand for technology service providers is expected to increase due to the need for Federal agencies to maintain core operational functions while the available technical workforce shrinks. L-1 believes this trend will continue, despite the fact that certain

agencies within the Intelligence community have indicated a goal of reducing reliance on contractors. Given the difficulty the Federal government has experienced in hiring and retaining skilled technology personnel in recent years, L-1 believes the Federal government will continue to rely on technology service providers that have experience with government systems, can sustain mission — critical operations and have the required government security clearances to deploy qualified personnel in classified environments.

 

Alternative choices of contract acquisition vehicles have created market-based environments in government procurement. In recent years, Federal agencies have had increased access to alternative choices of contract acquisition vehicles-such as indefinite delivery/indefinite quantity (ID/IQ) contracts, Government Wide Acquisition Contracts (GWACs), the General Services Administration (GSA) schedule and agency specific Blanket Purchase Agreements (BPAs). These choices have created a market-based environment in government procurement that has increased contracting flexibility and provided government agencies access to multiple channels to contractor services. Contractors’ successful past performance, as well as technical capabilities and management skills, remain critical elements of the award process. L-1 believes that the increased flexibility associated with the multiple channel access, such as ID/IQ contracts, GWACs, GSA schedule contracts and BPAs, will result in the continued utilization of these contracting vehicles in the future, and will facilitate access to service providers to meet the demand for, and delivery of, required services and solutions.

 

An emphasis on addressing cyber-security is expected to drive greater demand for a variety of L-1 government services. The Comprehensive National Cyber Security Initiative of 2008 has a dozen components intended to better protect computer systems and networks from cybercrime and improve information technology processes and policies within the government. Specific improvements aimed at cyber counter intelligence, situational awareness, and implementation of information technology will have the most impact on L-1.

The current strategic environment dictates the need for more dependencies in the form of alliances and partnerships. Alliances with large and small companies that have agency mission knowledge and/or established credentials related to specific solutions and services are critical in winning large contracts.

 

CUSTOMERS

 

Over 95 percent of L-1 sales are to Federal, State, Local and foreign governments and government agencies. Contracts with governments and agencies generally allow the customer to terminate the contract for convenience or failure of the government to appropriate funds.

 

For the year ended December 31, 2009, U.S. Federal government agencies accounted for 59 percent of L-1’s consolidated revenues. Historically, L-1 has experienced minimal customer turnover and the Company believes this is a result of its strong solutions and emphasis on customer service and support.

 

L-1 customers include:

 

 

L-1 Growth in International Sales of

Products and Solutions

 

As a percentage of L-1 revenue, excluding the domestically focused service businesses, L-1’s international sales in products and solutions have grown from 12 percent in 2006 to 14 percent in 2007 to 16 percent in 2008 to 17 percent in 2009. The trend reflects an increased international marketing focus, which we expect to continue.

 

COMPETITION

 

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

 

State-of-the-art technologies and solutions that encompass every major biometric modality. L-1 is the only Company that directly offers Fingerprint and Palm print (AFIS/APIS), facial and iris recognition technologies. Accordingly, L-1 can provide a complete turnkey solution. Because of L-1’s in depth knowledge of the core identity technologies, L-1 can offer customers speed of operation and value for identity solutions. Furthermore, L-1 remains at the forefront of innovation through its strong and focused internal development team.

 

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

civil, State and Local, criminal, border management and commercial markets.

 

Strong and tenured relationships with customers and partners.  Today L-1 customers include most Federal agencies and branches of the U.S. military, more than 29 international governments, the majority of U.S. State Departments of Motor Vehicle (DMV) and local law enforcement agencies, and other commercial customers. The pervasiveness of L-1 relationships makes the Company a trusted choice for customers and partners seeking relationships with proven vendors. L-1 is on several teams for Biometric Operations Systems and Services (BOSS) program.

 

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

 

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

 

 

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

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

 

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

 

BUSINESS DEVELOPMENT, MARKETING AND SALES, BIDS AND PROPOSALS

 

Marketing and Sales

 

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

 

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

 

L-1’s marketing efforts were realigned in 2009 to improve coordination of State and Local offerings across L-1 businesses. The Company also adopted a coordinated team approach to

pursuing intelligence agency opportunities to provide broader and stronger service offerings.

 

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

 

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

 

At the end of 2009, L-1 employed 140 professionals in business development, sales and marketing.

 

Strategic Partnerships

 

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

 

Bids and Proposals

 

The majority of L-1 government services business and much of its solutions business is won through submission of formal competitive bids. Commercial bids are frequently negotiated as to terms and conditions for schedule, specifications, delivery and payment. However, in most cases the client specifies the terms and conditions and form of contract. In situations where the client-imposed contract type and/or terms appear to expose L-1 to

inappropriate risk, the Company may seek alternative arrangements or opt not to bid for the work.

 

L-1 contracts and subcontracts are composed of many contract types, including firm fixed-price, cost reimbursement, time-and-materials, indefinite delivery/indefinite quantity (ID/IQ) and Government Wide Acquisition Contracts (GWACs), the General Services Administration (GSA) schedule and agency specific Blanket Purchase Agreements (BPAs).

 

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

 

RESEARCH AND DEVELOPMENT

 

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

 

The research and development team totals approximately 260 developers, scientists and engineers distributed among these centers. Activities are coordinated at the corporate level under the Company’s Chief Strategic Officer to ensure support of the overall innovation goals and mission of L-1 and the realization of synergies in the research and development investment.

 

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

 

 

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

 

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

 

The Company benefits from the development activities of manufacturers of the components integrated into L-1 systems. This includes cameras, database software and computers. L-1 performs research and development for customers, including efforts for the U.S. government and its agencies.

 

Gross research and development expenditures aggregated to $46.9 million for the year ended December 31, 2009 compared to $43.0 million in the prior year. Virtually all of L-1 research and development costs are attributable to the Solutions segment. As a percentage of Solutions revenues, gross research and development costs were 15 percent for years ended December 31, 2009 and 2008.

 

INTELLECTUAL PROPERTY

 

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

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

 

The Company owns a portfolio of 219 U.S. and foreign patents. In addition, L-1 has 160 U.S. and foreign patent applications in process for biometrics and document authentication technologies. While the duration of patents varies, the Company believes that the duration of its patents is adequate relative to the expected lives of L-1 products. L-1 owns the registered trademarks for “L-1” and “L-1 Identity Solutions”, and owns a broad portfolio of other vital registered and pending trademarks in the U.S. and foreign jurisdictions.

 

BACKLOG

 

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

 

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

 

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

 

L-1 Backlog of $1.3 Billion

 

At December 31, 2009 backlog, determined as described above, approximated $1.3 billion, of which approximately $510.0 million is expected to be realized in 2010.

 

Revenues from backlog, together with other recurring revenues not in backlog, are expected to be approximately $645.0 million or 87 percent of 2010 expected revenues.

 

MANUFACTURING

 

L-1 engineers and designs the hardware products it sells and develops much of the software embedded in them. Except as described below with respect to secure credentials, L-1 either limits manufacturing activities to the assembly, repair, and testing of these products, or manages production through contract manufacturers. In either case, L-1 qualifies suppliers for the core components which typically have established supply chains. L-1 believes this permits rapid expansion of production capacity to meet any significant increase in product demand and minimizes both development costs and the cost of scaling of manufacturing capabilities.

 

L-1 believes that these costs will decline if manufacturing volumes increase. L-1 engineers, designs and produces most of the card products used for the production of secure credentials that have proprietary features or functionality and which account for over 50 percent of L-1 credentialing volume. L-1 purchases the remaining card products from established sources. L-1 produces driver licenses for 21 States in secure central issuance facilities in Texas, Florida, North Carolina, Pennsylvania, Indiana, California, Georgia, and Washington. In 2010 the Company expects to open a new central issuance facility in Massachusetts to accommodate States converting,

or expected to convert, to central issuance in 2010 and 2011. L-1 also produces the Mexican voter identification credentials in a central issuance facility in Mexico City.

 

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

 

SEASONALITY

 

In general, the L-1 business is not seasonal. However, because most of its government consulting services revenue is earned on a time and material and fixed price level of effect basis, the Company is impacted by holidays and vacations taken by employees.

 

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

delays can affect L-1 revenue and profit during the period of delay.

