KeyW Corporation
KEYW HOLDING CORP (Form: 10-Q, Received: 11/02/2016 16:36:45)
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)  
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended:           September 30, 2016
or
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from ________________ to ________________
 
Commission File Number: 001-34891
 
The KEYW Holding Corporation
(Exact name of registrant as specified in its charter)
 
Maryland
 
27-1594952
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
 
7740 Milestone Parkway, Suite 400
Hanover, Maryland
 
21076
(Address of principal executive offices)
 
(Zip Code)
 
(443) 733-1600
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý        No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  ý        No  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨
Accelerated filer x
Non-accelerated filer ¨  (Do not check if smaller reporting company)
Smaller reporting company ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨             No ý
 
The number of shares outstanding of the issuer’s common stock ($0.001 par value), as of October 25, 2016 was 40,964,048.



TABLE OF CONTENTS
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 



PART I - FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Condensed Consolidated Balance Sheets
(In thousands, except share and par value per share amounts) 
 
September 30, 2016
 
December 31, 2015
 
(Unaudited)
 
 
ASSETS
 

 
 

Current assets:
 

 
 

Cash and cash equivalents
$
42,505

 
$
21,227

Receivables
47,472

 
53,111

Inventories, net
15,680

 
15,616

Prepaid expenses
1,815

 
1,538

Income tax receivable
345

 
302

Assets of discontinued operations
3,072

 
7,765

Total current assets
110,889

 
99,559

 
 
 
 
Property and equipment, net
32,060

 
28,750

Goodwill
290,772

 
297,223

Other intangibles, net
9,521

 
10,957

Other assets
1,462

 
1,508

Non-current assets of discontinued operations

 
15,408

TOTAL ASSETS
$
444,704

 
$
453,405

LIABILITIES AND STOCKHOLDERS’ EQUITY
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
8,536

 
$
10,299

Accrued expenses
10,167

 
9,345

Accrued salaries and wages
15,639

 
8,916

Deferred income taxes
965

 
964

Liabilities of discontinued operations
2,620

 
7,084

Total current liabilities
37,927

 
36,608

 
 

 
 

Convertible senior notes, net of discount
130,888

 
126,188

Non-current deferred tax liability
29,513

 
26,890

Other non-current liabilities
11,462

 
11,894

TOTAL LIABILITIES
209,790

 
201,580

Commitments and contingencies


 


Stockholders’ equity:
 

 
 

Preferred stock, $0.001 par value; 5 million shares authorized, none issued

 

Common stock, $0.001 par value; 100 million shares authorized, 40,975,827 and 39,940,667 shares issued and outstanding
41

 
40

Additional paid-in capital
332,651

 
327,045

Accumulated deficit
(97,778
)
 
(75,260
)
Total stockholders’ equity
234,914

 
251,825

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$
444,704

 
$
453,405


The accompanying notes to the condensed consolidated financial statements are an integral part of these condensed consolidated financial statements. 
3

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Operations (unaudited)
(In thousands, except share and per share amounts)
 
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
Revenues
$
72,111

 
$
78,100

 
$
219,099

 
$
222,818

Costs of Revenues, excluding amortization
48,312

 
54,252

 
148,576

 
154,474

Gross Profit
23,799

 
23,848

 
70,523

 
68,344

Operating Expenses
 

 
 

 
 

 
 

Operating expenses
18,031

 
18,774

 
51,815

 
50,521

Intangible amortization expense
1,528

 
1,766

 
4,463

 
5,373

Total Operating Expenses
19,559

 
20,540

 
56,278

 
55,894

Operating Income
4,240

 
3,308

 
14,245

 
12,450

Non-Operating Expense, net
2,612

 
2,561

 
6,776

 
7,655

Earnings before Income Taxes from Continuing Operations
1,628

 
747

 
7,469

 
4,795

Income Tax (Benefit) Expense, net on Continuing Operations
(1,876
)
 
7,876

 
2,491

 
32,800

Net Income (Loss) from Continuing Operations
3,504

 
(7,129
)
 
4,978

 
(28,005
)
Loss before Income Taxes from Discontinued Operations
(1,044
)
 
(8,854
)
 
(27,990
)
 
(28,702
)
Income Tax Benefit, net on Discontinued Operations
(4
)
 
(7,979
)
 
(494
)
 
(11,180
)
Net Loss on Discontinued Operations
(1,040
)
 
(875
)
 
(27,496
)
 
(17,522
)
Net Income (Loss)
$
2,464

 
$
(8,004
)
 
$
(22,518
)
 
$
(45,527
)
 
 
 
 
 
 
 
 
Weighted Average Common Shares Outstanding
 

 
 

 
 

 
 

Basic
40,955,372

 
39,144,935

 
40,367,963

 
38,339,646

Diluted
41,305,545

 
39,144,935

 
40,930,999

 
38,339,646

 
 
 
 
 
 
 
 
Basic net earnings (loss) per share:
 

 
 

 
 

 
 

Continuing operations
$
0.09

 
$
(0.18
)
 
$
0.12

 
$
(0.73
)
Discontinued operations
(0.03
)
 
(0.02
)
 
(0.68
)
 
(0.46
)
Basic net earnings (loss) per share
$
0.06

 
$
(0.20
)
 
$
(0.56
)
 
$
(1.19
)
 
 
 
 
 
 
 
 
Diluted net earnings (loss) per share:
 
 
 
 
 
 
 
Continuing operations
$
0.09

 
$
(0.18
)
 
$
0.12

 
$
(0.73
)
Discontinued operations
(0.03
)
 
(0.02
)
 
(0.67
)
 
(0.46
)
Diluted net earnings (loss) per share
$
0.06

 
$
(0.20
)
 
$
(0.55
)
 
$
(1.19
)
 


The accompanying notes to the condensed consolidated financial statements are an integral part of these condensed consolidated financial statements. 
4

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statement of Stockholders’ Equity (unaudited)
(In thousands except share amounts)
 
 
Common Stock
 
Additional Paid-In Capital
 
Accumulated Deficit
 
Total Stockholders’ Equity
 
Shares
 
Amount
 
 
 
Balance, January 1, 2016
39,940,667

 
$
40

 
$
327,045

 
$
(75,260
)
 
$
251,825

Net loss

 

 

 
(22,518
)
 
(22,518
)
Warrant exercise, net
820,648

 
1

 
1,919

 

 
1,920

Option exercise, net
60,050

 

 
385

 

 
385

Restricted stock issuances
184,125

 

 
2,570

 

 
2,570

Restricted stock forfeitures
(159,193
)
 

 
(1,125
)
 

 
(1,125
)
Equity issued related to Milestone earnout
129,530

 

 
1,130

 

 
1,130

Stock based compensation

 

 
727

 

 
727

Balance, September 30, 2016
40,975,827

 
$
41

 
$
332,651

 
$
(97,778
)
 
$
234,914

 

The accompanying notes to the condensed consolidated financial statements are an integral part of these condensed consolidated financial statements. 
5

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Condensed Consolidated Statements of Cash Flows (unaudited)
(In thousands except share amounts) 
 
Nine months ended September 30,
 
2016
 
2015
Net loss
$
(22,518
)
 
$
(45,527
)
Adjustments to reconcile net loss to net cash provided by operating activities:
 

 
 

Stock compensation
2,172

 
4,389

Depreciation and amortization expense
10,460

 
15,184

Impairment of Commercial Cyber Solutions goodwill
6,980

 

Amortization of discount on convertible debt
4,700

 
3,842

(Gain) loss on disposal of assets
(3,447
)
 
1,186

Loss on sale of assets held for sale
3,568

 

Write-off of deferred financing costs
340

 

Deferred taxes
1,974

 
21,464

Changes in operating assets and liabilities:
 

 
 

Receivables
11,113

 
6,171

Inventories, net
(1,165
)
 
(4,298
)
Prepaid expenses
(1,224
)
 
176

Accounts payable
(3,071
)
 
2,265

Accrued expenses
3,417

 
8,125

Other
340

 
1,277

Net cash provided by operating activities
13,639

 
14,254

Cash flows from investing activities:
 

 
 

Acquisitions, net of cash acquired
(2,504
)
 
(20,766
)
Purchases of property and equipment
(8,388
)
 
(12,741
)
Proceeds from sale of assets
16,226

 

Net cash provided by (used in) investing activities
5,334

 
(33,507
)
Cash flows from financing activities:
 

 
 

Proceeds from option and warrant exercises, net
2,305

 
4,623

Net cash provided by financing activities
2,305

 
4,623

Net increase (decrease) in cash and cash equivalents
21,278

 
(14,630
)
Cash and cash equivalents at beginning of period
21,227

 
39,601

Cash and cash equivalents at end of period
$
42,505

 
$
24,971

Supplemental disclosure of cash flow information:
 

 
 

Cash paid for interest
$
3,858

 
$
3,850

Cash paid for taxes
$
89

 
$
97

 
Supplemental disclosure of non-cash investing and financing activities:
In conjunction with the Ponte Technology acquisition in the first quarter of 2015, the Company issued 242,250 shares of KEYW common stock with an approximate value of $2 million .
During the second quarter of 2016, in conjunction with the Milestone Intelligence Group acquisition earnout, the Company issued 129,530 shares of KEYW common stock with an approximate value of $1 million .


