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TMCNet:  EXELIS INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[February 28, 2014]

EXELIS INC. - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) (In millions, except per share amounts, unless otherwise stated) The following discussion of our financial condition and results of operations should be read in conjunction with the audited Consolidated and Combined Financial Statements and the notes thereto as well as the discussion in the section of this Annual Report on Form 10-K entitled "Description of Business." This discussion contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed in the sections of this Annual Report on Form 10-K entitled "Risk Factors" and "Cautionary Statement Concerning Forward-looking Statements." OVERVIEW Exelis is a diversified aerospace, defense, information and services company that leverages a 50-year legacy of deep customer knowledge and technical expertise to deliver affordable mission-critical solutions in the areas of imaging and analysis, electronic warfare, air traffic solutions, positioning and navigation, communications and information systems, logistics, and technical services to military, government and commercial customers in the United States and globally. We are focused on strategic growth in the areas of: critical networks; intelligence, surveillance, reconnaissance (ISR) and analytics; electronic warfare; and composite aerostructures. The Company's customers include the U.S. Department of Defense (DoD) and its prime contractors, U.S. Government intelligence agencies, the National Aeronautics and Space Administration (NASA), the Federal Aviation Administration (FAA), allied foreign governments and domestic and foreign commercial customers. As a prime contractor, subcontractor, or preferred supplier, Exelis participates in many high priority defense and civil government programs in the United States and internationally. Exelis conducts most of its business with the U.S. Government, principally the DoD.


We operate in two segments: Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (C4ISR) Electronics and Systems, and Information and Technical Services. Our C4ISR Electronics and Systems segment provides engineered systems and solutions, including: ISR systems; integrated electronic warfare systems; radar and sonar systems; electronic attack and release systems; communications solutions; space systems; and composite aerostructures, for government and commercial customers around the world. Our Information and Technical Services segment provides a broad range of service solutions, including: systems integration; network design and development; air traffic management; cyber; intelligence; operations; sustainment; advanced engineering; logistics; and space launch and range-support, for a wide variety of U.S. military and U.S. Government customers.

Separation from ITT Corporation Exelis, formerly ITT Corporation's ("ITT") Defense & Information Solutions segment, became an independent, publicly traded company on October 31, 2011, when ITT completed the spin-off (the "ITT Spin-off") of Exelis. The financial information included herein may not necessarily reflect what our financial position, result of operations and cash flows would have been had we been an independent, publicly traded company during the periods presented prior to October 31, 2011.

Spin-off of Mission Systems On December 11, 2013, Exelis announced that its Board of Directors approved a plan to spin-off part of its military and government services business ("Mission Systems") through a transaction that is intended to be tax-free to Exelis and its shareholders (the "Mission Systems Spin-off"). The spin-off is subject to final approval of the Company's Board of Directors. Following completion of the spin-off, Mission Systems will be an independent, publicly traded company.

Mission Systems is currently part of the Company's Information and Technical Services segment and includes the following major program areas: Infrastructure Asset Management; Logistics and Supply Chain Management; and Information Technology and Network Communication Services.

Page | 33 -------------------------------------------------------------------------------- Table of Contents Known Trends and Uncertainties Economic Opportunities, Challenges, and Risks U.S. defense and other discretionary budgets have been under pressure as the United States continues to face economic challenges and as concerns over persistent U.S. fiscal deficits and the level of U.S. national debt continue to drive political debate. The Bipartisan Budget Act of 2013 provides combined defense and domestic discretionary top line spending of $1.012 trillion in fiscal year 2014 and $1.014 trillion in fiscal year 2015. The new 2014 budget celling is $26 billion above the $986 billion combined discretionary spending level assumed in the 2013 continuing resolution and even further above the fiscal year 2014 U.S. House of Representatives budget resolution target of $967 billion. The bill also provides $63 billion in near-term sequester relief to be evenly apportioned between defense and discretionary with $45 billion of the relief being applied in fiscal year 2014. The new bill provides $85 billion in spending offsets through a combination of mandatory spending changes that reduce longer term federal borrowing and fee increases such as Pension Benefit Guaranty Corporation (PBGC) premiums and Transportation Security Administration (TSA) per flight security fees that generate additional revenue.

The Consolidated Appropriations Act of 2014, which was signed into law on January 17, 2014, provides $1.012 trillion in discretionary spending and adheres to the Bipartisan Budget Act of 2013. Within the $1.012 trillion in discretionary spending, the amount for national security and defense related spending for fiscal year 2014 is $520 billion, about $2 billion more than in fiscal year 2013. Within the $1.014 trillion in discretionary spending for fiscal year 2015, the amount for national security and defense related spending increases slightly to $521 billion.

The Budget Control Act of 2011 (Budget Control Act) provided for a reduction in planned defense budgets and mandated substantial additional spending reductions through a process known as "sequestration." The sequestration spending reductions required for defense were approximately $43 billion for fiscal year 2013, increasing to approximately $55 billion for fiscal year 2014 and beyond.

The combined effect of the Bipartisan Budget Act of 2013 and the Consolidated Appropriations Act of 2014 is a substantial alteration of sequestration in the near term. The Congressional Budget Office (CBO) is now reporting that there will be no additional cuts, across the board cuts or sequestration in fiscal year 2014. This is the expectation, because Congress has enacted a fiscal year 2014 appropriations bill complying with the new defense and non-defense caps.

The same could occur in fiscal year 2015 if Congress appropriates no more than the $1.014 trillion in discretionary spending and adheres to the revised defense and non-defense caps. By incorporating these alterations to the original Budget Control Act, the CBO still anticipates achievement of $539 billion in discretionary spending reductions from fiscal year 2016 to 2021.

Companies which derive substantial revenues from federal contracting will benefit from comprehensive legislation which implements fundamental multi-year changes that would prevent sequestration from continuing. The debate over how and when a solution may be reached over the as-yet unresolved sequestration matter remains a significant issue for the defense industry.

The DoD has emphasized a shift to a leaner force that is agile, flexible and technologically advanced. This shift in force structure focuses on addressing a range of continuously evolving threats including terrorism, state aggression, weapons of mass destruction and cyberspace-related aggression. Geographically, the DoD recognizes the growing importance of the Pacific Rim regarding U.S.

economic and security interests. As a result, the DoD is emphasizing the intent to build upon its Asia-Pacific presence while maintaining commitments in the Middle East and Europe, and at the same time increasing reliance on allied partnerships. We believe ongoing instability in the Middle East will result in continued U.S. involvement in the region, however, making a full and complete "pivot" to Asia-Pacific less attainable. We believe our portfolio of defense solutions, which covers a broad range of differentiated products and services, aligns well with the priorities outlined in the DoD's guidance. However, uncertainty related to potential changes in appropriations and strategic priorities and continued spending reductions from sequestration could materially impact our business.