 

FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT SALES

 

For the years ended December 31, 2009, 2008 and 2007, foreign and export sales were approximately $56.0 million, $47.7 million, and $29.0 million, respectively.

 

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

 

 

2007 – 2009 L-1 Foreign Operations and Export Sales

 

REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION

 

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

 

RECENT ACQUISITIONS

 

During 2009, L-1 did not consummate any acquisitions. In 2008, L-1 acquired Bioscrypt Inc. and the ID Systems business of Digimarc Corporation. In 2007, L-1 acquired Advanced Concepts Inc., McClendon Corporation and ComnetiX Inc. See Note 13 of L-1’s Consolidated Financial Statements provided in response to Item 8 of this annual report on Form 10-K.

CAPITAL REQUIREMENTS

 

L-1’s most significant capital requirements arise primarily from acquisitions in support of its business strategy, capital expenditures for new secure credentialing contracts, expenditures for research and development and working capital needs. For example, L-1 must commit to provide up-front capital expenditures in order to install systems necessary to perform when bidding on new State driver’s license contracts. The most significant capital expenditures are related to the Secure Credentialing business, which has increased in size and scope due to the acquisition of the ID Systems business of Digimarc Corporation (“Old Digimarc”) in August 2008. Accordingly, L-1 expects capital requirements to increase as the Company bids on and is awarded new contracts or as contracts are renewed. In 2009, L-1’s capital expenditures increased to $55.0 million compared to $22.5 million in 2008 and are expected to increase to $60.0 million in 2010 as L-1 is required to fund capital expenditures for contracts awarded and expected to be awarded. L-1 expects capital expenditures to decline significantly in 2011, as it completes the build out of systems for recently awarded contracts.

 

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

 

ENVIRONMENTAL PROTECTION REGULATIONS

 

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

 

EMPLOYEES

 

As of December 31, 2009, L-1 had 2,339 full time employees. No employees are covered by collective bargaining agreements. The Company believes that its relations with employees are good.

 

OFFICERS

 

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

Robert V. LaPenta, 64, has served as the Chairman of the Board since December 2005, President and Chief Executive Officer of L-1 since August 2006. Mr. LaPenta is the founder and Chief Executive Officer of L-1 Investment Partners, LLC, a private investment management firm. From April 1997 to April 2005, Mr. LaPenta served as President, Chief Financial Officer and a Director of L-3 Communications Holdings, Inc., which he co-founded in April 1997. From April 1996 when Loral Corporation was acquired by Lockheed Martin Corporation, until April 1997, Mr. LaPenta was a Vice President of Lockheed Martin and was Vice President and Chief Financial Officer of Lockheed Martin’s Command, Control, Communications and Intelligence and Systems Integration Sector. Prior to the April 1996 acquisition of Loral, he was Loral’s Senior Vice President and Controller, a position he held since 1991. He joined Loral in 1972 and was named Vice President and Controller of its largest division in 1974. He became Corporate Controller in 1978 and was named Vice President in 1979. Mr. LaPenta is on the Board of Trustees of Iona College, the board of directors of Core Software Technologies and the board of directors of Leap Wireless International, Inc.

 

Dr. Joseph Atick, 45, joined L-1 in August 2006 as Executive Vice President and Chief Strategic Officer effective with the merger of Identix with L-1. Prior to that, he served as President & Chief Officer of Identix since June of 2002. Prior to that, he had co-founded one of the original facial recognition companies, Visionics Corporation. Over the years, Dr. Atick co-founded and managed several companies focused on technology transfer and development, and has served as a technical advisor to many high-tech enterprises and organizations, including NATO. He had also led the Computational Neuroscience Laboratory at Rockefeller University and the Neural Cybernetics Group at the Institute for Advanced Study in Princeton, New Jersey. Dr. Atick holds a Ph.D. in Mathematical Physics from Stanford University.

 

James A. DePalma, 58, joined L-1 as Executive Vice President, Chief Financial Officer and Treasurer effective with the merger of Identix with L-1. He brings three decades of operational

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

 

Doni L. Fordyce, 50, joined L-l as Executive Vice President of Corporate Communications effective with the merger of Identix with L-1. Prior to August 2006, she was a founding partner of L-1 Investment Partners and brings two decades of senior executive and investment management experience to the Company, serving most recently as Chief Executive Officer, President and Chief Operation Officer of Bear Stearns Asset Management (BSAM) Inc. Prior to that Ms. Fordyce was Vice President of Goldman Sachs Inc. from 1986 to 1996 where she was one of the founders of the asset management business. She has also worked in IT solutions consulting, specializing networking, data management and printing for investment banks and financial institutions.

 

Mark S. Molina, 50, joined L-1 in August 2006 as Executive Vice President, Chief Legal Officer and Secretary in August 2006 effective with the merger of Identix with L-1. Prior to joining L-1, he was Executive Vice President, Chief Legal Officer and Secretary at Identix, which he joined as Vice President and General Counsel in 1999. Mr. Molina is a business and technology lawyer with over 20 years experience structuring and negotiating mergers, acquisition, dispositions, joint ventures, technology licenses, financings and investments. He has considerable experience with public offerings and private placements as well as SEC reporting compliance and obligations of publicly traded companies.

Joseph Paresi, 54, joined L-1 in August 2006 as Executive Vice President and Chief Marketing Officer effective with the merger of Identix with L-1. He was a founding partner of L-1 Investment Partners LLC. Mr. Paresi brings three decades of executive management, product development, and design engineering experience in the technology and defense industries to his role with the Company. Prior to joining L-1 Investment Partners, he served as Corporate Vice President of product development for L-3 Communications and as President of L-3 Security & Detection Systems from 1997 to 2005.

 

Vincent A. D’Angelo, 65, joined L-1 as Senior Vice President of Finance in August 2006 effective with the merger of Identix with L-1. Prior to that, he was a consultant for L-1 Investment Partners. Prior to that, Mr. D’Angelo was a Senior Audit Partner with PricewaterhouseCoopers for more than 35 years where he was involved in all facets of the business, including client service, management, operations, governance, SEC filings, and mergers and acquisitions.

 

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

 

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

 

INTERNET WEBSITE

 

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

 

L-1 is not incorporating information contained in the website by reference into this Annual Report on Form 10-K. The Company makes available, free of charge through the website, its Annual

Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments to these reports as soon as reasonably practicable after electronically filing such material with, or furnish such material to, the Securities and Exchange Commission.

 

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

 

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

BUSINESS RISKS

 

L-1 has a history of operating losses. L-1 has a history of operating losses before income taxes. The business operations began in 1993 and, except for 1996 and 2000, have resulted in losses before income taxes in each year, which have included significant asset impairments and merger related expenses, amortization of intangible assets and stock-based compensation expense. At December 31, 2009, L-1 had an accumulated deficit of approximately $627.4 million. L-1 will continue to invest in the development of secure credential and biometric technologies, as well as government services and will make significant capital expenditures to meet the requirements of recently awarded secure credentialing contracts. The need for these expenditures to grow the business will affect the ability to report operating profit and reduce the accumulated deficit.

 

Over 95 percent of L-1 revenue is from government contracts which are often non-standard, involve competitive bidding, may be subject to cancellation with or without penalty and may produce volatility in earnings and revenue. More than 95 percent of L-1’s business involves providing solutions and services under contracts with U.S. Federal, State, Local and foreign government agencies. Obtaining contracts from government agencies is challenging and government contracts often include provisions that are not standard in commercial transactions.

 

For example, government contracts may:

 

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

 

In addition, government contracts may specify performance criteria that must be satisfied before the customer accepts the products and services. Collection of accounts receivable may be dependent on meeting customer requirements, which may be unpredictable, subject to change by the customer, and not fully understood by L-1 at the time of acceptance of the order, and may require the incurrence of unexpected costs that may be uncompensated and could negatively affect profit margins and liquidity.