The accompanying notes to the condensed consolidated financial statements are an integral part of these condensed consolidated financial statements. 
6

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES



1.     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
We prepared our interim condensed consolidated financial statements that accompany these notes in conformity with accounting principles generally accepted in the United States of America for interim information and in accordance with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.

The interim financial information is unaudited, but reflects all normal adjustments that are, in our opinion, necessary to provide a fair statement of results for the interim periods presented. Certain information and note disclosures normally included in the annual financial statements have been condensed or omitted pursuant to those instructions. This interim information should be read in conjunction with the consolidated financial statements for the year ended December 31, 2015 , contained in our Annual Report on Form 10-K and filed with the Securities and Exchange Commission on March 15, 2016 . Interim results may not be indicative of our full fiscal year performance.
 
Corporate Organization
The KEYW Holding Corporation (“Holdco” or "KEYW") was incorporated in Maryland in December 2009. Holdco is a holding company and conducts its operations through The KEYW Corporation (“Opco”), and its wholly owned subsidiaries. As further described in Note 12, during the second quarter of 2016, the Company sold the Hexis Cyber Solutions, Inc. ("Hexis") business in its entirety.

KEYW is a highly specialized provider of mission-critical cybersecurity, cyber superiority and geospatial intelligence solutions to US Government defense, intelligence and national security agencies and commercial enterprises. Our core capabilities include solutions, services and products to support the collection, processing, analysis, and use of intelligence data and information in the domains of cyberspace and geospace. Our solutions are designed to respond to meet the critical needs for agile intelligence in the cyber age and to assist the US government in national security priorities. 

Principles of Consolidation
The condensed consolidated financial statements include the transactions of KEYW, Opco, Hexis and their wholly owned subsidiaries from the date of their acquisition. All intercompany accounts and transactions have been eliminated.
 
Revenue Recognition
We derive the majority of our revenue from time-and-materials, firm-fixed-price, cost-plus-fixed-fee, cost-plus-award-fee contracts and software licensing and maintenance.
Revenues from cost reimbursable contracts are recorded as reimbursable costs are incurred, including an estimated share of the applicable contractual fees earned. For performance-based fees under cost reimbursable contracts, we recognize the relevant portion of the expected fee to be awarded by the client at the time such fee can be reasonably estimated, based on factors such as prior award experience and communications with the client regarding performance. For cost reimbursable contracts with performance-based fee incentives, we recognize the relevant portion of the fee upon customer approval. For time-and-materials contracts, revenue is recognized based on billable rates times hours delivered plus materials and other reimbursable costs incurred. For firm-fixed-price service contracts, revenue is recognized using proportional performance based on the estimated total costs of the project. For fixed-price production contracts, revenue and cost are recognized at a rate per unit as the units are delivered or by other methods to measure services provided. This method of accounting requires estimating the total revenues and total contract costs of the contract. During the performance of contracts, these estimates are periodically reviewed and revisions are made as required. The impact on revenue and contract profit as a result of these revisions is included in the periods in which the revisions are made. This method can result in the deferral of costs or the deferral of profit on these contracts. Because we assume the risk of performing a fixed-price contract at a set price, the failure to accurately estimate ultimate costs or to control costs during performance of the work could result, and in some instances has resulted, in reduced profits or losses on such contracts. Estimated losses on contracts at completion are recognized when identified.
Contract revenue recognition inherently involves estimation. Examples of estimates include the contemplated level of effort to accomplish the tasks under the contract, the cost of the effort, and an ongoing assessment of our progress toward completing the contract. From time to time, as part of our management processes, facts develop that require us to revise our estimated total costs or revenue. To the extent that a revised estimate affects contract profit or revenue previously recognized, we record the cumulative effect of the revision in the period in which the facts requiring the revision become known.

7

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

In certain circumstances, and based on correspondence with the end customer, management authorizes work to commence or to continue on a contract option, addition or amendment prior to the signing of formal modifications or amendments. We recognize revenue to the extent it is probable that the formal modifications or amendments will be finalized in a timely manner and that it is probable that the revenue recognized will be collected.
The Company recognizes software licenses, maintenance or related professional services revenue only when there is persuasive evidence of an arrangement, delivery to the customer has occurred, the fee is fixed and determinable and collectability is reasonably assured.
Revenue from software arrangements is allocated to each element of the arrangement based on the relative fair values of the elements, such as software licenses, upgrades, enhancements, maintenance contract types and type of service delivered, installation or training. The determination of fair value is based on objective evidence that is specific to the vendor (“VSOE”). The Company determines VSOE for each element based on historical stand-alone sales to third parties for the elements contained in the initial agreement. In determining VSOE, the Company requires that a substantial majority of the selling process fall within a fairly narrow pricing range. The Company has established VSOE of fair value for maintenance and professional services. If VSOE of fair value for each element of the arrangement does not exist, all revenue from the arrangement is deferred until such time as VSOE of fair value exists or until all elements of the arrangement are delivered, except in those circumstances in which the residual method may be used as described below.

Some software products are licensed on a perpetual basis. In addition, the Company provides maintenance under a separate maintenance agreement, typically for twelve months. Maintenance includes technical support and unspecified software upgrades and enhancements if and when available. Revenue from perpetual software licenses is recognized under the relative selling price method, as noted above, for arrangements in which the software is sold with maintenance and/or professional services. When software is licensed on a subscription basis, revenue is recognized ratably over the length of the subscription, typically one to three years.

Software arrangements that also include hardware where the relative hardware and software components are both essential to the functionality are accounted for under ASC 605-25, “Multiple Element Arrangements”. As such, we allocate revenue to each unit of accounting based on an estimated selling price at the arrangement inception. The estimated selling price for each element is based upon the following hierarchy: VSOE of selling price, if available, third-party evidence ("TPE') of selling price if VSOE of selling price is not available, or best estimate of selling price ("BESP") if neither VSOE of selling price nor TPE of selling price are available. The total arrangement consideration is allocated to each separate unit of accounting using the relative estimated selling prices of each unit based on the aforementioned selling price hierarchy. We limit the amount of revenue recognized for delivered elements to an amount that is not contingent upon future delivery of additional products or services or meeting of any specified performance conditions.

To determine the estimated selling price in multiple element arrangements, the Company determines VSOE for each element based on historical stand-alone sales to third parties for the elements contained in the initial agreement, as noted above. If VSOE of selling price cannot be established for a deliverable, we establish TPE of selling price by evaluating similar and interchangeable competitor products or services in standalone arrangements with similarly situated partners. However, as our products contain a significant element of proprietary technology and offer substantially different features and functionality from our competitors, we are unable to obtain comparable pricing of our competitors’ products with similar functionality on a stand-alone basis. Therefore, we have not been able to obtain reliable evidence of TPE of selling price. If neither VSOE nor TPE of selling price can be established for a deliverable, we establish BESP primarily based on our pricing model and our go-to-market strategy or use our established list price.

Cost of Revenues
Cost of revenues consists primarily of compensation expenses for program personnel, the fringe benefits associated with this compensation and other direct expenses incurred to complete programs, including cost of materials and subcontract efforts.
 
Inventories
Inventories are valued at the lower of cost or net realizable value. Our inventory consists of specialty products that we manufacture on a limited quantity basis for our customers. As of September 30, 2016 and December 31, 2015 , we had an inventory reserve balance of $0.4 million and $0.1 million respectively, for certain products where the market has not developed as expected.

Accounts Receivable
Accounts receivable are stated at the amount management expects to collect from outstanding balances. Invoice terms range from net 10 days to net 90 days. Management provides for probable uncollectible amounts through a charge to earnings and a credit to a valuation allowance (allowance for doubtful accounts) based on its assessment of the current status of individual accounts.

8

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Balances that are still outstanding after management has used reasonable collection efforts are written-off through a charge to the valuation allowance and a credit to accounts receivable.
 
Property and Equipment
All property and equipment are stated at acquisition cost or, in the case of self-constructed assets, the cost of labor and a reasonable allocation of overhead costs (no general and administrative costs are included). The cost of maintenance and repairs, which do not significantly improve or extend the life of the respective assets, are charged to operations as incurred.

Provisions for depreciation and amortization are computed on either a straight-line method or accelerated methods acceptable under accounting principles generally accepted in the United States of America (“US GAAP”) over the estimated useful lives of between 3 and 7 years . Leasehold improvements are amortized over the lesser of the lives of the underlying leases or the estimated useful lives of the assets.
 
Lease Incentives
As part of entering into certain building leases, the lessors have provided the Company with tenant improvement allowances. Typically, such allowances represent reimbursements to the Company for tenant improvements made to the leased space. These improvements are capitalized as property and equipment, and the allowances are classified as a deferred lease incentive liability. This incentive is considered a reduction of rental expense by the lessee over the term of the lease and is recognized on a straight-line basis over the same term.