Programs related specifically to the support of ongoing operations in Afghanistan are subject to changes in the level of U.S. commitment. The current Presidential Administration has stated its intent to withdraw all major forces by 2014 and maintain a limited presence after the subsequent transition to the Afghan government.

Page | 34 -------------------------------------------------------------------------------- Table of Contents The DoD is focused on several initiatives to improve efficiency, refocus priorities, and enhance DoD business practices. As part of these initiatives, the DoD is re-evaluating the way capabilities are procured and continues to experiment with novel approaches. This acquisition reform could increase competitive pressures and impact defense industry revenue levels and profit margins going forward. We believe, however, that we are well positioned for this environment by offering affordable and ready-now solutions, which may realize true cost savings for the DoD.

As large-scale ground deployments continue to decline, less emphasis is being placed on capabilities required for U.S. soldiers (Soldier Systems), including counter-IED jammers, night vision equipment and tactical communications systems.

These declines are reflected in our business plans. While it is evident that reductions in demand for Soldier Systems are occurring, the specific end state remains uncertain.

We believe that spending on recapitalization, modernization and maintenance of defense and security assets will continue despite possible reductions to some defense programs in which we participate or for which we expect to compete. We expect ongoing DoD emphasis to be placed on our areas of strength, such as ISR and analytics, critical network development and operation, electronic warfare, precision navigation and timing, and cyber solutions.

Although the federal government faces budget pressures and constraints for the foreseeable future, we believe that we are well positioned in areas of persistent demand in certain civil agencies, including our development and operation of the FAA's ADS-B system, and management and operation of NASA's space communications networks.

Globally, continued fiscal pressures in overseas economies could impact our business in markets such as the United Kingdom and continental Europe. However, we are forecasting continued market growth in the Middle East and Asia-Pacific regions with new opportunities to expand our international business.

The information provided above represents a list of known trends and uncertainties that could impact our business in the foreseeable future. It should, however, be considered along with the risk factors identified under the caption "Risk Factors" and the discussion under the section "Cautionary Statement Concerning Forward-Looking Statements" in this Annual Report on Form 10-K.

Executive Summary Exelis reported revenue of $4.8 billion for the year ended December 31, 2013, a decrease of approximately 13% compared to 2012. The decrease in revenue was driven by a revenue decline of 14% within our C4ISR Electronics and Systems segment primarily due to lower demand for counter-IED jammer products and Night Vision products. Revenue also declined 12% within our Information and Technical Services segment, primarily due to lower activity on our Middle East and Afghanistan based contacts within our Infrastructure Asset Management and Logistics and Supply Chain Management program areas.

Operating income for the year ended December 31, 2013 was $476, reflecting a decrease of $85 or 15% compared to 2012 primarily due to lower revenue and higher restructuring charges. Operating margin decreased year-over-year to 9.9% from 10.2% primarily due to higher restructuring charges.

Additional Company highlights for the year ended December 31, 2013 included the following: • We recorded an increase in funded orders of $486, a year-over-year increase of 10%.

• We reported $258 of operating income within our Information and Technical Services segment, an increase of 22% compared to 2012.

• We substantially completed a significant restructuring action, which we believe will increase our cost competitiveness going forward.

• We experienced a year-over-year net improvement of $743 or 38% in the funded status of our defined benefit pension plans.

• We declared four quarterly cash dividends totaling $80 or $0.41 per share.

Page | 35 -------------------------------------------------------------------------------- Table of Contents Key Performance Indicators and Non-GAAP Measures Management reviews key performance indicators including revenue, segment operating income and margins, orders growth, and backlog, among other metrics on a regular basis. In addition, we consider certain additional measures to be useful to management and investors evaluating our operating performance for the periods presented, and provide a tool for evaluating our ongoing operations, liquidity and management of assets. This information can assist investors in assessing our financial performance and measures our ability to generate capital for deployment among competing strategic alternatives and initiatives, including, but not limited to, acquisitions and debt repayment. These metrics, however, are not measures of financial performance under accounting principles generally accepted in the United States of America (GAAP) and should not be considered a substitute for revenue, operating income, income from continuing operations, or net cash from continuing operations as determined in accordance with GAAP. We consider the following non-GAAP measure, which may not be comparable to similarly titled measures reported by other companies, to be a key performance indicator: • "Adjusted net income" defined as net income, adjusted to exclude items that include, but are not limited to, significant charges or credits that impact current results, but are not related to our ongoing operations, unusual and infrequent non-operating items and non-operating tax settlements or adjustments. A reconciliation of adjusted net income is provided below.

Year Ended December 31, 2013 2012 2011 Net income $ 281 $ 330 $ 326 Separation costs for the ITT Spin-off, net of tax - 19 29 Separation costs for the Mission Systems spin-off, net of tax 2 - - Tax-related special items for the ITT Spin-off 5 - 16 Adjusted net income 288 349 371 Net income per diluted share $ 1.46 $ 1.75 $ 1.75 Adjusted net income per diluted share $ 1.50 $ 1.85 $ 1.99 DISCUSSION OF FINANCIAL RESULTS YEAR ENDED DECEMBER 31, 2013 COMPARED TO YEAR ENDED DECEMBER 31, 2012 Year Ended December 31, 2013 2012 Change Product and service revenue $ 4,816 $ 5,522 (12.8 )% Cost of product and service revenue 3,748 4,359 (14.0 )% Operating expense 592 602 (1.7 )% Operating income 476 561 (15.2 )% Operating margin 9.9 % 10.2 % Interest expense, net 37 37 - % Other expense (income), net 2 3 (33.3 )% Income tax expense 156 191 (18.3 )% Effective income tax rate 35.7 % 36.7 % Net Income $ 281 $ 330 (14.8 )% Revenue Revenue for the year ended December 31, 2013 was $4,816, reflecting a decrease of $706 or 12.8% as compared to 2012. The following table illustrates revenue for our segments for the years ended December 31, 2013 and 2012: Page | 36 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2013 2012 ChangeC4ISR Electronics and Systems $ 2,136 $ 2,487 (14.1 )% Information and Technical Services 2,680 3,035 (11.7 )% Total revenue $ 4,816 $ 5,522 (12.8 )% Revenue from our C4ISR Electronics and Systems segment was $2,136 in 2013, a decline of $351 or 14.1% as compared to 2012. The decrease in revenue was primarily due to volume declines in counter-IED jammer products, including CREW related products and other counter-IED systems, of approximately $151 and Night Vision products of approximately $146. Additionally, revenue decreased on our Worldview-3 satellite imaging program by approximately $60, as this program nears completion. The decrease in revenue was partially offset by higher revenue on our Advance Integrated Defensive Electronic Warfare Suite (AIDEWS) products for international military aircraft of approximately $27.