 

Government contracts are subject to continued appropriations by Congress and availability of funding for State and Local programs. Reduced funding or changes in procurement policies that curtail the use of outside contractors could result in terminated, delayed or de-scoped contracts with L-1 and adversely affect the ability for L-1 to meet sales and earnings goals. For the year ended December 31, 2009 and 2008, U.S. Federal government agencies, directly or indirectly, accounted for 59 percent and 64 percent of L-1 consolidated revenues, respectively. Future sales under existing and future awards of U.S. government contracts are conditioned upon the continuing availability of Congressional appropriations, which could be affected by current or future economic conditions. In addition, while spending authorizations for intelligence and defense-related programs by the Federal government has increased in recent years, particularly after the 2001 terrorist attacks and more recently in support of U.S. war efforts in Southwest Asia,

future levels of expenditures, mission priorities and authorizations for these programs may decrease, remain constant or shift to programs in areas where L-1 does not currently provide services. Current Federal government spending levels for defense-related programs are in part related to the U.S. military operations in Afghanistan and Iraq, and may not be sustainable, as a result of changes in government leadership, policies or priorities.

 

Recently the Federal government has indicated a goal of reducing the use of contractors in certain areas and “in-sourcing” the related functions. These initiatives may adversely impact the growth of portions of L-1 government services businesses.

 

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

 

The full amount of L-1 revenues reflected in backlog may not be realized, which could harm operations and significantly reduce future revenues. There can be no assurances that backlog estimates will result in actual revenues in any particular fiscal period because clients may modify or terminate projects and contracts and may decide not to exercise contract options or estimate of quantities may not materialize.

 

L-1 backlog represents sales value of firm orders for products and services not yet delivered and, for long term executed contractual arrangements (contracts, subcontracts, and customer’s commitments), the estimated future sales value

of estimated product shipments, transactions processed and services to be provided over the term of the contractual arrangements, including renewal options expected to be exercised. For contracts with indefinite quantities backlog reflects estimated quantities based on current activity levels. Backlog includes estimates of revenues that are dependent on future government appropriation, option exercise by clients and/or is subject to contract modification or termination. Due to current economic environment and potential spending constraints experienced by State and Local governments, in particular, realization of backlog may be adversely impacted. At December 31, 2009, L-1 backlog was approximately $1.3 billion of which approximately $510.0 million is expected to be realized in 2010. Revenues from backlog, together with other recurring revenues not in backlog comprise $645.0 million or 87 percent of expected 2010 revenues. These estimates are based on L-1 experience under such contracts and similar contracts, and the Company believes such estimates to be reasonable in the circumstances. However, L-1 believes that the estimate of revenues reflected in backlog for the following twelve months will generally be more reliable than estimate for periods thereafter.

 

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

 

Quarterly results are difficult to predict due to factors including long sales cycles; if quarterly financial expectations are missed, the L-1 stock price could decline. Quarterly revenue and operating results are difficult to predict and fluctuate from quarter to quarter. The sales cycle for solutions and services is typically long and subject to a number of significant risks and potential delays over which the Company has no or little control. While potential customers are evaluating L-1 products, the Company may incur substantial selling and marketing costs and expend significant management resources in an effort to obtain sales order and contracts that may never materialize. In addition, as operating expenses are based on anticipated revenue levels, fluctuations in revenues as a result of the timing of contract awards and the exercise of

options and task orders can cause operating results to vary significantly between periods. Factors which may delay procuring decisions include:

 

 

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

 

 

L-1’s exploration of strategic alternatives may not result in any sale transaction. In January 2010, L-1 announced that one of its strategic goals and objectives for 2010 was to explore alternatives to enhance shareholder value. At this time, there can be no assurance that the exploration of

strategic alternatives will result in any sale transaction, the timing of such a sale transaction, or whether a significant premium to current market trading prices for L-1’s common stock can be obtained as part of any such transaction.

 

L-1 may be unable to obtain additional capital required to finance acquisitions due to continuing adverse market conditions and the Company must fund substantial capital expenditures for the secure credentialing business. One of the components of the L-1 strategy is growth through strategic acquisitions. In addition, the installation of secure credentialing systems requires significant capital expenditures. The need to fund such capital expenditures has increased following the acquisition of the secure credentialing business of Digimarc.

 

For the twelve months ended December 31, 2009, capital expenditures increased to $55.0 million, as compared to $22.5 million in the corresponding period of the prior year and are expected to increase to $60.0 million in 2010. While L-1 expects to fund capital requirements primarily from operating cash flows, in the near term, cash otherwise available to fund strategic opportunities and prepay long-term debt is reduced. At December 31, 2009, L-1 had cash and cash equivalents of $6.6 million and availability under the line of credit of $123.0 million, net of borrowings and letters of credit, subject to continuing compliance with covenants contained in the agreement. While the Company believes it has adequate capital resources to meet current working capital and capital expenditure requirements and has been successful in the past in obtaining financing for acquisitions, L-1 expects to have increased capital needs as it continues to expand its business.

 

In addition, the ability to execute the Company’s acquisition strategy may be adversely affected by the current market conditions which may continue over a prolonged period. The Company may be unsuccessful in raising additional financing to fund growth or it may have difficulty in obtaining financing at attractive rates or on terms that are not excessively dilutive to existing stockholders. Failure to secure additional financing in a timely manner and on favorable terms could have a

material adverse effect on the growth strategy, financial performance and stock price and could require the Company to delay or abandon expansion.

 

Covenants in the Company’s credit facility may restrict financial and operating flexibility. L-1 maintains a credit agreement with Bank of America N.A. The agreement provides for up to $435 million in available borrowings through 2013, pursuant to which $123 million is currently available, subject to continuing compliance with debt covenants. Under the agreement, L-1 is required to maintain specific financial covenants related to a leverage ratio and fixed charge coverage. The agreement also places limitations on additional borrowings, mergers and related-party transactions, on payment of dividends and with respect to capital expenditures. Borrowings under the agreement are collateralized by Company’s assets and bear interest at the Eurodollar Rate, or the lender’s base rate, plus market-rate spreads that are determined based on the Company’s leverage ratio calculation.

 

The ability to satisfy these financial ratios can be affected by events beyond the Company’s control and it cannot assure meeting these ratios. Default under the credit facility could allow the lenders to declare all amounts outstanding to be immediately due and payable. L-1 has pledged substantially all of its assets to secure the debt under the credit facility. If the lenders declare amounts outstanding under the credit facility to be due, the lenders could proceed against those assets. Any event of default, therefore, could have a material adverse effect on the business if the creditors determine to exercise their rights. The Company also may incur future debt obligations that might subject L-1 to restrictive covenants that could affect financial and operational flexibility, restrict ability to pay dividends on common stock, or subject L-1 to other events of default.

 

L-1 is subject to government regulation and failure to comply with applicable regulations could subject the Company to penalties that may restrict its ability to conduct business. L-1 is affected by and must comply with various government regulations that impact operating costs, profit margins and the internal organization and operation of the business.

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

 

 

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

 

The Company could be adversely affected by a negative audit by the U.S. government. U.S. government agencies, including the Defense Contract Audit Agency and various agency Inspectors General, routinely audit and investigate government contractors. These agencies review a contractor’s performance under its contracts, cost structure and compliance with applicable laws, regulations, and standards. The U.S. government also

reviews the adequacy of, and a contractor’s compliance with, its internal control systems and policies, including the contractor’s management, purchasing, property, estimating, compensation, accounting, and information systems. Any costs found to be misclassified may be subject to repayment. If an audit or investigation uncovers improper or illegal activities, L-1 may be subject to civil or criminal penalties and administrative sanctions, including termination of contracts, forfeiture of profits, suspension of payments, fines, and suspension or prohibition from doing business with the U.S. government. In addition, L-1 could suffer serious reputational harm if allegations of impropriety were made.

 

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

 

 

L-1 does not know when, if ever, biometric solutions and services will gain widespread commercial acceptance. Certain groups have publicly objected to the use of biometric solutions and services for some applications on civil liberties grounds and legislation has been proposed to regulate the use of biometric security solutions. Biometric technologies have been the focus of organizations and individuals seeking to curtail or eliminate such technologies on the grounds that they may be used to diminish personal privacy rights. If such initiatives result in restrictive legislation, the market for biometric solutions may be adversely affected. Even if biometric technologies gain wide market acceptance, L-1 biometric solutions and services may not adequately address the requirements of the market and may not gain widespread commercial acceptance.

 

L-1 faces intense competition that could result in lower revenues and higher R&D expenditures and could adversely affect results of the Company’s operations. Since the events of September 11, 2001 regulatory and policy changes in the U.S. and abroad have heightened interest in the use of biometric security solutions, and L-1 expects competition in this field, which is already substantial, to intensify.