Software Development Costs
Costs of internally developed software for resale are expensed until the technological feasibility of the software product has been established. In accordance with the Accounting Standards Codification (“ASC”), software development costs are capitalized and amortized over the product's estimated useful life. As of September 30, 2016 and December 31, 2015 , we had capitalized $2.1 million and $1.9 million of software development costs, respectively. Capitalized software development costs are amortized using the greater of the straight-line method or as a percentage of revenue recognized from the sale of the capitalized software. During the nine months ended September 30, 2016 , the Company recorded related amortization of  $0.4 million . During the nine months ended September 30, 2015 , the Company had no computer software amortization costs, due to the products still being under development and not having been placed into service during those periods.

Long-Lived Assets (Excluding Goodwill)
The Company follows the provisions of Financial Accounting Standards Board ("FASB") ASC topic 360-10-35, Impairment or Disposal of Long-Lived Assets, in accounting for long-lived assets such as property and equipment and intangible assets subject to amortization. The guidance requires that long-lived assets be reviewed for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be fully recoverable. The possibility of impairment exists if the sum of the long-term undiscounted cash flows is less than the carrying amount of the long-lived asset being evaluated. Impairment losses are measured as the difference between the carrying value of long-lived assets and their fair market value based on discounted cash flows of the related assets. Impairment losses are treated as permanent reductions in the carrying amount of the assets. The Company has not recorded any long-lived asset impairments since inception.

Goodwill
Purchase price in excess of the fair value of tangible assets and identifiable intangible assets acquired and liabilities assumed in a business combination is recorded as goodwill. In accordance with FASB ASC Topic 350-20, Goodwill , the Company tests for impairment at least annually. Impairment of goodwill is tested at the reporting unit level by comparing the reporting unit's carrying amount, including goodwill, to the fair value of the reporting unit. The fair value of each reporting unit is estimated using either qualitative analysis or a combination of income and market approaches. If the carrying amount of the unit exceeds its fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any.

Determining the fair value of a reporting unit is a judgment involving significant estimates and assumptions. These estimates and assumptions include revenue growth rates, operating margins and working capital requirements used to calculate projected future cash flows, risk-adjusted discount rates, selected multiples, control premiums and future economic and market conditions. We have based our fair value estimates on assumptions that we believe to be reasonable, but that are unpredictable and inherently uncertain. The Company evaluated goodwill at the beginning of the fourth quarter of fiscal year 2015 and found no impairment to the carrying value of goodwill.

Late in the fourth quarter of 2015, management began to evaluate strategic alternatives related to its Commercial Cyber Solutions segment. The Company began exploring the possibility of minority investments into this segment, the sale of the entire segment or the possibility of altering the level of investment going forward. The Company also implemented cost reductions in this segment subsequent to December 31, 2015, to reduce the funding required to cover operating losses and further committed to a reduced

9

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

level of internal funding targeted to a range of $5 million to $7 million for 2016. Management believed these activities represented a triggering event and further believed that it was more likely than not that as a result of these activities and information, which came to light subsequent to December 31, 2015, relative to indications from potential transaction parties, that the fair value of the segment had fallen below the carrying value. As such the Company completed a Step 1 analysis of goodwill, which indicated the fair value was lower than the segment’s carrying value. In accordance with ASC 350-20-35-18 management elected to make an estimate of the goodwill impairment charge as of December 31, 2015, subject to finalizing a Step 2 analysis during the first quarter of 2016. The estimate was based on a number of factors including the estimated fair value of working capital assets, fixed assets, customer relationships, deferred revenue and developed technology as well as relevant market related data. The estimated impairment to goodwill for the Commercial Cyber Solutions segment as of December 31, 2015, was $8 million . During the first quarter of 2016 the Company completed the Step 2 analysis of goodwill for the Commercial Cyber Solutions segment and determined that no additional goodwill impairment charge was needed as of December 31, 2015.

Subsequently, during the first quarter of 2016 the Company determined to divest of the Commercial Cyber Solutions segment (see Note 12). In accordance with applicable accounting guidance for the disposal of long-lived assets, the results of the Commercial Cyber Solutions segment are presented as discontinued operations. As a result, the goodwill attributable to the Commercial Cyber Solutions segment as of December 31, 2015 , is excluded from the following table and is reported as part of assets of discontinued operations in the Condensed Consolidated Balance Sheets.

In March 2016, the Company completed the divestiture of its systems engineering and technical assistance ("SETA") business to Quantech Services, Inc. for $11.2 million in cash (see Note 12). The Company has determined that the relative fair value of the goodwill associated with the SETA business disposed of was $7.2 million .
A summary of the changes to goodwill, is as follows (in thousands):
 
 
Goodwill as of December 31, 2015
$
297,223

Acquisition
782

Divestiture
(7,233
)
Goodwill as of September 30, 2016
$
290,772

 
Intangibles
Intangible assets consist of the value of customer related intangibles acquired in various acquisitions. Intangible assets are amortized on a straight line basis over their estimated useful lives unless the pattern of usage of the benefits indicates an alternative method is more representative. The useful lives of the intangibles range from one to seven years.
 
Concentrations of Credit Risk
We maintain cash balances that at times exceed the federally insured limit on a per financial institution basis. The Company has not experienced any losses in such accounts and believes it is not exposed to any significant credit risk related to cash. In addition, we have credit risk associated with our receivables that arise in the ordinary course of business. In excess of 90% of our total revenue is derived from contracts where the end customer is the US Government and any disruption to cash payments from our end customer could put the Company at risk.

Use of Estimates
Management uses estimates and assumptions in preparing these condensed consolidated financial statements in accordance with US GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Significant estimates include useful lives of long-lived assets, revenue based on proportional performance, VSOE, TPE, BESP, inventory obsolescence reserves, accruals for medical self-insurance incurred but not reported ("IBNR") claims, income taxes and stock compensation expense. Actual results could vary from the estimates that were used.
 
Cash and Cash Equivalents
We consider all highly liquid investments purchased with original maturities of three months or less, when purchased, to be cash equivalents.


10

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Fair Value of Financial Instruments
The balance sheet includes various financial instruments consisting of cash and cash equivalents, accounts receivable, and accounts payable. The fair values of these instruments approximate the carrying values due to the short maturity of these instruments. The balance sheet also includes our convertible senior notes, which the fair value is estimated using a market approach with Level 2 inputs.

Research and Development
Internally funded research and development expenses are expensed as incurred and are included in operating expenses in the accompanying condensed consolidated statement of operations. In accordance with FASB ASC Topic 730, Research and Development , such costs consist primarily of payroll, materials, subcontractor and an allocation of overhead costs related to product development. Research and development costs totaled  $1.2 million  and  $0.7 million  for the  three months ended September 30, 2016  and 2015, respectively.  Research and development costs totaled $3.3 million and $2.2 million for the nine months ended September 30, 2016 and 2015 , respectively.
 
Income Taxes
Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enacted date. In evaluating our ability to realize our deferred tax assets, we consider all available positive and negative evidence, including cumulative historic earnings, reversal of deferred tax liabilities, projected taxable income, and tax planning strategies. The assumptions utilized in evaluating both positive and negative evidence require the use of significant judgment concerning our business plans.
 
For a tax position that meets the more-likely-than-not recognition threshold, the Company initially and subsequently measures the tax liability or benefit as the largest amount that it judges to have a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority. The liability associated with unrecognized tax benefits is adjusted periodically due to changing circumstances, such as the progress of tax audits, case law developments and new or emerging legislation. Such adjustments are recognized entirely in the period in which they are identified. The effective tax rate includes the net impact of changes in the liability for unrecognized tax obligations or benefits and subsequent adjustments as considered appropriate by management. The Company's policy is to record interest and penalties as an increase in the liability for uncertain tax obligations or benefits and a corresponding increase to the income tax provision. No such adjustments were recorded during the three or nine months ended September 30, 2016 or the respective periods for 2015.
 
(Loss) Earnings per Share
Basic net (loss) earnings per share is calculated by dividing net (loss) income by the weighted average number of common shares outstanding during the period. Diluted (loss) earnings per share is calculated by dividing net (loss) income by the diluted weighted average common shares, which reflects the potential dilution of stock options, warrants, and contingently issuable shares that could share in our (loss) income if the securities were exercised.