Revenue from our Information and Technical Services segment was $2,680 in 2013, a decrease of $355 or 11.7% as compared to 2012. The decrease in revenue was primarily due to lower net activity on our Infrastructure Asset Management and Logistics and Supply Chain Management program area contracts, including Middle East and Afghanistan based contracts (primarily K-BOSSS, APS-5 Kuwait and ANSF Facilities Support programs) of approximately $156 and the remaining contracts of approximately $70, our Operations Maintenance and Defense of Army Communications in Southwest Asia and Central Asia (OMDAC-SWACA) contract of approximately $91, and our Advanced Information Solutions program area contracts of approximately $41. The decrease in revenue was partially offset by higher revenue on our Automated Dependent Surveillance-Broadcast (ADS-B) contract of approximately $36.

Cost of Revenue and Operating Expenses Cost of product and service revenue and other operating expenses are comprised of the following: Year Ended December 31, 2013 2012 Change Cost of product revenue $ 1,517 $ 1,726 (12.1 )% % of product revenue 71.0 % 69.4 % Cost of service revenue $ 2,231 $ 2,633 (15.3 )% % of service revenue 83.2 % 86.8 %Selling, general and administrative expenses $ 455 $ 516 (11.8 )% % of total revenue 9.4 % 9.3 % Research and development expenses $ 54 $ 67 (19.4 )% % of total revenue 1.1 % 1.2 % Restructuring and asset impairment charges $ 83 $ 19 337 % % of total revenue 1.7 % 0.3 % Cost of Product and Service Revenue The decrease in cost of product revenue of $209 or 12.1% in 2013 as compared to 2012 was primarily due to volume declines within our C4ISR Electronics and Systems segment. The cost of product revenue as a percent of product revenue increased primarily due to a net sales mix of lower margin products.

The decrease in cost of service revenue of $402 or 15.3% in 2013 as compared to 2012 was primarily due to lower activity within our Information and Technical Services segment. The cost of service revenue as a percent of service revenue decreased primarily due to productivity improvements, that decreased the cost of service revenue, and favorable contract pricing adjustments, including improved incentive and award fees and contract modifications, that increased revenue without an increase to costs, on several contracts in our Civil and Aerospace Systems program area and our Infrastructure Asset Management (primarily Middle East and Afghanistan based contracts) program area.

Page | 37 -------------------------------------------------------------------------------- Table of Contents Selling, General & Administrative (SG&A) Expenses SG&A expenses as a percent of total revenue was 9.4% in 2013, compared to 9.3% in 2012. The increase in SG&A expenses as a percent of total revenue was due to lower revenue partially offset by lower SG&A expenses. SG&A expenses decreased primarily due to cost reductions resulting from current and prior year restructuring actions in our C4ISR Electronics and Systems segment and other cost saving initiatives, partially offset by higher net periodic benefit cost.

Research and Development (R&D) Expenses The decrease in R&D expenses of $13 or 19.4% in 2013 as compared to 2012 was primarily due to more narrowly focusing R&D expenses in strategic growth areas.

Restructuring and Asset Impairment Charges We recognized restructuring and asset impairment charges of $83 in 2013 as compared to $19 in 2012. The increase in restructuring and asset impairment charges was primarily due to a restructuring action started in the first quarter of 2013 to reduce the size of our workforce and consolidate our facilities footprint to align our cost structure more closely to customer and market conditions. Through voluntary and involuntary employee reductions, we eliminated approximately 1,168 positions. Charges incurred under this action primarily related to employee severance, and to a lesser extent, lease cancellation and other costs associated with the consolidation of certain facilities. This restructuring action was substantially completed by December 31, 2013.

Operating Income The following table illustrates the 2013 and 2012 operating income results of our business segments, including operating margin results: Year Ended December 31, 2013 2012 Change C4ISR Electronics and Systems $ 218 $ 350 (37.7 )% Operating margin 10.2 % 14.1 % Information and Technical Services 258 211 22.3 % Operating margin 9.6 % 7.0 % Total operating income $ 476 $ 561 (15.2 )% Total operating margin 9.9 % 10.2 % Operating income at our C4ISR Electronics and Systems segment decreased $132 or 37.7% in 2013 as compared to 2012 primarily due to lower product revenue and higher restructuring charges. Operating income as a percentage of revenue was 10.2% in 2013 as compared to 14.1% in 2012. The decrease in operating margin was primarily due to higher restructuring charges.

Operating income at our Information and Technical Services segment increased $47 or 22.3% in 2013 as compared to 2012 primarily due to lower cost of service revenue. Operating income as a percentage of revenue was 9.6% in 2013 as compared to 7.0% in 2012. The increase in operating margin was primarily due to lower cost of service revenue as a percentage of service revenue.

During the performance of long-term sales contracts, estimated final contract prices and costs are reviewed periodically and revisions are made as required and recorded in income in the period in which they are determined. Changes in estimated revenue, cost of revenue and the related effect to operating income are recognized using a cumulative catch-up adjustment which recognizes in the current period the cumulative effect of the changes on current and prior periods based on a contract's percent complete. Net favorable cumulative catch-up adjustments related to prior periods increased operating income by approximately $107 and $65 for the years ended December 31, 2013 and 2012, respectively.

Productivity improvements and contract pricing adjustments primarily contributed to the net favorable cumulative catch-up adjustments in the current year.

Page | 38 -------------------------------------------------------------------------------- Table of Contents Impact to Operating Income from Defined Benefit Plan Expense We recorded net periodic benefit cost of $87 in 2013 as compared to $43 in 2012.

The increase in net periodic benefit cost was primarily attributable to the effect of a lower expected long-term rate of return on plan assets and higher amortization of net actuarial losses, partially offset by lower interest cost due to a decrease in the discount rate.

During the second quarter of 2013, we amended our U.S. Salaried Retirement Plan (U.S. SRP), our largest defined benefit pension plan, and the related Excess Pension Plans to freeze all future benefit accruals effective December 31, 2016.

As a result, the assets and liabilities of the U.S. SRP and related plans were re-measured as of May 31, 2013. The re-measurement reduced net periodic benefit cost by approximately $14 in 2013 primarily due to lower service costs.

In 2014, we anticipate a decrease of approximately $17 to $27 in net periodic benefit cost as compared to 2013. This anticipated decrease is primarily attributable to a full year's benefit of reduced cost resulting from the future freezing of future benefit accruals for the U.S. SRP and lower amortization of net actuarial losses, partially offset by a lower expected return of assets and higher interest costs.

Interest Expense, Net We recorded interest expense, net, of $37 in both 2013 and 2012. Interest expense, net, was primarily related to our senior notes.

Other Expense (Income), Net We recorded other expense, net, of $2 in 2013 as compared to $3 in 2012. The year-over-year change was not significant.

Income Tax Expense We recorded income tax expense of $156 and $191 in 2013 and 2012, respectively, which represented effective income tax rates of 35.7% and 36.7%, respectively.