 

Competitors are developing and marketing semiconductor ultrasonic and optically based direct contact fingerprint image capture devices, or retinal blood vessel, iris pattern, hand geometry, voice or various types of facial structure solutions.

 

L-1 solutions also compete with non-biometric technologies which may be less costly, such as

certificate authorities and traditional keys, cards, surveillance systems and passwords. Widespread adoption of one or more of these technologies or approaches in the markets targeted could significantly reduce the potential market for L-1 systems and solutions. Some competitors have significantly more resources than L-1. Competitors may introduce products that are more price competitive, have increased performance or functionality or incorporate technological advances that L-1 has not yet developed or implemented. To remain competitive, L-1 must continue to develop, market and sell new and enhanced solutions at competitive prices, which will require significant research and development expenditures. If L-1 does not develop new and enhanced solutions or if the Company is not able to invest adequately in research and development activities, the business, financial condition and results of operations could be severely and negatively impacted.

 

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

 

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

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

 

L-1 may be required to expend significant capital and other resources to protect the Company against the threat of security breaches or to alleviate problems caused by the occurrence of any such breaches. In addition, protective or remedial measures may not be available at a reasonable price or at all, or may not be entirely effective.

 

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

 

L-1 relies on contract manufacturers to produce hardware products under short term manufacturing arrangements. Although L-1 believes it can find alternative sources for the manufacturing of hardware, any disruption of

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

 

The market for L-1 solutions is still developing and if the biometrics industry adopts standards or a platform different from L-1’s, then the Company’s competitive position would be negatively affected. The market for identity solutions is still developing. The evolution of this market may result in the development of different technologies and industry standards that are not compatible with L-1’s current solutions, products or technologies.

 

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

 

The L-1 plan to pursue sales in international markets may be limited by risks related to conditions in such markets. For the year ended December 31, 2009 L-1 derived approximately 9 percent of total revenues from international sales and the Company’s strategy is to expand its international operations. There is a risk that the Company may not be able to successfully market, sell and deliver solutions, products and services in foreign countries.

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

 

 

L-1 expects that it will have increased exposure to foreign currency fluctuations. As of December 31, 2009, accumulated other comprehensive gain includes foreign currency translation gains of approximately $1.2 million.

 

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

 

If L-1 does not successfully expand direct sales and services organizations and

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

 

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

 

The Company relies in part upon system integrators, Original Equipment Manufacturers (OEMs) and distribution partners to sell some L-1 solutions, technologies and services; the Company may be adversely affected if those parties do not actively promote the products or pursue installations that do not use L-1 solutions, technologies and services. A portion of L-1 revenue comes from sales to partners including OEMs, systems integrators, distributors and resellers. Some of these relationships have not been formalized in a detailed contract, and may be subject to termination at any time. Even where these relationships are formalized in a detailed contract, the agreements can often be terminated with little or no notice and subject to periodic amendment.

 

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

whether current or future relationships will be successful.

 

If solutions, systems and products are not delivered in a timely fashion or do not perform as promised, L-1 could experience increased costs, lower margins, liquidated damage payment obligations and reputational harm. L-1 often provides complex systems that are required to operate in difficult or sensitive circumstances. The development of such complex systems may be subject to delays or failure to meet performance requirements to customer specifications. The negative effects of any delay or failure to deliver to meet performance requirements could be exacerbated if the delay or failure occurs in systems that provide personal security, secure sensitive computer data, authorize significant financial transactions or perform other functions where a security breach could have significant consequences.

 

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

 

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

increased costs, lower margins, liquidated damage payment obligations and harm to reputation. This could result in contract terminations and have a material adverse effect on business and financial results.

 

Failure to maintain the proprietary nature of L-1 technology, intellectual property and manufacturing processes could have a material adverse affect on the business and the Company’s ability to effectively compete. L-1 principally relies upon patent, trademark, copyright, trade secret and contract law to establish and protect proprietary rights. There is a risk that claims allowed on any patents or trademarks held by L-1 may not be broad enough to protect the Company’s technology. In addition, patents or trademarks may be challenged, invalidated or circumvented and L-1 cannot be certain that the rights granted there under will provide competitive advantages.

 

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

 

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

 

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

 

To determine the priority of inventions, L-1 may participate in interference proceedings declared by the United States Patent and Trademark Office or oppositions in foreign patent and trademark offices, which could result in

substantial cost and limitations on the scope or validity of patents or trademarks.

 

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

 

Legal claims regarding infringement by L-1 or suppliers of third party intellectual property rights could result in substantial costs, diversion of managerial resources and reputational harm. Although L-1 believes that its solutions, products and services do not infringe currently existing and validly issued intellectual property rights of others, the Company might not be able to defend successfully against a third-party infringement claim. A successful infringement claim against L-1, its customers or suppliers could subject the Company to:

 

 

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

termination of customer contracts and harm to the Company’s reputation.

 

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

 

L-1 is dependent on a small number of individuals and if the Company loses key personnel, the business will be adversely affected. Much of L-1’s future success depends on the continued service and availability of senior management, including the Chairman of the Board, President and Chief Executive Officer, Robert V. LaPenta, and other members of the executive team. These individuals have acquired specialized knowledge and skills with regards to advanced technology identity solutions. The loss of any of these individuals could severely harm the business. L-1 also is highly dependent on the ability to retain, hire and motivate talented highly skilled personnel. Experienced personnel in the advanced technology identity solutions industry are in high demand and competition for their talents is intense. If L-1 is unable to successfully attract, retain and motivate key personnel, the business may be severely harmed.

 

If L-1 fails to recruit and retain skilled employees or employees with the necessary

security clearances, the Company may not be able to perform under government services contracts or win new business. To be competitive, L-1 must have employees with advanced information technology and technical services skills that work well with customers in a government or defense-related environment. Often, these employees require some of the highest security clearances in the United States. These employees are in great demand and are likely to remain a limited resource in the foreseeable future. If L-1 is unable to recruit and retain a sufficient number of these employees, the ability to maintain and grow the business could be negatively impacted.

 

In addition, some government services contracts contain provisions requiring L-1 to commit to staff a program with certain personnel the customer considers key to successful performance under the contract. In the event L-1 is unable to provide these key personnel or acceptable substitutions, the customer may terminate the contract and the Company may not be able to recover certain incurred costs.

 

Certain L-1 shareholders have significant relationships with the Company that could result in actions taken that are not supported by unaffiliated shareholders. In connection with the Aston investment in the Company, Aston became the largest shareholder of L-1, currently owning approximately 8.3 percent of L-1’s outstanding common stock. As a result, Aston (together with its affiliate, L-1 Investment Partners LLC) has an influence on matters requiring approval by shareholders, including the election of directors and most corporate actions, such as mergers and acquisitions. In addition, L-1 has significant relationships within L-1 Investment Partners LLC and Aston including Mr. Robert V. LaPenta, founder and Chief Executive Officer of L-1 Investments Partners LLC who is Chairman of the Board and Chief Executive Officer and President of L-1.

 

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

and Sales Officer, and Executive Vice President of Corporate Communications, respectively.

 

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

 

Mr. LaPenta also has a significant personal investment in L-1 common stock through his controlling interest in Aston and his direct ownership which, considered in the aggregate, represents beneficial ownership of approximately 14.6 percent of outstanding L-1 common stock. The concentration of large percentages of ownership in any single shareholder, or in any series of single shareholders, may influence the likelihood or timing of any change in control of the Company. Additionally, the sale of a significant number of shares in the open market by single shareholders or otherwise could adversely affect stock price.