11

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

The following table presents the calculation of basic and diluted net loss per share (in thousands except per share amounts):
 
Three months ended September 30,
 
Nine months ended September 30,
 
2016
 
2015
 
2016
 
2015
Net Income (Loss) from Continuing Operations
$
3,504

 
$
(7,129
)
 
$
4,978

 
$
(28,005
)
Loss on Discontinued Operations
(1,040
)
 
(875
)
 
(27,496
)
 
(17,522
)
Net Income (Loss)
$
2,464

 
$
(8,004
)
 
$
(22,518
)
 
$
(45,527
)
Weighted average shares – basic
40,955

 
39,145

 
40,368

 
38,340

Effect of dilutive potential common shares
351

 

 
563

 

Weighted average shares – diluted
41,306

 
39,145

 
40,931

 
38,340

 
 
 
 
 
 
 
 
Net Income (Loss) per share from Continuing Operations – basic
$
0.09

 
$
(0.18
)
 
$
0.12

 
$
(0.73
)
Net Loss per share from Discontinued Operations – basic
(0.03
)
 
(0.02
)
 
(0.68
)
 
(0.46
)
Net Income (Loss) per share – basic
$
0.06

 
$
(0.20
)
 
$
(0.56
)
 
$
(1.19
)
Net Income (Loss) per share from Continuing Operations – diluted
$
0.09

 
$
(0.18
)
 
$
0.12

 
$
(0.73
)
Net Loss per share from Discontinued Operations – diluted
(0.03
)
 
(0.02
)
 
(0.67
)
 
(0.46
)
Net Income (Loss) per share – diluted
$
0.06

 
$
(0.20
)
 
$
(0.55
)
 
$
(1.19
)
Outstanding options and warrants, total
1,591

 
5,358

 
1,591

 
5,358

Employee equity share options, restricted shares and warrants granted by the Company are treated as potential common shares outstanding in computing diluted earnings (loss) per share. Diluted shares outstanding include the dilutive effect of in-the-money options and in-the-money warrants and unvested restricted stock. The dilutive effect of such equity awards is calculated based on the average share price for each fiscal period using the treasury stock method. Under the treasury stock method, the amount the employee must pay for exercising stock options, the amount of compensation cost for future service that the Company has not yet recognized, and the amount of tax benefits that would be recorded in additional paid-in capital when the award becomes deductible, are collectively assumed to be used to repurchase shares.
The Company uses the treasury stock method for calculating any potential dilutive effect of the conversion spread of our Convertible Senior Notes due 2019 (the "Notes") on diluted earnings per share, if applicable. The conversion spread will have a dilutive impact on diluted earnings per share of common stock when the average market price of our common stock for a given period exceeds the Notes' conversion price of $14.83 . For the three and nine months ended September 30, 2016 , 10.1 million shares related to the Notes have been excluded from the computation of diluted earnings per share as the effect would be anti-dilutive since the conversion price of the Notes exceeded the average market price of the Company’s common shares for the three and nine months ended September 30, 2016 .

Stock Based Compensation
A s discussed in Note 10, the Company applies the fair value method that requires all share-based payments to employees and non-employee directors to be expensed over their requisite service period based on their fair value at the grant date, using a prescribed option-pricing model. The expense recognized is based on the straight-line amortization of each individually vesting piece of a grant. The calculated expense is required to be based upon awards that ultimately vest and we have accordingly reduced the expense by estimated forfeitures.
 
The following assumptions were used for share-based awards granted.
 
Dividend Yield — The Company has never declared or paid dividends on its common stock and has no plans to do so in the foreseeable future.
Risk-Free Interest Rate — Risk-free interest rate is based on US Treasury zero-coupon issues with a remaining term approximating the expected life of the share-based award term assumed at the date of grant.

12

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

Expected Volatility — Volatility is a measure of the amount by which a financial variable such as a share price has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. The Company's expected volatility is based on its historical volatility for a period that approximates the estimated life of the share-based awards.
Expected Term of the Share-based Awards — This is the period of time that the share-based awards granted are expected to remain unexercised. The Company estimates the expected life of the share-based award term based on the expected tenure of employees and historical experience.
Forfeiture Rate — The Company estimates the percentage of share-based awards granted that are expected to be forfeited or canceled on an annual basis before share-based awards become fully vested. The Company uses the forfeiture rate that is a blend of past turnover data and a projection of expected results over the following twelve-month period based on projected levels of operations and headcount levels at various classification levels with the Company.
 
Segment Reporting
FASB ASC Section 280, Segment Reporting , establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that these enterprises report selected information about operating segments in interim financial reports. The guidance also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company defines its reportable segments based on the way the chief operating decision maker ("CODM"), currently its chief executive officer, manages the operations of the Company for allocating resources and assessing performance. The Company has historically operated two segments, Government Solutions and Commercial Cyber Solutions. The Company disposed of the assets and liabilities of its Commercial Cyber Solutions during the second quarter of 2016, (see Note 12). Therefore, we have also reclassified the results of our Hexis business, which comprised our entire Commercial Cyber Solutions reportable segment, as discontinued operations for all periods presented in our condensed consolidated financial statements and determined that the Company is now operating one reporting segment.

Recently Issued Accounting Pronouncements
I n May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers , an accounting pronouncement related to revenue recognition (FASB ASC Topic 606), which amends the guidance in former ASC Topic 605, Revenue Recognition , and provides a single, comprehensive revenue recognition model for all contracts with customers. This standard contains principles that an entity will apply to determine the measurement of revenue and timing of when it is recognized. The entity will recognize revenue to reflect the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services. This pronouncement is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. The FASB also approved permitting early adoption of the standard, but not before January 1, 2017. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.

In November 2015, the FASB issued ASU 2015-17, Income Taxes , amending the accounting for income taxes and requiring all deferred tax assets and liabilities to be classified as non-current on the consolidated balance sheet.  The ASU is effective for reporting periods beginning after December 15, 2016, with early adoption permitted.  The ASU may be adopted either prospectively or retrospectively.  We are currently evaluating the method of adoption and the impact on our consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases . The new standard establishes a right-of-use (“ROU”) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting . The amendments in ASU 2016-09 to Topic 718, Compensation - Stock Compensation, require recognition of all excess tax benefits and tax deficiencies through income tax expense or benefit in the income statement. Other amendments in this new standard include guidance on the classification of share-based payment transactions in the statement of cash flows and an option to account for forfeitures of share-based awards as they occur rather than estimating the compensation cost based on the number of awards that are expected to vest. The amendments in the new standard are effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods. Early adoption is permitted in any interim or annual period. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows. The new guidance addresses the diversity in practice in how certain cash receipts and payments are classified in the statement of cash flows, including debt prepayment or extinguishment

13

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

costs, the settlement of contingent liabilities arising from a business combination, proceeds from insurance settlements, and distributions from certain equity method investees. The guidance is effective for interim and annual periods beginning after December 15, 2017, and early adoption is permitted. The guidance requires application using a retrospective transition method. We are currently evaluating the impact of this pronouncement on our consolidated financial statements.


2. ACQUISITIONS
 
The Company has completed multiple acquisitions since it began operations in August 2008. The acquisitions were made to increase the Company’s skill sets and to create sufficient critical mass to be able to serve as prime contractor on significant contracts. Most of the acquisitions resulted in the Company recording goodwill and other intangibles. The goodwill was primarily a result of acquiring cleared personnel to expand our presence with our main customers. The value of having that personnel generated the majority of the goodwill from the transactions and drove much of the purchase price in addition to other identified intangibles including contracts, customer relationships, contract rights and intellectual property. Several of the acquisitions involved issuance of Company common stock. The stock price for acquisition accounting was determined by the fair value on the acquisition date.
 
Details of the acquisitions completed since January 1, 2015 are outlined below:
 
During the first and second quarters of 2015, the Company acquired Milestone Intelligence Group, Inc. ("Milestone"), Ponte Technologies, LLC ("Ponte Tech") and certain assets of Innovative Engineering Solutions, Inc. in three separate transactions. The total consideration paid for these three acquisitions was $21.4 million in cash and 242,250 shares of KEYW stock valued at $1.9 million . These acquisitions are not considered material to the financial results of KEYW.
During the second quarter of 2016, in conjunction with the Milestone Intelligence Group acquisition earnout, the Company issued 129,530 shares of KEYW common stock with an approximate value of $1 million .
The total purchase price paid for the 2015 acquisitions described above have been allocated as follows (in thousands):
 
2015 Acquisitions
 
 
Cash
$
643

Current assets, net of cash acquired
1,533

Fixed assets
155

Intangibles
5,059

Goodwill
16,706

Total Assets Acquired
24,096

Total Liabilities Assumed
844

Net Assets Acquired
$
23,252

Net Cash Paid
$
20,751

Equity Issued
1,858

Actual Cash Paid
$
21,394

 
During the third quarter of 2016, the Company acquired a geospatial intelligence collection business for a preliminary purchase price of $3.9 million . The purchase price included $2.5 million of cash and contingent cash consideration of up to $2.5 million , preliminarily valued at $1.4 million as of the acquisition date. The contingent cash consideration is based on the acquired company achieving certain revenue targets by March 31, 2018.
All acquisitions were accounted for using the acquisition method of accounting. Results of operations for each acquired entity were included in the condensed consolidated financial statements from the date of each acquisition.

Pro forma income statements are not presented for the nine months ended September 30, 2016 and 2015 , as there were no material acquisitions during that period.

14

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


3. FAIR VALUE MEASUREMENTS
 
The fair value hierarchy prioritizes the inputs to valuation techniques used to measure the fair value of financial assets and liabilities on a recurring basis into three broad levels:
Level 1
Inputs are unadjusted quoted prices in active markets for identical assets or liabilities the Company has the ability to access.
Level 2
Inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
Level 3
Inputs are unobservable for the asset or liability and rely on management’s own assumptions about what market participants would use in pricing the asset or liability.

At September 30, 2016 , we did not have any assets or liabilities measured at fair value on a recurring basis that would require disclosure based on the fair value hierarchy of valuation techniques.