The year-over-year decrease in the effective income tax rate was primarily due to an increase in the U.S. manufacturing deduction and the favorable impact of the renewal of the 2012 federal research and development tax credit.

DISCUSSION OF FINANCIAL RESULTS YEAR ENDED DECEMBER 31, 2012 COMPARED TO YEAR ENDED DECEMBER 31, 2011 Year Ended December 31, 2012 2011 Change Product and service revenue $ 5,522 $ 5,839 (5.4 )% Cost of product and service revenue 4,359 4,616 (5.6 )% Operating expense 602 688 (12.5 )% Operating income 561 535 4.9 % Operating margin 10.2 % 9.2 % Interest expense, net 37 10 270 % Other expense (income) , net 3 (12 ) 125 % Income tax expense 191 211 (9.5 )% Effective income tax rate 36.7 % 39.3 % Net Income $ 330 $ 326 1.2 % Revenue Revenue for the year ended December 31, 2012 was $5,522, reflecting a decrease of $317 or 5.4% as compared to 2011. The decline in revenue within our C4ISR Electronics and Systems segment was slightly offset by revenue growth in our Information and Technical Services segment. The following table illustrates revenue for our segments for the years ended December 31, 2012 and 2011: Page | 39 -------------------------------------------------------------------------------- Table of Contents Year Ended December 31, 2012 2011 ChangeC4ISR Electronics and Systems $ 2,487 $ 2,817 (11.7 )% Information and Technical Services 3,035 3,022 0.4 % Total revenue $ 5,522 $ 5,839 (5.4 )% Revenue from our C4ISR Electronics and Systems segment was $2,487 in 2012, a decline of $330 or 11.7% as compared to 2011. The decrease in revenue was primarily due to volume declines in surge-related products, including Night Vision products of approximately $175, SINCGARS products of approximately $173, and CREW 2.1 and special purpose jammer products of approximately $36. The decrease in revenue was partially offset by higher revenue from the sale of our Band C Upgrade kits for legacy CREW products of approximately $82 and our other counter-IED systems of approximately $24.

Revenue from our Information and Technical Services segment was $3,035 in 2012, an increase of $13 or 0.4% as compared to 2011. The increase in revenue was primarily due to efforts to support the U.S Armed Services on our Afghanistan based contracts, including the ANSF Facilities Support programs contracts and LOGCAP contract, which had had revenue increases of approximately $63 and $38, respectively, and efforts to support NASA under our SCNS contract, which had a revenue increase of approximately $47. The increase in revenue was partially offset by lower revenue on our Technology and Systems Engineering Bridge (TSE Bridge) program of approximately $65, and lower activity on our APS-5 Kuwait contract of approximately $45. The TSE Bridge program, part of our Advanced Information Solutions business, ended in late 2011.

Cost of Revenue and Operating Expenses Cost of product and service revenue and other operating expenses are comprised of the following: Year Ended December 31, 2012 2011 Change Cost of product revenue $ 1,726 $ 1,933 (10.7 )% % of product revenue 69.4 % 68.6 % Cost of service revenue $ 2,633 $ 2,683 (1.9 )% % of service revenue 86.8 % 88.8 %Selling, general and administrative expenses $ 516 $ 566 (8.8 )% % of total revenue 9.3 % 9.7 % Research and development expenses $ 67 $ 99 (32.3 )% % of total revenue 1.2 % 1.7 % Restructuring and asset impairment charges $ 19 $ 23 (17.4 )% % of total revenue 0.3 % 0.4 % Cost of Product and Service Revenue The decrease in cost of product revenue of $207 or 10.7% in 2012 as compared to 2011 was primarily due to lower sales in our C4ISR Electronics and Systems segment. The cost of product revenue as a percent of product revenue increased primarily due to a net sales mix of lower margin products.

The decrease in cost of services revenue of $50 or 1.9% in 2012 as compared to 2011 was primarily due to productivity improvements in our Information and Technical Services segment. The cost of service revenue as a percent of service revenue decreased primarily due to productivity improvements and contract pricing adjustments on several contracts in our Civil and Aerospace Systems and Infrastructure Asset Management (primarily Afghanistan based contracts) program areas.

Page | 40 -------------------------------------------------------------------------------- Table of Contents Selling, General & Administrative (SG&A) Expenses SG&A expenses as a percent of total revenue was 9.3% in 2012 as compared to 9.7% in 2011. The decrease in SG&A expenses as a percent of total revenue was due to lower SG&A expenses partially offset by lower revenue. SG&A expenses decreased primarily due to the absence of general corporate expense allocations from ITT of $102 and cost reductions partially resulting from prior year restructuring in our C4ISR Electronics and Systems segment, partially offset by higher general corporate expenses necessary to operate as a stand-alone company. The corporate expense allocations received from ITT during 2011 included allocations for defined benefit pension and other postretirement defined benefit plan costs of $79.

Research and Development (R&D) Expenses The decrease in R&D expenses of $32 or 32.3% in 2012 as compared to 2011 primarily reflected the completion of certain R&D projects for integrated electronic warfare systems, other communication technologies and night vision technologies primarily within our C4ISR Electronics and Systems segment.

Restructuring and Asset Impairment Charges We recognized restructuring and asset impairment charges of $19 in 2012 as compared to $23 in 2011. The decrease in restructuring and asset impairment charges primarily represented lower severance costs, partially offset by higher asset impairment charges, in our C4ISR Electronics and Systems segment.

Restructuring charges in 2012 and 2011 primarily represented severance costs in our C4ISR Electronics and Systems segment to better align our headcount with reduced production volume on Night Vision, SINCGARS and CREW products.

Operating Income The following table illustrates the 2012 and 2011 operating income results of our business segments, including operating margin results: Year Ended December 31, 2012 2011 Change C4ISR Electronics and Systems $ 350 $ 385 (9.1 )% Operating margin 14.1 % 13.7 % Information and Technical Services 211 150 40.7 % Operating margin 7.0 % 5.0 % Total operating income $ 561 $ 535 4.9 % Total operating margin 10.2 % 9.2 % Operating income at our C4ISR Electronics and Systems segment decreased $35 or 9.1% in 2012 as compared to 2011. Operating income as a percentage of revenue was 14.1% in 2012 as compared to 13.7% in 2011. The increase in operating margin was primarily due to lower R&D and SG&A expenses as a percentage of product revenue, partially offset by higher cost of product revenue as a percentage of product revenue.

Operating income at our Information and Technical Services segment increased $61 or 40.7% in 2012 as compared to 2011. Operating income as a percentage of revenue was 7.0% in 2012 as compared to 5.0% in 2011. The increase in operating margin was primarily due to lower cost of service revenue as a percentage of service revenue.

Net favorable cumulative catch-up adjustments related to prior periods increased operating income by approximately $65 and $143 for the years ended December 31, 2012 and 2011, respectively. Productivity improvements and contract pricing adjustments primarily contributed to the net favorable cumulative catch-up adjustments in 2012.