 

ACQUISITION STRATEGY RISKS

 

Integration of recently acquired businesses may be difficult to achieve and will consume significant financial and managerial resources, which may adversely affect operations. The L-1 operating philosophy is to let acquired businesses operate in autonomous manner subject to corporate oversight but integrating and rationalizing duplicative functions to achieve revenue and cost synergies. The Company may encounter substantial difficulties, costs and delays in integrating the operations recently acquired and future acquisitions such as:

 

 

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

 

Acquisitions could result in future impairment and other charges, which could adversely affect operational results. Although no impairment was recorded in 2009, L-1 recorded impairment charges aggregating $528.6 million in 2008 for goodwill and long-lived assets, primarily related to the biometric businesses. At December 31, 2009, goodwill,

intangible assets and property and equipment amounted to $889.8 million, $102.4 million and $115.5 million, respectively. Because goodwill represents a residual after the purchase price is allocated to the fair value of acquired assets and liabilities, it is difficult to quantify the factors that contribute to the recorded amounts and subsequent impairments, if any. Nevertheless, management believes that the following factors have contributed to the amount recorded:

 

 

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

 

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

 

If L-1 stock price were to decrease materially from current levels and remain depressed for a sustained period of time, the Company may be required to

assess the carrying amount of goodwill and long-lived assets of reporting units before the next scheduled annual impairment test. If at that time the estimated fair values of the reporting units are less than their respective carrying amounts, L-1 would need to determine whether goodwill and long-lived assets would be impaired. Moreover, if economic conditions deteriorate and capital markets conditions negatively impact the valuation of enterprises, the estimated fair values of L-1 reporting units could be adversely impacted, which could result in future impairments.

 

If L-1 does not achieve expected benefits from completed acquisitions, the price of L-1 common stock could decline. L-1 expects that its consummated acquisitions will enhance leadership in the identity solutions industry through the combination of respective technologies. However, the combination of such technologies might not meet the demands of the customers.

 

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

 

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

 

 

There are no unresolved staff comments.

 

 

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

 

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

 

Information about the Company’s leased facilities follows.

 

 

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

 

While the Company believes that these facilities are adequate to meet immediate needs, it may become necessary to secure additional space in the future to accommodate any future growth. The Company believes that such additional space will

be available as needed in the future on commercially reasonable terms.

 

 

OLD DIGIMARC LITIGATION

 

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

 

Beginning in May 2001, a number of substantially identical class action complaints alleging violations of the Federal securities laws were filed in the United States District Court for the Southern District of New York naming approximately 300 companies, including Old Digimarc, certain officers and directors and certain underwriters of the Companies’ initial public offerings as defendants. The complaints were subsequently consolidated into a single action, and a consolidated amended complaint was filed in April 2002. The amended complaint alleges, among other things, that the underwriters of Old Digimarc’s initial public offering violated securities laws by failing to disclose certain alleged compensation arrangements in Old Digimarc’s initial public offering registration statement and by engaging in manipulative practices to artificially inflate the price of Old Digimarc’s stock in the aftermarket subsequent to the initial public offering. Old Digimarc and certain of its officers and directors are named in the amended complaint pursuant to Section 11 of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 on the basis of an alleged failure to disclose the underwriters’ alleged compensation arrangements and manipulative practices. The complaint sought unspecified damages. In July 2002, the claims against Old Digimarc under Section 10(b) were dismissed. In October 2002, the individual officer and director defendants were dismissed without prejudice pursuant to tolling agreements. In June 2004, a stipulation of partial settlement among the plaintiffs, the companies, and the officers and directors was submitted to the District Court. While the partial settlement was pending approval, the plaintiffs continued to litigate their claims against the

underwriter defendants. The district court directed that the litigation proceed within a number of “focus cases” rather than in all of the 309 cases that have now been consolidated. Old Digimarc was not one of these focus cases. In October 2004, the district court certified the focus cases as class actions. The underwriter defendants appealed that ruling and, on December 5, 2006, the Court of Appeals for the Second Circuit reversed the district court’s class certification decision for the six focus cases. In light of the Second Circuit opinion, in June 2007, the district court entered an order terminating the settlement. On August 14, 2007, the plaintiffs filed their second consolidated amended class action complaints against the focus cases and on September 27, 2007, again moved for class certification. On November 12, 2007, certain of the defendants in the focus cases moved to dismiss the second consolidated amended class action complaints. The court issued an opinion and order on March 26, 2008, denying the motions to dismiss except as to Section 11 claims raised by those plaintiffs who sold their securities for a price in excess of the initial offering price and those who purchased outside the previously certified class period. The class certification motion was withdrawn without prejudice on October 10, 2008. On April 2, 2009, a stipulation and agreement of settlement among the plaintiffs, issuer defendants (including Old Digimarc) and underwriter defendants was submitted to the Court for preliminary approval. Old Digimarc’s portion of the settlement, which is wholly immaterial, is covered entirely by insurance. On June 10, 2009, the Judge granted preliminary approval of the settlement, and on October 5, 2009, the Judge granted final approval of the settlement. Notices of appeal of this decision have been filed; the deadline for filing further notices of appeal is February 22, 2010.

 

On October 10, 2007, an Old Digimarc stockholder filed a lawsuit in the United States District Court for the Western District of Washington against several companies that acted as lead underwriters for the Old Digimarc initial public offering. The complaint, which also named Old Digimarc as a nominal defendant but did not assert any claims against Old Digimarc, asserted claims against the underwriters under Section 16(b) of the Securities Exchange Act of 1934. On

February 28, 2008, an amended complaint was filed, with Old Digimarc still named only as a nominal defendant. Similar complaints have been filed by this same plaintiff against a number of other issuers in connection with their initial public offerings, and the factual allegations are closely related to the allegations in the litigation pending in the United States District Court for the Southern District of New York which is described above. On March 12, 2009, after considering motions to dismiss, one filed by thirty moving issuers and the other filed by the underwriters, the judge dismissed the plaintiff’s claims on a jurisdictional and statute of limitations basis. On April 10, 2009, the plaintiff filed a notice of appeal of the dismissal. The final appellate brief was filed on November 17, 2009; the Ninth Circuit has not indicated whether it will schedule oral arguments. The Company currently believes that the outcome of this litigation will not have a material adverse impact on its condensed consolidated financial position and results of operations.

 

OTHER

 

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

 

No matters were submitted to a vote of security holders during the fourth quarter of 2009.

 

 

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

 

OVERVIEW

 

L-1 Identity Solutions, Inc. (“L-1” or the “Company”) is a provider of technology, products, systems and solutions, and services that protect and secure personal identities and assets. Together with its divisions, L-1 delivers the full range of offerings required for solving complex problems associated with managing identity.

 

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

 

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

 

The Solutions reportable segment consists of the Secure Credentialing and Biometrics / Enterprise Access Divisions. Solutions from these divisions are marketed to Federal agencies, State and Local government agencies (including law enforcement and department of corrections), foreign governments, and commercial entities (such as financial and health care institutions and casinos).

 

Solutions revenue includes products and related services, which are comprised of hardware, components, consumables and software, as well as maintenance, consulting and training services.

 

The Services reportable segment includes the Enrollment Services Division and Government Consulting Services group.

 

Enrollment services perform fingerprinting and process background checks for civilians.

Government Consulting Services includes the businesses of Advanced Concepts (Information Technology Solutions), McClendon (Engineering & Analytical Solutions), and SpecTal (Intelligence Services).

 

Government Consulting Services offer comprehensive consulting, program management, information analysis, training, security, technology development, and information technology solutions to the U.S. intelligence community.

 

Depending upon customer needs, identity solutions can be bundled with services offerings to create an integrated solution.

 

REVENUES

 

The Secure Credentialing business, which prior to December 15, 2005 comprised L-1’s sole business, generates revenues from the sales of solutions consisting of bundled proprietary software with commercial off-the-shelf equipment and related maintenance and services, the sale of secure printing solutions and related consumables, and the design, customization and installation of secure credential issuance systems which generate revenues as the credentials are issued by the customer. The division also generates revenues from sales of solutions using biometric technologies of other divisions.

 

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

include biometrics-based readers used to secure buildings and restricted areas.

 

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

 

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

 

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

 

L-1 revenues have grown to $650.9 million in 2009 from $66.2 million in 2005. L-1 growth in revenues is due principally to acquisitions consummated, as well as increased demand for identity solutions related to heightened emphasis on security, secure credentials, document authentication and biometrics, as well as increased demand for government security services. L-1 anticipates that the U.S. government agencies will continue to be major customers for the foreseeable future. L-1 also expects to experience increased demand

from a number of other government entities as they deploy identity solutions, particularly document authentication, at points of entry and exit, including borders, seaports and airports and in connection with national identification programs. Notwithstanding expectations regarding demand for these solutions, the quantity and timing of orders from both U.S. and foreign government entities depends on a number of factors outside of the Company’s control, such as the level and timing of budget appropriations. Any funding delays or other changes in the rollout of government programs utilizing L-1 solutions, products and services could cause revenues to fall short of expectations.