4. RECEIVABLES
 
Receivables consist of the following:
 
September 30, 2016
 
December 31, 2015
 
(In thousands)
Receivables
 

 
 

Billed
$
30,055

 
$
36,278

Unbilled
17,417

 
16,833

Total Receivables
$
47,472

 
$
53,111

 
Unbilled amounts represent revenue recognized which could not be billed by the period end based on contract terms. The majority of the unbilled amounts were billed subsequent to period end. Retainages typically exist at the end of a project and/or if there is a disputed item on an invoice received by a customer, at September 30, 2016 and December 31, 2015 , retained amounts are insignificant and are expected to be collected subsequent to the balance sheet date.
Most of the Company's revenues are derived from contracts with the US Government, in which we are either the prime contractor or a subcontractor, depending on the award.

5. INVENTORIES
 
Inventories at September 30, 2016 and December 31, 2015 consist of work in process at various stages of production and finished goods. This inventory, which consists primarily of mobile communications devices, aeroptic cameras and radars, are valued at the lower of cost (as calculated using the weighted average method) or net realizable value. The cost of the work in process consists of materials put into production, the cost of labor and an allocation of overhead costs. At September 30, 2016 , and December 31, 2015 , we had an inventory reserve balance of $0.4 million and $0.1 million respectively, for certain products where the market has not developed as expected.

6. PREPAID EXPENSES
 
Prepaid expenses at September 30, 2016 and December 31, 2015 , primarily consist of prepaid insurance, deferred financing costs and software licenses.


15

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

7. PROPERTY AND EQUIPMENT
 
Property and equipment are as follows:
 
September 30, 2016
 
December 31, 2015
 
(In thousands)
Property and Equipment
 

 
 

Aircraft
$
15,883

 
$
11,296

Leasehold Improvements
23,032

 
22,469

Manufacturing Equipment
5,799

 
5,452

Software Development Costs
2,132

 
1,942

Office Equipment
13,174

 
10,967

Total
60,020

 
52,126

Accumulated Depreciation
(27,960
)
 
(23,376
)
Property and Equipment, net
$
32,060

 
$
28,750


Depreciation expense charged to operations was  $1.5 million and $1.5 million for the three months ended September 30, 2016 and 2015 , respectively. Depreciation expense charged to operations was $5.0 million and $4.3 million for the nine months ended September 30, 2016 and 2015 , respectively.

8. AMORTIZATION OF INTANGIBLE ASSETS
 
Intangible assets consisted of the following:
 
 
September 30, 2016 (In thousands)
Intangible
 
Gross Carrying
Value
 
Accumulated
Amortization
 
Net Carrying
Value
Customer Relationships and Contracts
 
$
26,837

 
$
(19,441
)
 
$
7,396

Software Technology and Other
 
2,162

 
(37
)
 
2,125

 
 
$
28,999

 
$
(19,478
)
 
$
9,521

 
The Company recorded amortization expense of $1.5 million and $1.8 million for the three months ended September 30, 2016 and 2015 , respectively. The Company recorded amortization expense of $4.5 million and $5.4 million for the nine months ended September 30, 2016 and 2015 , respectively.

Estimated future intangible amortization expense by year as of September 30, 2016 (In thousands):
Remainder of 2016
 
2017
 
2018
 
2019
 
2020
 
Thereafter
$1,650
 
$5,555
 
$996
 
$626
 
$416
 
$278

9. DEBT

2.5% Convertible Senior Notes
In July 2014, the Company initially issued $130.0 million aggregate principal amount of Notes in an underwritten public offering. The Company granted an option to the underwriters to purchase up to an additional $19.5 million aggregate principal amount of Notes, which was subsequently exercised in full in August 2014, resulting in a total issuance of $149.5 million aggregate principal amount of Notes. The Notes bear interest at a rate of 2.50% per annum on the principal amount, payable semi-annually in arrears on January 15 and July 15 of each year, beginning on January 15, 2015, to holders of record at the close of business on the preceding January 1 and July 1, respectively. The Notes mature on July 15, 2019, unless earlier repurchased or converted. The Company may not redeem the Notes prior to their stated maturity date.

Holders of the Notes may convert their notes at their option under the following circumstances: (i) during any calendar quarter commencing after the calendar quarter ending September 30, 2014, if the last reported sale price of the Company’s common stock for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading

16

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price for the Notes on each applicable trading day; (ii) during the five business day period immediately after any five consecutive trading day period in which the trading price per $1,000 principal amount of Notes for each trading day of that period was less than 98% of the product of the last reported sale price of Company’s common stock and the conversion rate for the Notes for each such trading day; or (iii) upon the occurrence of specified corporate events. On and after January 15, 2019, holders may convert their Notes at any time, regardless of the foregoing circumstances.

Upon conversion, the Company will settle the Notes in cash, shares of Company common stock or a combination of cash and shares of Company common stock, at the Company’s election. The Notes have an initial conversion rate of 67.41 shares of common shares per $1,000 principal amount of the Notes, which is equal to an initial conversion price of approximately $14.83 per common share. The conversion price is subject to adjustments upon the occurrence of certain specified events.

In addition, upon the occurrence of a fundamental change (as defined in the Indenture), holders of the Notes may require the Company to repurchase the Notes at a purchase price of 100% of the principal amount of the Notes, plus accrued and unpaid interest, if any, to, but excluding, the fundamental change repurchase date.

The Company incurred approximately $5.7 million of debt issuance costs during the third quarter of 2014 as a result of issuing the Notes. Of the approximately $5.7 million incurred, the Company recorded $4.6 million and $1.1 million to deferred financing costs and additional paid-in capital, respectively, in proportion to the allocation of the proceeds of the Notes as discussed below. The Company is amortizing the deferred financing costs over the contractual term of the Notes using the effective interest method.

The Company used the net proceeds from the Notes to repay the outstanding balances under the credit facility the Company entered into in 2012, (the "2012 Credit Agreement"). Net proceeds also will be used for working capital, capital expenditures and other general corporate purposes, including potential acquisitions.

The Company allocated the $149.5 million proceeds from the issuance of the Notes between long-term debt, the liability component, and additional paid-in-capital, the equity component, in the amounts of $122.1 million and $27.4 million , respectively. The initial value of liability component was measured using the nonconvertible debt interest rate. The carrying amount of the equity component representing the conversion option was determined by deducting the fair value of the liability component from the face value of the Notes. Since the Company must still settle the Notes at face value at or prior to maturity, the Company will accrete the liability component to its face value resulting in additional non-cash interest expense being recognized in the Company’s condensed consolidated statements of operations while the Notes remain outstanding. The equity component is not remeasured as long as it continues to meet the conditions for equity classification.

As of September 30, 2016 , the outstanding principal of the Notes was $149.5 million , the unamortized debt discount was $16.0 million , the unamortized deferred financing costs were $2.6 million and the carrying amount of the liability component was $130.9 million , which was recorded as long-term debt within the Company’s condensed consolidated balance sheet. As of September 30, 2016 , the fair value of the liability component relating to the Notes, based on a market approach, was approximately $133.9 million and represents a Level 2 valuation.

During the three months ended September 30, 2016 , the Company recognized $2.5 million of interest expense related to the Notes, which included $1.3 million for noncash interest expense relating to the debt discount and $0.2 million relating to amortization of deferred financing costs. During the nine months ended September 30, 2016 , the Company recognized $7.5 million of interest expense related to the Notes, which included $4.0 million for noncash interest expense relating to the debt discount and $0.7 million relating to amortization of deferred financing costs. During the three months ended September 30, 2015 , the Company recognized $2.5 million of interest expense related to the Notes, which included $1.3 million for noncash interest expense relating to the debt discount and $0.2 million relating to amortization of deferred financing costs. During the nine months ended September 30, 2015 , the Company recognized $7.4 million of interest expense relating to the Notes, which included $3.8 million for noncash interest expense relating to the debt discount and $0.7 million relating to amortization of deferred financing costs.

Capped Call
During the third quarter of 2014 in conjunction with the issuance of the Notes, the Company paid approximately $18.4 million to enter into capped call transactions with respect to its common shares, (the "Capped Call Transactions"), with certain financial institutions. The Capped Call Transactions generally are expected to reduce the potential dilution to the Company's common stock upon conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount of any converted Notes, as the case may be, in the event that the market price of the common stock is greater than the strike price of the Capped Call Transactions, initially set at $14.83 , with such reduction of potential dilution subject to a cap based on the cap price, which is initially set at $19.38 . The strike price and cap price are subject to anti-dilution adjustments under the terms of the Capped Call Transactions.

17

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


2014 Revolving Credit Facility
In July 2014, the Company, as guarantor and certain of the Company's subsidiaries, entered into a senior secured credit agreement, (the "2014 Credit Agreement") with certain financial institutions. The 2014 Credit Agreement provided the Company a $42.5 million revolving credit facility (the "2014 Revolver"). The 2014 Revolver includes a swing line loan commitment of up to $10 million and a letter of credit facility of up to $15 million . The Company has not drawn on the 2014 Credit Agreement.

Borrowings under the 2014 Credit Agreement bear interest at a rate equal to an applicable rate plus, at the Company’s option, either (a) adjusted LIBOR or (b) a base rate. The Company is required to pay a facility fee to the Lenders for any unused commitments and customary letter of credit fees.