Impact to Operating Income from Defined Benefit Plan Expense We recorded net periodic benefit cost of $43 in 2012 as compared to $46 in 2011.

In 2011, prior to the ITT Spin-off, we also received intercompany expense allocations from ITT for the defined benefit pension plan and other postretirement defined benefit plan costs of $79.

Page | 41 -------------------------------------------------------------------------------- Table of Contents Total defined benefit plan costs, including both net periodic benefit cost and the allocations from ITT, decreased $82 in 2012 as compared to 2011. This decrease was primarily attributable to a longer amortization period for the net actuarial losses, partially offset by the amortization of higher unamortized net actuarial losses and the assumption of the full costs of certain defined benefit plans received from ITT in connection with the ITT Spin-off (Transferred Plans).

Beginning on January 1, 2012, we started using a new amortization period for the U.S. SRP as a result of changes to the plan from the ITT Spin-off and other plan modifications that caused almost all plan participants to stop accruing future benefits. Net actuarial losses are now amortized over the average remaining life expectancy of the plan participants instead of the average remaining service period of plan participants.

Interest Expense, Net We recorded interest expense, net, of $37 in 2012 as compared to $10 in 2011.

Interest expense, net, was primarily related to our senior notes issued in late September 2011.

Other Expense (Income), Net We recorded other expense, net, of $3 in 2012 as compared to other income, net, of $12 in 2011. In 2011, other income, net, was primarily related to our sale of an investment in marketable securities.

Income Tax Expense We recorded income tax expense of $191 and $211 in 2012 and 2011, respectively, which represented effective income tax rates of 36.7% and 39.3%, respectively.

The year-over-year decrease in the effective income tax rate was primarily due to the absence of unfavorable impacts of the planned future repatriation of foreign earnings due to the ITT Spin-off recorded in 2011, partially offset by the expiration of the federal research and development tax credit, which expired at the end of 2011.

BACKLOG Total backlog includes both funded backlog (firm orders for which funding is contractually obligated by the customer) and unfunded backlog (firm orders for which funding is not currently contractually obligated by the customer).

Unfunded backlog represents firm orders, potential options on multi-year contracts and multi-year commercial contracts when demand is supported by customer backlog, and excludes potential orders under indefinite delivery / indefinite quantity (IDIQ) contracts. Backlog is converted into revenue as work is performed or deliveries are made. The level of order activity related to defense programs can be affected by the timing of government funding authorizations and project evaluation cycles. Year-over-year comparisons could, at times, be impacted by these factors, among others.

Funded orders received in 2013 increased 10% or $0.5 billion to $5.3 billion as compared to 2012. The increase in funded awards was primarily driven by higher awards in our Infrastructure Asset Management and Command, Control and Communications Systems program areas, including our K-BOSSS and SLRS contracts, respectively, within our Information and Technical Services segment. Funded orders also increased within our C4ISR Electronics and Systems segment primarily due to higher international orders in our Intelligence, Surveillance and Reconnaissance Systems and Radar, Reconnaissance and Undersea Systems product lines, including our contract to provide electronic support measures to the Royal Australian Navy and our contract to provide an advanced geostationary weather imager to South Korea, respectively. Composite aerostructure products also generated higher funded orders in 2013 as compared to 2012.

At December 31, 2013, total backlog was $9.4 billion compared to $9.5 billion at the end of 2012. Total backlog decreased by $0.1 billion primarily due to the timing of the contract cycle within our Information and Technical Services segment related to our Infrastructure Asset Management and Logistics and Supply Chain Management program area contracts, partially offset by the award of a significant composite aerostructures commercial supply contract.

Page | 42 -------------------------------------------------------------------------------- Table of Contents Backlog consisted of the following: Year Ended December 31, (In billions) 2013 2012 Funded backlog $ 3.4 $ 2.9 Unfunded backlog 6.0 6.6 Total backlog $ 9.4 $ 9.5 LIQUIDITY AND CAPITAL RESOURCES Liquidity We expect to fund our ongoing working capital, capital expenditures, strategic investments, and financing requirements through cash flows from operations, cash on hand and access to capital markets. If our cash flows from operations are less than we expect, we may need to access the short or long-term capital markets. We believe our $600 credit facility and commercial paper program will permit us to finance our operations on acceptable terms and conditions.

Our access to, and the availability of, financing on acceptable terms and conditions in the future will be impacted by many factors, including: (i) our credit ratings or absence of a credit rating, (ii) the liquidity of the overall capital markets, and (iii) the current state of the economy. We cannot assure that such financing will be available to us on acceptable terms or that such financing will be available at all.

A portion of our cash is held by our foreign subsidiaries. We manage our cash requirements considering available funds among our subsidiaries and the cost effectiveness with which those funds can be accessed. We continue to look for opportunities to access cash balances in excess of local operating requirements to meet liquidity needs in a cost-efficient manner.

Funding of Pension Plans Funding requirements under applicable laws and regulations are a major consideration in making contributions to our U.S. pension plans. While the Company has significant discretion in making voluntary contributions, the Employee Retirement Income Security Act of 1974, as amended by the Pension Protection Act of 2006 and further amended by the Worker, Retiree, and Employer Recovery Act of 2008, the Moving Ahead for Progress in the 21st Century Act and applicable Internal Revenue Code regulations, mandate minimum funding thresholds. Failure to satisfy the minimum funding thresholds could result in restrictions on our ability to amend the plan or make benefit payments. With respect to U.S. qualified pension plans, we intend to contribute annually not less than the required minimum funding thresholds.

At December 31, 2013, our defined benefit pension plans were underfunded by $1.2 billion. In 2013, we made total contributions of $186 to our qualified pension plans, including $40 of voluntary contributions. We currently anticipate making total contributions to our qualified pension plans in the range of $185 to $200 during 2014.

Future required contributions will depend primarily on the actual annual return on assets and the discount rate used to measure the benefit obligation at the end of each year. Depending on these factors, and the resulting funded status of our pension plans, the level of future statutory minimum contributions could be material.

Dividend Our Board of Directors will review and approve the declaration and distribution of any future dividends based on an analysis of many factors, including our operating performance and outlook, financial condition, available liquidity and expected future requirements for cash and capital resources. Moreover, if we determine to pay any dividend in the future, there can be no assurance that we will continue to pay such dividends.

On October 9, 2013, our Board of Directors declared a cash dividend of $0.10 per share, payable on January 2, 2014 to shareholders of record on November 15, 2013. In 2013, we declared four quarterly dividends totaling $80 or $0.41 per share.

Page | 43 -------------------------------------------------------------------------------- Table of Contents Sources and Uses of Liquidity The following table provides net cash provided by or used in operating activities, investing activities and financing activities for each of the previous three years.