 

L-1 revenues increased to $650.9 million for the year ended December 31, 2009 from $562.9 million for the year ended December 31, 2008. Net loss for the year was $4.2 million compared to $551.6 million loss in 2008. The 2009 loss includes $1.0 million for financing costs related to the modification of debt and a provision of $1.2 million related to the suspension of the Registered Traveler program. The 2008 loss includes impairments of long-lived assets of $98.6 million and goodwill of $430.0 million, as well as merger related expenses of $1.1 million. In addition, the 2008 results reflect an increase in the deferred tax valuation allowance of $48.0 million and an income tax benefit of $37.4 million for the tax benefit of the impairment of long-lived assets. Also in 2009, L-1 incurred interest expense of $41.3 million compared to interest expense of $27.9 million in 2008, as a result of increased borrowings to fund the acquisition of Old Digimarc.

 

ACQUISITIONS

 

L-1 has pursued strategic acquisitions to complement and expand its existing solutions and services. Acquisitions since January 1, 2007 include:

 

 

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

 

 

ADJUSTED EBITDA

 

L-1 uses Adjusted EBITDA as a non-GAAP financial performance measurement. Adjusted EBITDA is calculated by adding back to net income (loss): interest-net, income taxes, depreciation and amortization, goodwill and long-lived asset impairments and stock-based compensation, including retirement plan contributions settled, or to be settled, in common stock. Adjusted EBITDA is provided to investors to supplement the results of operations reported in accordance with GAAP. Management believes Adjusted EBITDA is useful to help investors analyze the operating trends of the business and to assess the relative underlying

performance of businesses with different capital and tax structures. Management also believes that Adjusted EBITDA provides an additional tool for investors to use in comparing L-1 financial results with other companies in the industry, many of which also use Adjusted EBITDA in their communications to investors. By excluding non-cash charges such as amortization and depreciation, stock-based compensation expense, goodwill and long-lived asset impairments as well as non-operating charges for interest-net and income taxes, investors can evaluate L-1 operations and can compare L-1 results on a more consistent basis to the results of other companies. Management uses Adjusted EBITDA to evaluate potential acquisitions, establish internal budgets and goals, evaluate performance of L-1 business units and management, and to evaluate compliance with debt covenants.

 

L-1 considers Adjusted EBITDA to be an important indicator of the Company’s operational strength and performance of its business and a useful measure of L-1’s historical and prospective operating trends. However, there are significant limitations to the use of Adjusted EBITDA since it excludes interest income and expense, income taxes, goodwill and long-lived asset impairments, and stock-based compensation expense, including retirement plan contributions settled, or to be settled in common stock, all of which impact L-1 profitability, as well as depreciation, and amortization related to the use of long-lived assets that benefit multiple periods. The Company believes that these limitations are compensated for by providing Adjusted EBITDA only with GAAP performance measures and clearly identifying the difference between the two measures. Consequently, Adjusted EBITDA should not be considered in isolation or as a substitute for net income (loss), or operating income (loss) presented in accordance with GAAP. Adjusted EBITDA as defined by the Company may not be comparable with similarly named measures provided by other entities.

A reconciliation of GAAP net income (loss) to Adjusted EBITDA follows (in thousands):

 

 

REPORTABLE SEGMENTS AND RESULTS OF OPERATONS

 

L-1 operates in two reportable segments, the Solutions segment and the Services segment. During the first quarter of 2008, L-1 integrated the authentication and identification business of ComnetiX in the Solutions segment and the fingerprinting services business in the Services segment. In 2009, the Company integrated the McClendon segment into the SpecTal segment and is in process of integrating the Enterprise Access segment into the Biometrics segment. L-1 measures segment performance primarily based on revenues, operating income (loss) and Adjusted EBITDA and unlevered free cash flow. Operating results by segment, including allocation of corporate expenses, for the three years ended December 31, 2009 are as follow (in thousands):

 

In 2009, the Solutions reportable segment includes a provision of $1.2 million related to the suspension of the Registered Traveler program. In 2008, the Solutions and Services reportable segments include goodwill and long-lived asset impairments of $527.2 million and $1.4 million, respectively, and the Solutions segment includes merger related severance costs of $1.1 million. In 2007, the Solutions segment includes asset impairments and merger related costs of $5.0 million.

 

Excluding the above charges, the operating loss for Solutions was $21.4 million in 2009, $0.3 million in 2008 and $4.2 million in 2007. The 2008 and 2007 periods reflect higher intangible amortization of intangible assets. Excluding impairment costs, Services operating income was $14.9 million in 2009, $15.6 million in 2008 and $5.9 million in 2007.

 

Revenue and EBITDA increases for the Solutions segment are primarily attributable to the acquisition of Digimarc in August 2008 and Bioscrypt in March 2008 as well as organic growth in the business as discussed below. Revenue and EBITDA increases for the Services segment reflect the acquisition of ACI and McClendon in 2007, as well as organic revenue growth of L-1’s SpecTal business and L-1’s Enrollment Services businesses.

DEPENDENCE ON SIGNIFICANT CUSTOMERS

 

For the year ended December 31, 2009, U.S. Federal government agencies, directly or indirectly, accounted for 59 percent of consolidated revenues. For the years ended December 31, 2008 and 2007, U.S. Federal Government agencies, directly or indirectly accounted for 64 percent and 69 percent of consolidated revenues, respectively. Accounts receivable from U.S. government agencies amounted to $47.4 million and $53.6 million at December 31, 2009 and 2008, respectively.

 

CONSOLIDATED RESULTS OF OPERATIONS

 

Comparative results of operations have been affected by the February 2007 acquisition of ComnetiX, the July 2007 acquisitions of ACI and McClendon, the March 2008 acquisition of Bioscrypt and the August 2008 acquisition of Old Digimarc (collectively the “Acquisitions”).

 

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

 

 

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

 

COMPARISON OF 2009 TO 2008

 

Revenues (in thousands)

 

Products and Services Revenues

 

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

 

 

Revenues increased by $88.1 million for the year ended December 31, 2009, of which $59.9 million related to the Acquisitions. Excluding the impact of the Acquisitions, revenues increased $28.2 million or 6 percent from the year ended December 31, 2008. The increase from the prior year is a result of increased revenue and new contracts in L-1’s enrollment services and increases in L-1’s government services, both of which are included in L-1’s Services segment.

 

Approximately 50 percent of L-1 revenues in 2009 and 2008 were derived from long-term service contracts with the U.S. Federal and State governments included in L-1 Services reportable segment. These contracts are fixed unit price contracts for which L-1 is compensated as the Company provides the services, as fingerprints are transmitted to the appropriate government agency for fingerprinting services and on a time and material, fixed price level of effort or cost reimbursable basis for government services.

 

Approximately 18 percent and 12 percent of L-1 revenues in 2009 and 2008, respectively, were derived from long-term contracts for the production of driver’s licenses and credentials for which L-1 is compensated on a fixed unit price per license or credential produced. The unit price for these contracts is fixed throughout the term of the contract. The prices are established in competitive bids in which price is one among many important criteria evaluated by the customer.

 

The remaining revenues, including other revenues from the driver’s licenses contracts which are not based on card production volumes, comprise

32 percent and 38 percent of revenues for the years ended December 31, 2009 and 2008, respectively, and were derived from contracts and purchase orders for consumables, hardware, software and custom solutions, including maintenance. These revenues are priced at prevailing prices at the time the order or contract is negotiated. These orders and contracts are often competitively bid, although some, particularly consumables sold pursuant to driver license and credential contracts, are sole source. Most of L-1 research and development and sales and marketing costs are related to generating these revenues.

 

Cost of Revenues and Gross Margin
(in thousands)

 

 

Cost of revenues increased by $64.5 million for the year ended December 31, 2009 compared to the year ended December 31, 2008, of which $44.4 million is related to the Acquisitions. Excluding the Acquisitions, cost of revenues increased by $20.1 million or 6 percent in 2009 compared to the previous year which is consistent with increased sales. Gross margin for 2009 was 29 percent compared to 30 percent in 2008. The decrease was due primarily to increased revenue from lower margin enrollment and government consulting services, offset in part by the growth in L-1’s higher margin biometrics solutions.