The 2014 Revolver will mature on the earlier to occur of (i) the fifth anniversary of the closing of the 2014 Credit Agreement, and (ii) the date that is 180 days prior to the maturity date of the Notes unless the Notes are converted into equity, repaid, refinanced or otherwise satisfied on terms permitted under the 2014 Credit Agreement. The Company may voluntarily repay outstanding loans under the 2014 Revolver at any time without premium or penalty, subject to customary fees in the case of prepayment of LIBOR based loans.

In February 2016, the Company amended the 2014 Credit Agreement. The amendment permanently decreases the amount available under the revolver to $20.0 million . At September 30, 2016 , we were in compliance with all of our debt covenants under the 2014 Credit Agreement. As a result of the amendment permanently decreasing the amount available under the revolver the Company wrote off $0.3 million of unamortized deferred financing costs, which were included as part of interest expense.

10. STOCK - BASED COMPENSATION

At September 30, 2016, KEYW had stock-based compensation awards outstanding under the following plans: The 2008 Stock Incentive Plan ("2008 Plan"), The 2009 Stock Incentive Plan ("2009 Plan") and The Amended and Restated 2013 Stock Incentive Plan ("2013 Plan").

On August 15, 2012, the shareholders approved the 2013 KEYW Holding Corporation Stock Incentive Plan. The 2013 plan, which took effect on January 1, 2013 , replaced the 2009 Plan and provides for the issuance of additional restricted stock, stock options, and restricted stock units. Pursuant to an amendment approved by the Company’s shareholders on August 12, 2015, the number of shares available for issuance under the 2013 Plan was increased by 700,000 shares to a maximum of 2,700,000 shares.

2013 Stock Incentive Plan
 
Total equity available to issue
2,700,000

Total equity outstanding or exercised
1,998,998

Total equity remaining for future grants
701,002


The Company has awarded stock options, restricted stock awards, restricted stock units and Long-Term Incentive Stock grants to attract and retain highly qualified officers, directors, key employees, and other persons, and to motivate such persons to serve the Company and to expend maximum effort to improve the business results and earnings of the Company, by providing to such persons an opportunity to acquire or increase a direct proprietary interest in the operations and future success of the Company and align employee and shareholder interests.

Stock Options
The Company has issued stock option awards that vest over varying periods, ranging from three to five years , and have a ten -year life. We estimate the fair value of stock options using the Black-Scholes option-pricing model. We use historical data to determine volatility of our stock. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by persons who receive equity awards. All option awards terminate within ninety days or sooner after termination of service with the Company, except as provided in certain circumstances under our senior executive employment agreements.
 
No stock options were issued during the nine months ended September 30, 2016 . Historically all equity issuances have an exercise price at market value or higher based upon our publicly-traded share price on the date of grant. The Black-Scholes model requires inputs related to dividend yield, risk-free interest rate, expected volatility and forfeitures in order to price the option values.


18

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

2016 Stock Option Exchanges
During 2016, the Company completed two shareholder-approved exchanges of options.

During July 2016, the Company completed an offer to exchange certain previously granted employee stock options for new restricted stock units on a three-for-one basis with certain eligible employees, excluding members of the Board of Directors and named executive officers. 390,570 options were exchanged for 130,265 restricted stock units. The restricted stock units granted will vest over a one year period from the date of the exchange. The exchange resulted in a modification charge of approximately $0.1 million , which will be recognized over the one year vesting period of the new restricted stock units. Terms of the restricted stock units are discussed in more detail below.

During August 2016, the Company completed an exchange of certain previously granted employee stock options for new Long-Term Incentive Shares on a three-for-one basis with certain members of the non-executive leadership team, excluding members of the Board of Directors and named executive officers. 178,900 options were exchanged for 59,636 Long-Term Incentive Shares. The Long-Term Incentive Shares granted have a weighted-average requisite service period of 2.2 years. There was no modification charge as result of the exchange. Long-Term Incentive Shares are discussed in more detail below.
 
A summary of stock option activity for the period ended September 30, 2016 is as follows:
 
Number of
Shares
 
Option Exercise
Price
 
Weighted Average
Exercise Price
Options Outstanding January 1, 2016
2,332,889

 
 
 
 
Granted

 

 

Exercised
(60,050
)
 
$5.00 - $9.25

 
$
6.41

Cancelled
(1,000,167
)
 
$5.00 - $17.71

 
$
13.59

Options Outstanding September 30, 2016
1,272,672

 
 
 
 

 
As of September 30, 2016 , outstanding stock options were as follows: 
Exercise Price
Options
Outstanding
 
Intrinsic
Value
 
Options
Vested
 
Intrinsic
Value
 
Weighted Average
Remaining Life
(Years)
$5.00 – $5.50
272,450

 
$
1,539,448

 
272,450

 
$
1,539,448

 
2.85
$6.90 – $7.66
204,261

 
736,580

 
204,261

 
736,580

 
5.32
$7.96 – $8.14
67,700

 
207,580

 
67,700

 
207,580

 
5.12
$9.17 – $10.98
142,263

 
197,275

 
142,263

 
197,275

 
4.30
$11.18 - $11.99
154,025

 

 
153,900

 

 
5.86
$12.28 - $12.97
111,849

 

 
111,849

 

 
6.04
$13.00 - $13.48
58,500

 

 
57,876

 

 
6.36
$14.03 - $14.88
82,124

 

 
82,124

 

 
4.57
$16.08 - $17.11
179,500

 

 
134,939

 

 
7.35
 
1,272,672

 
$
2,680,883

 
1,227,362

 
$
2,680,883

 
 
  
Restricted Stock Awards
During the first nine months of 2016, the Company issued 183,791 shares of restricted common stock as part of employee incentive plans and to new hires. The Company issued 74,100 shares of restricted common stock to existing employees under the long-term incentive plan and an additional 79,441 shares of restricted common stock to board members. The Company also issued 29,250 shares of restricted common stock to new employees. An additional 1,000 shares were issued to an existing employee as a discretionary award. The expense for these shares will be recognized over the vesting life of each individual tranche of shares based upon the fair value of a share of stock at the date of grant. All of the above shares cliff vest after three years , except for the shares issued to our board members. The shares granted to board members vest 50% on the 1st anniversary of the grant date and 50% on the 2nd anniversary of the grant date.


19

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

The following table summarizes the activities for our unvested restricted stock awards for the nine months ended September 30, 2016
 
Unvested Shares
Outstanding January 1, 2016
959,733

Granted
183,791

Vested
(258,582
)
Cancelled
(159,193
)
Outstanding September 30, 2016
725,749


Restricted Stock Units
As discussed above, the Company issued 130,265 restricted stock units as part of the July 2016 option exchange. The following table summarizes the activities for our unvested restricted stock units for the nine months ended September 30, 2016 :
 
Unvested Units
Outstanding January 1, 2016

Granted
130,265

Vested
(334
)
Cancelled
(5,168
)
Outstanding September 30, 2016
124,763


Long-Term Incentive Share Grants
During the first nine months of 2016, the Company granted 1,040,000 Long-Term Incentive Shares. 535,000 of these shares were granted to new hires, 445,364 were granted as part of employee incentive plans and 59,636 were granted as part of the August 2016 option exchange, discussed above. Of the grants to new hires 505,000 of the Long-Term Incentive Shares were granted outside of the 2013 Plan, in accordance with Section 4(2) of the Securities Act of 1933. The Long-Term Incentive Shares will be subject to a two-year holding period following the vesting date. The granting and vesting of the Long-Term Incentive Shares will be contingent upon the employees continued employment with KEYW, subject to acceleration upon certain events. We measured the fair value of the Long-Term Incentive Share grants using a Monte Carlo simulation approach with the following assumptions: risk-free interest rate ranging between 1.01% and 1.76% , expected volatility ranging between 53.15% and 59.5% and dividend yield of 0% . The grant-date fair value of these long term incentive shares is $5.2 million . The expense for these grants will be recognized over the requisite service period of each individual tranche, which have weighted average requisite service periods range from 2.2 years and 4.9 years .

The following table summarizes the activities for our Long-Term Incentive Share grants for the nine months ended September 30, 2016 :
 
Unvested Long-Term Incentive Shares
Outstanding January 1, 2016
400,000

Granted
1,040,000

Outstanding September 30, 2016
1,440,000


These Long-Term Incentive Share grants consist of five vesting tranches, which will vest at any time prior to the fifth anniversary of their grant date that the closing market price of the Company’s common stock over any 30 consecutive trading days is at or greater than the target price, set forth in the table below.
Target Price Per Share
Long-Term Incentive Shares
$13.00
180,000
$16.00
180,000
$20.00
360,000
$25.00
360,000
$30.00
360,000


20

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

All stock based compensation has been recorded as part of operating expenses. Accounting standards require forfeitures to be estimated at the time an award is granted and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Share-based compensation expense is based on awards ultimately expected to vest and has been reduced for estimated forfeitures for the periods ended September 30, 2016 and 2015 . The Company recorded total stock compensation expense of $1.0 million and $1.1 million for the three months ended September 30, 2016 and 2015 , respectively. The Company recorded total stock compensation expense of $2.2 million and $4.4 million for the nine months ended September 30, 2016 and 2015 , respectively. The total unrecognized stock compensation expense at September 30, 2016 , is approximately $9.6 million , which is expected to be recognized over a weighted average period of 2.6 years .