Year Ended December 31, 2013 2012 2011 Operating activities $ 310 $ 385 $ 334 Investing activities (83 ) (159 ) (85 ) Financing activities (51 ) (57 ) (147 ) Foreign exchange 1 7 (4 ) Net cash flow from continuing operations $ 177 $ 176 $ 98 Net cash provided by operating activities decreased by $75 in 2013 as compared to 2012, primarily due to changes in other liabilities of $132 and changes in accounts payable of $75, partially offset by a decrease in defined benefit plan payments of $84 and an increase in restructuring and asset impairment changes net of payments for restructuring of $26. Net cash provided by operating activities increased by $51 in 2012 as compared to 2011, primarily due to changes in inventory of $155, changes in receivables of $147 and changes in deferred taxes of $48, partially offset by increased defined benefit plan payments of $203 and changes in accounts payable of $124.

Net cash used in investing activities decreased by $76 in 2013 as compared to 2012, primarily due to lower capital expenditures of $41 and lower net cash paid for acquisitions of $27. Net cash used in investing activities increased by $74 in 2012 as compared to 2011, primarily due to net cash paid for acquisitions of $43 and higher capital expenditures related to facilities and equipment to support new and existing products of $24.

Net cash used in financing activities decreased by $6 in 2013 as compared to 2012, primarily due to lower dividends paid to our shareholders of $19, partially offset by cash paid for common stock repurchases of $16. Dividends declared during the fourth quarter of 2013 were not yet paid as of December 31, 2013, but dividends declared during the fourth quarter of 2012 were paid prior to December 31, 2012. Net cash used in financing activities decreased $90 in 2012 as compared to 2011, primarily due to the absence of $775 of cash transfers to our former Parent net of proceeds from the issuance of debt of $649, partially offset by higher dividend payments to our shareholders of $58.

Capital Resources At December 31, 2013, the Company held cash and cash equivalents of $469, which included $147 held by foreign subsidiaries, and the Company had a $600 revolving credit facility which expires in October 2015. There were no borrowings outstanding under the credit facility and there was no commercial paper outstanding under our commercial paper program as of December 31, 2013.

Borrowings under the credit facility would be unsecured and bear interest at rates based, at our option, on the Eurodollar rate or a bank defined alternative base rate. Each bank's obligation to make loans under the credit facility is subject to, among other things, our compliance with various representations, warranties and covenants, including limits on our ability to: incur additional debt or issue guarantees; create liens; enter into certain sale and lease-back transactions; merge or consolidate with another person; sell, transfer, lease or otherwise dispose of assets; liquidate or dissolve; and enter into restrictive covenants. As of December 31, 2013, we were in compliance with all covenants contained in the credit facility agreement.

The Company's commercial paper program generally enables the Company to borrow short-term funds at competitive rates. The commercial paper program is fully supported by available borrowing capacity under our credit facility. As with all other financing programs, our access to the commercial paper market will be impacted by many factors, including our credit ratings, liquidity of the capital markets, and state of the economy. As such, we cannot assure that we will have continued access to the commercial paper market or that the terms of the commercial paper will be acceptable to us.

We have outstanding long-term debt consisting of $250 of 4.25% senior notes due in 2016 and $400 of 5.55% senior notes due in 2021. Interest on the senior notes is payable on April 1 and October 1 of each year. The senior notes are Page | 44 -------------------------------------------------------------------------------- Table of Contents senior unsecured obligations and rank equally with all of our existing and future senior unsecured indebtedness. The senior notes have covenants that restrict our ability to, subject to exceptions, incur indebtedness secured by liens or engage in sale and leaseback transactions and the senior notes are subject to customary events of default. As of December 31, 2013, we were in compliance with all covenants required by the terms of our senior notes.

The credit facility, commercial paper and senior notes are discussed further in Note 12, "Debt," in the Notes to the Consolidated and Combined Financial Statements.

Contractual Obligations Our commitment to make future payments under long-term contractual obligations were as follows, as of December 31, 2013: Payments due by period Less than More than Total 1 year 1-3 Years 3-5 Years 5 years Debt (1) $ 650 $ - $ 250 $ - $ 400 Interest payments (2) 209 33 66 44 66 Operating leases (3) 269 60 92 65 52 Capital lease obligations 26 3 5 5 13 Purchase obligations (4) 408 333 71 4 - Other long-term obligations reflected on balance sheet (5) 40 5 10 10 15 Total contractual obligations $ 1,602 $ 434 $ 494 $ 128 $ 546 (1) See Note 12, "Debt", in the Notes to the Consolidated and Combined Financial Statements, for a discussion of the use and availability of debt and revolving credit agreements. Amounts represent total long-term debt, excluding unamortized discounts.

(2) Amounts represent estimate of future interest payments on long-term debt outstanding as of December 31, 2013.

(3) Refer to Note 11, "Leases and Rentals", in the Notes to the Consolidated and Combined Financial Statements, for further discussion of lease and rental obligations.

(4) Represents unconditional purchase agreements that are enforceable and legally binding, and specify all significant terms to purchase goods or services, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase agreements that are cancellable without penalty are excluded.

(5) Other long-term obligations include estimated environmental investigation and remediation payments. We estimate, based on historical experience that we will spend between $2 and $4 per year on environmental investigation and remediation. We are contractually required to spend a portion of these obligations based on existing agreements with various governmental agencies and other entities. At December 31, 2013, we estimated and accrued total environmental liabilities of $26.

The table above excludes estimated minimum funding requirements and expected voluntary contributions for defined benefit pension and other postretirement defined benefit plans. See Note 13, "Postretirement Benefit Plans," in the Notes to the Consolidated and Combined Financial Statements for additional discussion of contributions and estimated future benefit payments.

In the ordinary course of business, we use standby letters of credit, guarantees issued by commercial banks and surety bonds issued by insurance companies, as well as self-guarantees, principally to guarantee our performance on certain contracts and to support our self-insured workers' compensation plans. At December 31, 2013, there was an aggregate of approximately $102 in surety bonds, guarantees and stand-by letters of credit outstanding.

Off-Balance Sheet Arrangements At December 31, 2013, we had no significant off-balance sheet arrangements other than operating leases and certain indemnifications.

Page | 45 -------------------------------------------------------------------------------- Table of Contents Indemnifications We have acquired and disposed of numerous entities. The related acquisition and disposition agreements contain various representation and warranty clauses and may provide indemnities for a misrepresentation or breach of the representations and warranties by either party. The indemnities address a variety of subjects; the term and monetary amounts of each such indemnity are defined in the specific agreements and may be affected by various conditions and external factors. Many of the indemnities have expired either by operation of law or as a result of the terms of the agreement. We do not have a liability recorded for the historic indemnifications and are not aware of any claims or other information that we believe would give rise to material payments under such indemnities.