 

Included in the cost of revenues were $39.2 million and $47.8 million of non-cash charges for the

years ended December 31, 2009 and 2008, respectively, which decreased by $8.6 million, reflecting lower amortization in 2009 resulting from intangible asset impairments recorded in 2008, offset by additional amortization related to the Acquisitions. This decrease was offset by higher depreciation resulting from the acquisition of Digimarc and higher stock-based compensation expense. These non-cash charges reduced gross margins by 6 percent and 8 percent for the years ended December 31, 2009 and 2008, respectively.

 

Sales and Marketing Expenses (in thousands)

 

 

Sales and marketing expenses increased by approximately $2.9 million for the year ended December 31, 2009 compared to the prior year. Excluding the effects of the Acquisitions, sales and marketing expenses decreased by $1.9 million for the year ended December 31, 2009. These decreases are attributable to cost reductions from synergies and rationalization in certain of L-1 businesses, offset by continued investment in increasing sales and international marketing resources. Sales and marketing expenses consists primarily of salaries and costs including stock-based compensation, commissions, travel and entertainment expenses, promotions and other marketing and sales support expenses.

 

Research and Development Expenses
(in thousands)

 

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

 

General and Administrative Expenses
(in thousands)

 

 

General and administrative expense increased approximately by $7.1 million for year ended December 31, 2009 compared to 2008, of which approximately $5.8 million is directly related to the Acquisitions. Excluding the effects of the Acquisitions, the increase was $1.3 million over the year ended December 31, 2008 as the Company continues to realize operating leverage by increasing revenue without

corresponding increases in general and administrative expenses. As a percentage of revenues, general and administrative expenses decreased to 14 percent, as compared to 15 percent in the prior year and reflects the impact of improved leverage. General and administrative costs in 2009 also include a provision of $1.2 million related to suspension of the Registered Traveler program. General and administrative expenses consist primarily of salaries and related personnel costs, including stock-based compensation for L-1’s executive and administrative personnel, professional and Board of Directors’ fees, public and investor relations and insurance.

 

Asset Impairments and Merger Related Expenses (in thousands)

 

 

In 2008, assets impairments consist of goodwill of $430.0 million and long-lived assets of $98.6 million, principally intangible assets recorded in connection with acquisitions, and relate principally to the Company’s biometrics businesses included in the Solutions segment. The impairment charges resulted from the deteriorating economic conditions that manifested themselves in the fourth quarter of 2008 as well as capital market conditions that adversely impacted valuation of businesses L-1 acquired and the Company’s stock prices and market capitalization. The remaining $1.1 million related to merger related expense for the Old Digimarc acquisition.

Acquisition Related Expenses and Amortization of Acquired Intangible Assets (in thousands)

 

 

Acquisition related expenses and amortization of acquired intangible assets decreased by $1.1 million for the year ended December 31, 2009 from the comparable period in the prior year due to impairments recorded in the fourth quarter of 2008 which resulted in lower amortization, offset by $0.6 million in acquisition expenses recorded in 2009.

 

Interest Income and Expense (in thousands)

 

 

For the year ended December 31, 2009, net interest expense increased by approximately $13.6 million compared to the prior year as a result of increased borrowings under L-1’s credit facility in August 2008, incurred primarily to fund the Acquisitions, as well as higher interest rates and $1.0 million in costs incurred in connection with the July 2009 modification of L-1’s credit facility.

 

Other Expense, Net (in thousands)

 

 

Other expense, net includes realized and unrealized currency transaction gains and

losses on foreign currency transactions. The increases in other expense, net are related primarily to changes in the value of the U.S. dollar relative to the Canadian Dollar and the Japanese Yen during the periods.

 

Income Taxes (in thousands)

 

 

The 2009 results reflect an income tax benefit of $2.5 million, primarily reflecting an increase in deferred tax assets as a result of current year temporary differences, net of the utilization of net operating losses to offset estimated net taxable income. At December 31, 2009, the Company had U.S. Federal net operating loss carryforwards of $447.7 million, which may be used to reduce future taxable income. In addition, the Company has $159.5 million of deductible goodwill. Management evaluated the adequacy of the valuation allowance in light of the results for the year based on the cumulative results of operations for the three years ended December 31, 2009, after considering items that do not enter in the determination of taxable income, and the likely future operating results. The review indicated that the recorded valuation allowance related to net operating losses is adequate as of December 31, 2009. Management will continue to evaluate the adequacy of the valuation allowance annually, and when its assessment of whether it is more likely than not that the related tax benefits will be realized changes, the valuation allowance will be increased or reduced with a corresponding benefit or charge included in income.

 

The 2008 results reflect an income tax expense of $10.0 million, primarily reflecting an increase in the deferred tax asset valuation allowance of approximately $48.0 million offset by the deferred benefit of $40.5 million primarily related to the impairment of long-lived assets recorded for the year (excluding the impact of the goodwill impairment which is not deductible for income tax purposes), and a current tax provision of $2.4 million. During the fourth quarter of 2008, management evaluated the adequacy of the

valuation allowance in light of the results for the year and determined that, based on the cumulative results of operations for the three years ended December 31, 2008, after considering items that do not enter in the determination of taxable income, and the likely future operating results, it was more likely than not that the portion of the tax benefits of its net operating loss carryforwards that would not be realized would be higher than previously recorded. As a result, the Company increased the deferred tax asset valuation allowance to reflect the estimated tax benefits it expected to realize.

 

Comprehensive Loss (in thousands)

 

 

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

 

COMPARISON OF 2008 TO 2007

 

Revenues (in thousands)

 

Products and Services Revenues

 

The following details revenues by major categories of products and services for the years ended December 31, 2008 and 2007 (in thousands):

 

 

Revenues increased by $173.4 million for the year ended December 31, 2008 of which $121.1 million related to the Acquisitions. Excluding the impact of the Acquisitions, revenues increased $52.2 million or 15 percent from the year ended December 31, 2007. The increase from the prior year period reflects growth related to L-1’s secure credentialing solutions and government consulting services, offset by lower biometric revenues primarily due to unusually large shipments of biometric products in the fourth quarter of 2007.

 

Approximately 50 percent and 46 percent of L-1’s revenues in 2008 and 2007, respectively, were derived from long-term service contracts with the U.S. Federal and State governments included in L-1’s Services segment. These contracts are fixed unit price contracts for which L-1 is compensated as L-1 provides the services, as fingerprints are transmitted to the appropriate government agency for fingerprinting services and on a time and material, fixed price level of effort or cost reimbursable basis for government services.

 

Approximately 12 percent and 8 percent of L-1’s revenues in 2008 and 2007, respectively, were derived from long-term contracts for the production of driver’s licenses and credentials for which L-1 is compensated on a fixed unit

price per license or credential produced. The unit price for these contracts is fixed throughout the term of the contract. The prices are established in competitive bids in which price is one among many important criteria evaluated by the customer.

 

Remaining revenues, including other revenues from the driver’s licenses contracts which are not based on card production volumes, comprise 38 percent and 46 percent of revenues for the years ended December 31, 2008 and 2007, respectively, and were derived from contracts and purchase orders for consumables, hardware, software and custom solutions, including maintenance and services. These revenues are priced at prevailing prices at the time the order or contract is negotiated. These orders and contracts are often competitively bid, although some, particularly consumables sold pursuant to driver license and credential contracts, are sole source. Most of L-1’s research and development and sales and marketing costs are related to generating these revenues.

 

Cost of Revenues and Gross Margin
(in thousands)

 

 

Cost of revenues increased by $126.4 million for the year ended December 31, 2008 compared to the year ended December 31, 2007, of which $77.3 million is related to the Acquisitions. Excluding the Acquisitions, cost of revenues increased by $49.1 million or 20 percent in 2008 compared to the previous year which is consistent with increased sales. Gross margin for 2008 was

30 percent compared to 31 percent in 2007. The decrease was due to changes in the revenue mix resulting from lower biometric revenues and higher revenues from secure credentialing and services, as well as the impact of non cash charges described below.