11. WARRANTS
 
During the nine months ended September 30, 2016 , warrant holders exercised 2,213,935 warrants, with 349,144 exercised for cash and 1,864,791 exercised cashlessly. The warrants exercised for cash were exercised at $ 5.50 per share. The total cash received from these exercises was $1.9 million . Under our warrant agreements, warrants may be exercised cashlessly based on the average price of the Company's common stock for the five days prior to exercise. Under this methodology the warrants that were exercised cashlessly were exchanged for 471,504 shares of the Company's common stock.

As of September 30, 2016 , outstanding warrants were as follows: 
Exercise Price
 
Warrants Outstanding
 
Warrants Vested
 
Weighted Average
Remaining Life (Years)
$
9.25

 
160,000

 
160,000

 
0.46
$
12.65

 
158,116

 
158,116

 
3.16
 

 
318,116

 
318,116

 
 

12. BUSINESSES HELD FOR SALE, DISCONTINUED OPERATIONS AND DISPOSITIONS

Dispositions - Discontinued Operations
In our annual report for the fiscal year ended December 31, 2015, we announced that we were exploring strategic alternatives for our Hexis business. Our Hexis business marketed our HawkEye products and related maintenance and services to the commercial cyber sector and comprised our entire former Commercial Cyber Solutions reportable segment. As previously announced, the alternatives that we were evaluating included seeking an investment in or an outright sale of this business in one or more transactions to unrelated buyers.
During the first quarter of fiscal year 2016, we completed our assessment of the alternatives for the Hexis business and, the Company committed to a plan to sell the business in its entirety. Management and the Board decided that although the Hexis business had consistently demonstrated impressive capabilities in its product suites and gained some commercial traction in the marketplace, the progress had not been sufficient for the Company to continue to operate the business in the manner that it has been operated in the past. Accordingly, management decided that rather than continuing to commit the resources and investment that would be required to continue to grow the Hexis business, the Company would sell the business and refocus the use of resources and its strategy on the Government Solutions business.
The Company determined that the assets and liabilities of its Commercial Cyber Solutions business meet the held for sale criteria set forth in ASC 360 - Property, Plant, and Equipment, as (a) management with appropriate authority has committed to a plan to sell the disposal group, (b) the disposal group is available for immediate sale in its present condition, (c) actions to locate a buyer have been initiated, (d) management has concluded that the sale and transfer of the disposal is probable to occur within one year, (e) the disposal group is being actively marketed at a price that is reasonable in relation to its current fair value, and (f) management has concluded that it is unlikely that the Company will make significant changes to or withdraw its plan to sell the disposal group.
ASC 360 requires a disposal group that is reclassified as held for sale, but not yet sold, to be measured at the lower of its carrying amount or fair value less cost to sell. In addition, an entity ceases to recognize depreciation on assets included in the disposal group that has been classified as held for sale. Based upon this guidance, we compared the carrying value of the Hexis business to our estimate of the disposal group’s fair value less cost to sell. Development of an estimate of the fair value of the disposal group in this circumstance is complex, as consideration must be given to the nature of the potential sales transaction(s); the composition of the disposal group; market participant expectations regarding the performance, risks, and required returns of and for the disposal group; and the expected results of ongoing negotiations with potential buyers of the business - amongst other factors. These considerations require the application of assumptions that are deemed to be Level 3 inputs on the fair value hierarchy. Based upon our estimate of the fair value of the disposal group less cost to sale, we determined that the carrying value of the Hexis

21

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

business was greater than its fair value less cost to sell and, accordingly, we recorded an additional impairment charge of $7.0 million to our Commercial Cyber Solutions segment goodwill based on the preliminary asset purchase agreements and additional expense of $2.3 million representing the estimated cost to sell the disposal group. As a result we reduced the recorded carrying value of our Commercial Cyber Segment to $3.1 million at the end of the first quarter of 2016. The sale of the Hexis Cyber Solutions product lines during the second quarter of 2016, resulted in a pre-tax loss of approximately $5.5 million . This loss reflects the difference between the consideration received for Hexis and the net carrying value of the business less transaction costs.
We further note that from inception of the Hexis business through our decision to sell the business, we had been a relatively new participant in the commercial cyber security market. Accordingly, the Hexis business had historically required a significant amount of investment of the Company’s resources. The business has historically incurred losses and was expected to continue to include losses until we gained sufficient traction within the marketplace. Following completion of the sale of the Hexis business, the Company will no longer offer or market any products or services to the commercial cyber security market and does not intend to make similar investments in the development of commercial cyber security products. After consideration of these factors, we concluded that our decision to sell the Hexis business constitutes a strategic shift that is expected to have a major effect on our operations and financial results. Therefore, we also reclassified the results of our Hexis business, which comprised our entire Commercial Cyber Solutions reportable segment, as discontinued operations for all periods presented in our condensed consolidated financial statements. The results of our Commercial Cyber Solutions segment previously included the allocation of certain general corporate costs, which we have reallocated to our remaining continuing operations on a retrospective basis.
The following table summarizes the aggregate carrying amounts of the major classes of Hexis assets and liabilities included in discontinued operations as of September 30, 2016 and December 31, 2015 (in thousands):
 
September 30, 2016
 
December 31, 2015
Receivables
$
3,072

 
$
5,256

Inventories, net

 
2,164

Prepaid expenses

 
345

Property and equipment, net

 
5,341

Goodwill

 
7,467

Other intangibles, net

 
2,600

Total assets classified as held for sale:
$
3,072

 
$
23,173

 
 
 
 
Accounts payable and other accrued expenses
$
2,620

 
$
3,686

Deferred revenue

 
3,398

Total liabilities held for sale
$
2,620

 
$
7,084


The following table provides a summary of the operating results of Hexis, which we have reflected as discontinued operations for the three and nine months ended September 30, 2016 and 2015 (in thousands):
 
Three months ended September 30,
Nine months ended September 30,
 
2016
 
2015
2016
 
2015
Revenues
16

 
2,998

2,894

 
8,301

Costs of Revenues, excluding amortization
194

 
1,189

1,881

 
3,159

Operating expenses
866

 
9,485

16,133

 
30,141

Impairment of goodwill

 

6,980

 

Intangible amortization expense

 
1,178

381

 
3,703

Loss on disposal of Hexis

 

5,509

 

Loss before Income Taxes from Discontinued Operations
(1,044
)
 
(8,854
)
(27,990
)
 
(28,702
)
Income Tax Benefit, net on Discontinued Operations
(4
)
 
(7,979
)
(494
)
 
(11,180
)
Loss on Discontinued Operations
(1,040
)
 
(875
)
(27,496
)
 
(17,522
)


22

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

The following table presents the operating and investing cash flows of our discontinued Hexis business for the nine months ended September 30, 2016 and 2015 (in thousands):
 
Nine months ended September 30,
 
2016
 
2015
Non-Cash Operating Items
 
 
 
Depreciation and amortization expense
$
1,016

 
$
5,546

Impairment of Commercial Cyber Solutions Goodwill
6,980

 

Loss on disposal of long-lived assets
3,568

 

Cash Flows from Investing Activities
 
 
 
Purchases of property and equipment
(471
)
 
718

Proceeds from Hexis asset divestiture
$
5,000

 
$


Other Dispositions
In March 2016, we completed the sale of our SETA business to Quantech Services, Inc. for approximately $11.2 million in cash. The SETA business was not deemed an individually significant component of our Company. Management decided to sell the SETA business in connection with the ongoing strategic review of our overall business, through which we have determined that the growth potential of both KEYW's core business and the SETA business could be maximized if the two businesses were separated. The sale of SETA eliminated KEYW’s conflicts at two key government agencies and will allow our Company to focus 100% on technology development opportunities across the Intelligence Community. However, the sale of SETA did not represent a strategic shift that will have a major effect on our operations and financial results and, accordingly, the business historical results and the gain on sale were classified within continuing operations on our Condensed Consolidated Statements of Operations. Because the sale of SETA was not deemed a discontinued operation, its assets and liabilities of the business were not reclassified as held for sale on our December 31, 2015, balance sheet.
In connection with the sale of SETA, we recognized a pre-tax gain of approximately $3.0 million . This gain was reported within non-operating expense, net on our condensed consolidated statement of operations and reflects the difference between the consideration received for SETA and the net carrying value of the business less transaction costs. The net carrying value of the SETA business was deemed to include approximately $7.2 million of goodwill that, in accordance with ASC 350, was allocated to the business based upon the relative fair values of SETA and the overall Government Solutions reporting unit within which the SETA business has been historically reported.