As part of the ITT Spin-off, Exelis provided or is provided certain indemnifications and cross-indemnifications among ITT and Xylem Inc. The indemnifications address a variety of subjects. We expect ITT and Xylem Inc. to fully perform under the terms of the agreements and therefore we have not recorded a liability for matters for which we are indemnified. In addition, we are not aware of any claims or other circumstances that would give rise to material payments to ITT or Xylem Inc. under the indemnity that we provide to them.

CRITICAL ACCOUNTING POLICIES, ESTIMATES AND JUDGMENTS The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting periods. Estimates are revised as additional information becomes available.

Significant accounting policies used in the preparation of the Consolidated and Combined Financial Statements are discussed in Note 1, "Description of Business and Summary of Significant Accounting Policies," in the Notes to the Consolidated and Combined Financial Statements. Accounting estimates and assumptions discussed in this section are those that we consider most critical to an understanding of our financial statements because they are inherently uncertain, involve significant judgments, include areas where different estimates reasonably could have been used, and changes in the estimates that are reasonably possible could materially impact the financial statements. Management believes that the accounting estimates employed and the resulting balances are reasonable; however, actual results in these areas could differ from management's estimates under different assumptions or conditions.

Revenue Recognition As a defense contractor engaging in long-term contracts, the majority of our revenue is derived from long-term construction-type and production-type sales contracts and services provided to the federal government for which revenue is recognized under the percentage-of-completion method based on units of delivery, percentage of costs incurred to total costs, or the completion of scheduled performance milestones. For units of delivery, revenues and profits are recognized based upon the ratio of actual units delivered to estimated total units to be delivered under the contract. Under the cost-to-total cost method, revenue is recognized based upon the ratio of costs incurred to estimated total costs at completion of the contract. Revenue is recognized under the milestone method based upon accomplishing a clear deliverable output of contract performance with value to the customer. Revenues and profits on time-and-material type contracts are recognized based on billable rates times direct labor hours incurred plus material and other reimbursable costs incurred.

The completed contract method is utilized when reasonable and reliable cost estimates for a project cannot be made. Amounts invoiced to customers in excess of revenue recognized are recorded as deferred revenue, until the revenue recognition criteria are satisfied. Revenue that is earned and recognized in excess of amounts invoiced is recorded as a component of receivables, net.

During the performance of long-term sales contracts, estimated final contract prices and costs are reviewed periodically and revisions are made as required and recorded in income in the period in which they are determined. Additionally, the fees under certain contracts may be increased or decreased in accordance with cost or performance incentive provisions which measure actual performance against established targets or other criteria. Such incentive fee awards or penalties are included in revenue when there is sufficient information to reasonably assess anticipated contract performance. Amounts representing contract change orders, claims, requests for equitable adjustment, or limitations in funding on contracts are recorded only if it is probable the claim will result in additional contract revenue and the amounts can be reliably estimated. Provisions for estimated losses on uncompleted long-term sales contracts Page | 46 -------------------------------------------------------------------------------- are made in the period in which such losses are determined and are recorded as a component of costs of revenue. Contract revenue and cost estimates are reviewed and reassessed periodically. Changes in these estimates could result in recognition of cumulative catch-up adjustments to the contract's inception to date revenue, cost of revenue and profit in the period in which such changes are made, based on a contract's percent complete. Changes in revenue and cost estimates could also result in a forward loss or an adjustment to a forward loss. For the years ended December 31, 2013, 2012 and 2011, net favorable cumulative catch-up adjustments related to prior periods increased operating income by approximately $107, $65 and $143, respectively.

To a lesser extent, we enter into contracts that are not associated with the design, development, manufacture, or modification of complex aerospace or electronic equipment and related services, and for services to non-federal government customers. For such contracts, we recognize revenue at the time title and risks and rewards of ownership pass, which is generally when products are shipped or as services are performed if there is persuasive evidence of an arrangement, the price is fixed or determinable and collectability is reasonably assured. For agreements that contain multiple deliverables, we allocate revenue across all identified units of accounting based on relative fair values and then recognize revenue when the appropriate revenue recognition criteria for the individual deliverables have been satisfied.

Postretirement Benefit Plans Company employees participate in numerous defined benefit pension and other postretirement defined benefit plans (collectively referred to as "defined benefit plans") in the United States, which are sponsored by the Company. The determination of projected benefit obligations and the recognition of expenses related to defined benefit pension plans are dependent on various assumptions.

These major assumptions primarily relate to discount rates, long-term expected rates of return on plan assets, rate of future compensation increases, mortality, termination and other factors (some of which are disclosed in Note 13, "Postretirement Benefit Plans," in the Notes to the Consolidated and Combined Financial Statements). Actual results that differ from our assumptions are accumulated and are amortized generally over the estimated future life or service period of the plan participants.

Significant Assumptions Management develops assumptions using relevant Company experience, in conjunction with market-related data for each plan. Assumptions are reviewed annually with third party consultants and adjusted as necessary. The table included below provides the weighted average assumptions used to estimate projected benefit obligations and net periodic benefit cost as they pertain to our defined benefit pension plans, as of and for the years ended 2013 and 2012.

Year Ended December 31, 2013 2012 Obligation assumptions Discount rate 4.71 % 4.09 % Rate of future compensation increase 2.75 % 3.25 % Cost assumptions (1) Discount rate 4.28 % 4.75 % Expected return on plan assets 8.50 % 9.00 % Rate of future compensation increase 2.75 % 3.75 % (1) Cost assumptions for the current year are based on the prior year-end obligation assumptions, except for defined benefit pension plans that were remeasured at May 31, 2013.

Expected Return on Plan Assets Substantially all of our plan assets are managed on a commingled basis in a master investment trust. We determine our expected return on plan assets by evaluating both historical returns and estimates of future returns.

Specifically, the Company analyzes the plan's actual historical annual return on assets over the past 15, 20 and 25 years; estimates future returns based on independent estimates of long-term asset class returns; and evaluates historical broad market Page | 47 -------------------------------------------------------------------------------- returns over long-term timeframes based on our strategic target asset allocation, which is detailed in Note 13, "Postretirement Benefit Plans," in the Notes to the Consolidated and Combined Financial Statements. Based on this approach, the long-term annual rate of return on assets is estimated at 8.25% for 2014, compared to 8.50% in 2013, and 9.00% for 2012 and 2011.

The chart below shows actual returns versus the expected long-term returns for our pension plans that were utilized in the calculation of net periodic pension cost for each respective year.

2013 2012 2011 Expected long-term rate of return on plan assets 8.50 % 9.00 % 9.00 % Actual rate of return on plan assets 11.14 % 10.96 % (1.20 )% For the recognition of net periodic pension cost, the calculation of the expected return on plan assets is generally derived using a market-related value of plan assets based on average asset values at the measurement date over the last five years. The use of fair value, rather than a calculated value, could materially affect net periodic pension cost.