 

Included in the cost of revenues in 2008 were $47.8 million of non cash charges, which increased by approximately $13.2 million from the prior year primarily due to higher depreciation and stock-based compensation charges offset by lower amortization resulting from impairment of long-lived assets which included the acquired intangible assets. Non cash charges reduced consolidated gross margins by 8 percent and 9 percent for the years ended December 31, 2008 and 2007, respectively. Costs of revenues also reflect higher depreciation charges related to the acquisition of Digimarc.

 

Sales and Marketing Expenses (in thousands)

 

 

Sales and marketing expenses increased by approximately $9.3 million for the year ended December 31, 2008 compared to the prior year, of which the Acquisitions accounted for $8.1 million. Excluding the effects of the Acquisitions, sales and marketing expenses increased by $1.2 million for the year ended December 31, 2008. These increases are attributable to additional investments made to expand L-1’s focus on U.S. government and international opportunities. Sales and marketing expenses consists primarily of salaries and related personnel costs including stock-based compensation, commissions, travel and entertainment expenses, promotions and other marketing and sales support expenses.

Research and Development Expenses
(in thousands)

 

 

Research and development expenses increased by approximately $6.8 million for the year ended December 31, 2008 compared to the prior year, of which approximately $4.3 million is due to the Acquisitions. Excluding the effects of the Acquisitions, research and development expenses in 2008 increased by $2.5 million, as L-1 continued to focus on the development of biometric technology. Research and development expenses were offset by higher utilization of research and development resources in the performance of contracts, the cost of which is included in cost of revenues, and other products. Research and development expenses consist primarily of salaries, stock-based compensation and related personnel costs and prototype costs related to the design, development, testing and enhancement of L-1 products. Gross research and development expenditures aggregated to $43.0 million for the year ended December 31, 2008 compared to $26.4 million in the prior year. As a percentage of Solutions revenues, gross research and development costs were 15 percent and 13 percent for years ended December 31, 2008 and 2007, respectively. Virtually all of L-1 research and development costs are attributable to L-1’s Solutions segment.

General and Administrative Expenses
(in thousands)

 

 

General and administrative expense increased approximately $24.5 million for year ended December 31, 2008 compared to 2007, of which approximately $20.5 million are directly related to the Acquisitions. Excluding the effects of acquisitions, the increase was $3.9 million over the year ended December 31, 2007 and relates to stock-based compensation expense, legal, accounting and auditing and other professional services. As a percentage of revenues, general and administrative expenses decreased to 15 percent, as compared to 16 percent in the prior year as L-1 continues to leverage L-1’s cost structure over a larger revenue base. General and administrative expenses consist primarily of salaries and related personnel costs, including stock-based compensation for L-1’s executive and administrative personnel, professional and board of directors’ fees, public and investor relations and insurance.

 

Asset Impairments and Merger Related Expenses (in thousands)

 

 

In 2008, assets impairments consist of goodwill of $430.0 million and long-lived assets of $98.6 million, principally intangible assets recorded in connection with acquisitions, and relate principally to the Company’s biometrics businesses included in the Solutions segment. The impairment charges result from the deteriorating economic conditions that manifested themselves in the fourth quarter of

2008 as well as capital market conditions that adversely impacted valuation of businesses L-1 acquired and the Company’s stock prices and market capitalization. The remaining $1.1 million represents merger related expenses related to the Old Digimarc acquisition. In 2007, an impairment charge of $5.0 million was recognized related to certain acquired product lines of the biometrics business.

 

Acquisition Related Expenses and Amortization of Acquired Intangible Assets (in thousands)

 

 

Acquisition related expenses and amortization of acquired intangible assets increased by $0.5 million for the year ended December 31, 2008 from the comparable period in the prior year due to the Acquisitions.

 

Interest Income and Expense (in thousands)

 

 

For the year ended December 31, 2008, net interest expense increased by approximately $13.7 million compared to the prior year primarily as a result of the issuance of senior convertible notes in May 2007 and borrowings under L-1’s revolving credit facility and term loan incurred primarily to fund the Acquisitions.

Other Expense, Net (in thousands)

 

 

Other expense, net includes realized and unrealized currency transaction gains and losses on Yen-denominated purchases, as well as unrealized gains and losses forward currency contracts.

 

Income Taxes (in thousands)

 

 

The 2008 results reflect an income tax expense of $10.0 million, primarily reflecting an increase in the deferred tax asset valuation allowance of approximately $48.0 million offset by the deferred benefit of $40.5 million primarily related to the impairment of long-lived assets recorded for the year (excluding the impact of the goodwill impairment which is not deductible for income tax purposes) and a current tax provision of $2.4 million. During the fourth quarter of 2008, management evaluated the adequacy of the valuation allowance in light of the results for the year and determined that, based on the cumulative results of operations for the three years ended December 31, 2008, after considering items that do not enter in the determination of taxable income, and the likely future operating results, it was more likely than not that the portion of the tax benefits of its net operating loss carryforwards that would not be realized would be higher than previously recorded. As a result, the Company increased the deferred tax asset valuation allowance to reflect the estimated tax benefits it expects to realize.

 

The 2007 results reflect an income tax benefit of $25.2 million, primarily reflecting the reduction of the deferred tax asset valuation allowance of approximately $21.8 million. During the fourth quarter of 2007, management determined that based on the cumulative results of operations

for the three years ended December 31, 2007, after considering items that do not enter in the determination of taxable income, and the expected future operating results, it is more likely than not that the Company will realize a substantial portion of the tax benefits of its net operating loss carryforwards. As a result, the Company reduced its previously recorded deferred tax asset valuation allowance to reflect the estimated benefits it expected to realize.

 

Comprehensive Income (Loss) (in thousands)

 

 

The change in comprehensive income (loss) results from the net loss in 2008 of $551.6 million compared to $15.8 million net income in 2007, the components of which are described above, as well as foreign currency translation losses of $6.6 million and gains of $5.7 million in 2008 and 2007, respectively, resulting from the strengthening of the U.S. dollar in 2008 and the weakening in 2007 relative to foreign currencies which include the Euro and the Canadian Dollar. Also in 2008, L-1 recorded an unrealized loss of $1.1 million, net of related tax effect of $0.7 million, in comprehensive income for the fair value of an interest rate protection agreement.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Capital Requirements

 

The Company’s most significant capital requirements are capital expenditures for new secure credentialing contracts, research and development and working capital needs. The most significant capital expenditures are related to L-1’s Solutions segment. Generally, new State driver’s license contracts provide for up front capital expenditures necessary to perform under the

contract. As expected, with the acquisition of Old Digimarc, L-1’s capital requirements have increased as L-1 has bid on and was awarded new contracts or as contracts have been renewed. In 2009, L-1’s capital expenditures increased to $55.0 million compared to $22.5 million in 2008 and are expected to increase to $60.0 million in 2010 to fund capital expenditures for contracts awarded and expected to be awarded. L-1 expects capital expenditures to decline significantly in 2011 as we complete the build out of systems from recently awarded contracts. L-1 expects to fund L-1’s capital requirements primarily with operating cash flows.

 

Liquidity

 

As of December 31, 2009, L-1 had $9.4 million of working capital including deferred income taxes of $11.5 million, $6.6 million in cash and cash equivalents and current maturities of long term debt of $27.1 million. In addition, L-1 has financing arrangements, as further described below, available to support L-1’s ongoing liquidity needs, pursuant to which L-1 has available $123.0 million at December 31, 2009 under L-1’s revolving credit facility, subject to continuing compliance with debt covenants. L-1 believes that its existing cash and cash equivalent balances, existing financing arrangements and cash flows from operations will be sufficient to meet L-1’s operating and debt service requirements for the next 12 months. However, it is likely that L-1 will require additional financing to execute acquisitions and in that connection, L-1 evaluates financing needs and the terms and conditions and availability under L-1’s credit facility on a regular basis and consider other financing options. There can be no assurance that additional debt or equity financing will be available on commercially reasonable terms, or at all. L-1’s ability to meet L-1’s business plan is dependent on a number of factors, including those described in the section of this report entitled “Risk Factors”.

 

Credit Agreement

 

On August 5, 2008, L-1 entered into a Second Amended and Restated Credit Agreement (the “Credit Agreement”), among L-1’s wholly owned subsidiary L-1 Identity Operating, L-1, Bank of