Discount Rate The discount rate is used to calculate the present value of expected future cash payments for benefits at the measurement date. A decrease in the discount rate increases the present value of benefit obligations and increases pension expense. The discount rate assumption was based on current investment yields of high-quality fixed income investments during the retirement benefits maturity period. The pension discount rate was determined by considering an interest rate yield curve comprising AAA/AA bonds, with maturities between zero and thirty years, developed by the plan's actuaries. Annual benefit payments are then discounted to present value using this yield curve to develop a single discount rate matching the plan's characteristics.

Rate of Future Compensation Increases The rate of future compensation increase assumption reflects our long-term actual experience and future and near-term outlook. An increase in the rate of future compensation increases used to determine net periodic pension cost increases the present value of benefit obligations and increases pension expense.

Sensitivity Analysis Pension Expense A 25 basis point change in the long-term expected rate of return on plan assets, discount rate, or rate of future compensation increases, would have the following effect on the U.S. SRP's 2014 pension expense: Increase/(Decrease) in Pension Expense 25 Basis 25 Basis Point Increase Point Decrease Long-term rate of return on assets used to determine net periodic benefit cost $ (10 ) $ 10 Discount rate used to determine net periodic benefit cost (1 ) 1 Rate of future compensation increases used to determine net periodic benefit cost $ 0.3 $ (0.3 ) Funded Status Funded status is derived by subtracting the respective year-end values of the projected benefit obligations from the fair value of plan assets. We estimate that every 25 basis point change in the discount rate of the U.S. SRP impacts the funded status by approximately $140.

Page | 48 -------------------------------------------------------------------------------- Fair Value of Plan Assets The plan assets of our defined benefit plans comprise a broad range of investments, including domestic and international equity securities, fixed income investments, interests in private equity and hedge funds and cash and cash equivalents.

A substantial portion of our defined benefit plans asset portfolio is comprised of investments in private equity and hedge funds. The private equity and hedge fund investments are generally measured using the valuation of the underlying investments or at net asset value. However, in certain instances, the values reported by the asset managers were not current at the measurement date.

Accordingly, management has estimated adjustments to the last reported value where necessary to measure the assets at fair value at the measurement date.

These adjustments consider information received from the asset managers, as well as general market information. Asset values for other positions were generally measured using market observable prices. See Note 13, "Postretirement Benefit Plans" in the Notes to Consolidated and Combined Financial Statements for further information.

Income Taxes We determine the provision for income taxes using the asset and liability approach. Under this approach, deferred tax assets and liabilities are determined based on temporary differences between the financial reporting and tax bases of assets and liabilities, applying enacted tax rates in effect for the year in which we expect the differences will reverse. Based on the evaluation of available evidence, we recognize future tax benefits, such as net operating loss carryforwards, to the extent that we believe it is more likely than not we will realize these benefits. We periodically assess the likelihood that we will be able to recover our deferred tax assets and reflect any changes to our estimate of the amount we are more likely than not to realize in the valuation allowance, with a corresponding adjustment to earnings or other comprehensive income (loss), as appropriate.

In assessing the need for a valuation allowance, we look to the future reversal of existing taxable temporary differences, taxable income in carryback years, the feasibility of tax planning strategies, and estimated future taxable income.

The valuation allowance can be affected by changes to tax laws, changes to statutory tax rates and changes to future taxable income estimates.

We have provided U.S. deferred income taxes on a portion of the excess of the financial reporting basis over the U.S. tax basis for our foreign earnings, because we do not plan to reinvest such earnings indefinitely outside the United States. The timing and amount of foreign earnings remittances are based on projected cash flow needs, as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations.

Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact our effective income tax rate.

The calculation of our provision for income taxes involves dealing with uncertainties in the application of complex tax regulations in a multitude of jurisdictions across our global operations. We recognize tax liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and to the extent to which, additional taxes will be due. Furthermore, we recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. We adjust our liability for unrecognized tax benefits in light of changing facts and circumstances; however, due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from our current estimate. If our estimate proves to be less than the ultimate assessment, an additional tax expense would result. If these amounts ultimately prove to be less than the recorded amounts, the reversal of the liabilities may result in a tax benefit in the period when the liabilities are no longer necessary.

Prior to October 31, 2011, our income taxes as presented were calculated on a separate tax return basis and may not be reflective of the results that would have occurred on a standalone basis. Our operations were included in ITT's U.S. federal and state tax returns or non-U.S. jurisdictions tax returns prior to ITT Spin-off. Subsequent to the ITT Spin-off, we file our own consolidated income tax returns and we maintain taxes payable to and from federal and state taxing authorities.

Page | 49 -------------------------------------------------------------------------------- Goodwill and Other Intangible Assets We review goodwill for impairment annually and whenever events or changes in circumstances indicate the carrying value of goodwill may not be recoverable. We also review the carrying value of our finite-lived intangible assets for potential impairment when impairment indicators arise. We conduct our annual impairment test as of the first day of the fourth fiscal quarter. We perform a two-step impairment test for goodwill. In the first step, we compare the estimated fair value of each reporting unit to its carrying value. If the estimated fair value of the reporting unit exceeds the carrying value of the net assets assigned to that reporting unit, goodwill is not impaired and we are not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds its fair value, then we must perform the second step of the impairment test in order to measure the impairment loss to be recorded. If the carrying value of a reporting unit's goodwill exceeds its implied fair value, then we record an impairment loss equal to the difference.

We estimate the fair value of our reporting units using an income approach.

Under the income approach, we calculate fair value based on the present value of estimated future cash flows.

Determining the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions, particularly related to future operating results and cash flows. These estimates and assumptions include, but are not limited to, revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and identification of appropriate market comparable data. In addition, the identification of reporting units and the allocation of assets and liabilities to the reporting units when determining the carrying value of each reporting unit also requires judgment. Goodwill is tested for impairment at the reporting unit level. The fair values of our reporting units are based on estimates and assumptions that are believed to be reasonable.

Significant changes to these estimates and assumptions could adversely impact our conclusions. Actual future results may differ from those estimates. Our 2013 annual goodwill impairment analysis indicated the estimated fair value of all of our reporting units exceeded their carrying value. All six reporting units' fair values were substantially in excess of their carrying values. Accordingly, no reporting units failed step one of the goodwill impairment test at December 31, 2013.

In order to evaluate the sensitivity of the fair value estimates on the goodwill impairment test, we applied three sensitivity tests to each of our six reporting units; a hypothetical 100 basis point increase to the discount rates, a ten percent reduction in expected future cash flows, and a future terminal growth rate set to zero. Each of the reporting units passed each of the three sensitivity tests.

New Accounting Pronouncements See Note 2, "Recent Accounting Pronouncements," in the Notes to the Consolidated and Combined Financial Statements for a discussion of recent accounting pronouncements. There were no new pronouncements which we expect to have a material impact on our financial condition and results of operations in future periods.

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