13. INCOME TAXES

The Company’s quarterly provision for income taxes is measured using an estimated annual effective tax rate adjusted for discrete items that occur within the quarter. The provision for income taxes for continuing operations in the quarter ended September 30, 2016 and 2015 was a benefit of $1.9 million and an expense of $7.9 million , respectively. For the nine months ended September 30, 2016 and 2015 , the provision for income taxes for continuing operations was an expense of $2.5 million and $32.8 million , respectively. The provision for income tax expense for the three and nine months ended September 30, 2015 , includes the recording of a valuation allowance of $19.6 million to as a discrete item resulting in an effective rate that is significantly different than the Company’s statutory rate. The effective tax rate on income from continuing operations was (115.2)% and 1,054.4% for the three months ended September 30, 2016 and 2015 , respectively. The effective tax rate on income from continuing operations was 33.4% and 684.0% for the nine months ended September 30, 2016 and 2015 , respectively.
A full valuation allowance was established during the second quarter 2015 due to the uncertainty of the utilization of deferred tax assets in future periods. In evaluating the Company’s ability to realize the deferred tax assets we considered all available positive and negative evidence, including cumulative historical earnings, reversal of temporary difference, projected taxable income and tax planning strategies. The Company’s negative evidence currently outweighs its positive evidence, therefore it is more likely than not that we will not realize a significant portion of our deferred tax asset. The amount of the deferred tax asset to be realized in the future could however be adjusted if objective negative evidence is no longer present.

14. SUBSEQUENT EVENTS
 
In connection with the preparation of its condensed consolidated financial statements for the nine months ended September 30, 2016 , the Company has evaluated events that occurred subsequent to September 30, 2016 , to determine whether any of these

23

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

events required recognition or disclosure in the three or nine months of the 2016 condensed consolidated financial statements. The Company is not aware of any subsequent events which would require recognition or disclosure in the condensed consolidated financial statements.



24

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion provides information that management believes is relevant to an assessment and an understanding of the Company’s operations and financial condition. This discussion should be read in conjunction with the attached unaudited condensed consolidated financial statements and accompanying notes as well as our Annual Report on Form 10-K for the year ended December 31, 2015 , filed with the Securities and Exchange Commission on March 15, 2016 .

FORWARD-LOOKING STATEMENTS
The matters discussed in this Quarterly Report may constitute forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results, activity levels, performance or achievements to be materially different from any future results, activity levels, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify these statements by forward-looking words such as “could”, “expect”, “estimate”, “may”, “potential”, “will”, and “would”, or similar words. You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or of our financial position, or state other forward-looking information. There may be events in the future that we are not able to predict or control accurately, and numerous factors may cause events, our results of operations, financial performance, achievements, or industry performance, to differ materially from those reflected in the forward-looking statements. The factors listed in the section captioned “Risk Factors” contained in our Annual Report on Form 10-K for the year ended December 31, 2015 , filed with the Securities and Exchange Commission on March 15, 2016 , as well as any other cautionary language in this Quarterly Report, provide examples of such risks, uncertainties, and events.
 
You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report. Subsequent events and developments may cause our views to change. While we may elect to update the forward-looking statements at some point in the future, we specifically disclaim any obligation to do so.
 
DESCRIPTION OF THE COMPANY
We are a highly specialized provider of mission-critical cybersecurity, cyber superiority and geospatial intelligence solutions to US Government defense, intelligence and national security agencies and commercial enterprises. Our core capabilities include solutions, services and products to support the collection, processing, analysis, use of intelligence data and information in the domains of cyberspace and geospace, and the protection of networks and related infrastructure. Our solutions are designed to respond to meet the critical needs for agile intelligence in the cyber age and to assist the US Government in national security priorities.

We provide a full range of engineering services, cyber security and analytic products, and fully integrated platforms that support the entire intelligence process, including collection, processing, analysis and impact. Our platforms include a number of modified commercial turboprop aircraft for imagery and light detection and ranging (LIDAR), collection, products that we manufacture, as well as hardware and software that we integrate using the engineering services of our highly skilled and security-cleared workforce.

Our Government solutions are focused on Intelligence Community customers including the National Security Agency (NSA), the National Reconnaissance Office (NRO), the National Geospatial Intelligence Agency (NGA), the Army Geospatial Center (AGC) and various other agencies within the Intelligence Community and Department of Defense (DoD). In addition, we provide our products and services to US federal, state and local law enforcement agencies and commercial enterprises. Our innovative solutions, understanding of intelligence and national security missions, management's long-standing and successful customer relationships and operational capabilities, and best-in-class employee base position us to continue our growth as we continue to expand into the cybersecurity market. We are highly focused on assisting our customers in achieving their mission of cyber superiority both defensively and offensively within the entire domain of cyberspace and doing so in time to observe, respond to and where possible prevent threat events, actions and agents from inflicting harm. Our solutions also encompass a broad spectrum of geospatial intelligence or GEOINT, capabilities. We believe today's complex, geographically distributed cyber threat environment is driving a convergence of cyber intelligence and geospatial intelligence.

The President’s government fiscal year (GFY) 2017 budget requests $19 billion in cybersecurity funding, up 35% year-over-year. We also believe that the total addressable Intelligence Community IT budget is approximately $9.7 billion for GFY17 and have aligned our strategic business development efforts to target these opportunities. The Intelligence Community is focused on enhancing its next-generation affordable Intelligence, Surveillance and Reconnaissance (ISR) programs, which is a major strength of our solution set. In addition, studies indicate that the Intelligence Community is actively seeking better solutions for analyzing and curating massive amounts of data. We believe that our capabilities address these needs as well.

25

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


Our primary areas of expertise include:
providing sophisticated engineering services and solutions that help our customers solve discreet and complex cybersecurity, cyber superiority, and geospatial and other intelligence challenges;
using multiple intelligence collection techniques to collect data and information in cyberspace, encompassing the entire electromagnetic spectrum;
processing data and information from cyberspace to make it accessible to a wide range of analytical needs and resources;
analyzing data and information that have been collected, processed, correlated, and made easily accessible to transform them into usable information for our customers;
developing next generation cyber defense and security incident response platforms designed to detect, investigate, and remove advanced cyber threats from enterprise information technology networks;
developing data warehousing and business intelligence solutions to address the most advanced use cases in Security Information and Event Management, log management, and Call Detail Record (CDR) retention and retrieval;
providing specialized training, field support, and test and evaluation services;
development, integration, rapid deployment and sustainment of agile airborne intelligence, surveillance, and reconnaissance collection platforms to austere environments; and
responding quickly and decisively to demanding and emergent customer requirements, with agile processes and methods that enable us to satisfy requirements that are constantly changing to meet an agile, aggressive and ever-changing threat environment.

CRITICAL ACCOUNTING POLICIES
Management’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our condensed consolidated financial statements that have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and determine whether contingent assets and liabilities, if any, are disclosed in the financial statements. On an ongoing basis, we evaluate our estimates and assumptions, including those related to long-term contracts, product returns, bad debts, inventories, fixed asset lives, income taxes, environmental matters, litigation, and other contingencies. These estimates and assumptions are described in more detail in our Annual Report on Form 10-K for the year ended December 31, 2015 . We base our estimates and assumptions on historical experience and on various factors that are believed to be reasonable under the circumstances, including current and expected economic conditions, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from our estimates under different assumptions or conditions. There have been no material changes to our critical accounting policies, estimates and assumptions or the judgments affecting the application of those estimates and assumptions since the filing of our Annual Report on Form 10-K for year ended December 31, 2015 .


26

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

COMPARISON OF THREE MONTHS ENDED SEPTEMBER 30, 2016 AND SEPTEMBER 30, 2015
The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements (and notes thereto) and other financial information of the Company appearing elsewhere in this report.

CONSOLIDATED OVERVIEW
(In thousands)
 
Three months ended September 30, 2016
 
% of Revenue
 
Three months ended September 30, 2015
 
% of Revenue
Revenue
 
$
72,111

 
100.0
 %
 
$
78,100

 
100.0
 %
Gross Profit
 
23,799

 
33.0
 %
 
23,848

 
30.5
 %
Operating Expenses
 
18,031

 
25.0
 %
 
18,774

 
24.0
 %
Intangible Amortization
 
1,528

 
2.1
 %
 
1,766

 
2.3
 %
Non-operating Expense, net
 
2,612

 
3.6
 %
 
2,561

 
3.3
 %
Income Tax (Benefit) Expense, net on Continuing Operations
 
(1,876
)
 
(2.6
)%
 
7,876

 
10.1
 %
Loss on Discontinued Operations
 
(1,040
)
 
(1.4
)%
 
(875
)
 
(1.1
)%
 
Revenue decreased by $6.0 million, or 7.7%, for the three months ended September 30, 2016 , as compared to the three months ended September 30, 2015 . The largest drivers of the decrease in revenue were related to the systems engineering and technical assistance (SETA) divestiture, certain solutions contracts that ended in the second quarter of 2016 and delays in the follow-on efforts, partially offset by growth in our airborne ISR business, higher advanced geospatial intelligence products and solutions sales and increased revenue from other solutions contracts.
Gross profit was flat for the quarter ended September 30, 2016 , as compared to the quarter ended September 30, 2015 . Gross margin increased by 250 basis points for the three months ended September 30, 2016 , as compared to the three months ended September 30, 2015 . The increase in gross margin was predominately due to a change in our revenue mix towards our higher-margin airborne ISR business revenue and advanced geospatial intelligence products and solutions sales.
Our operating expenses for the three months ended September 30, 2016 decreased by $0.7 million and increased slightly as a percentage of revenue compared to the same period ended September 30, 2015 . The decrease in operating expenses was due primarily to a reduction of indirect costs, partially offset by increased business development costs and higher research and development spending.
Intangible amortization expense decreased for the three months ended September 30, 2016 because certain intangibles from prior acquisitions became fully amortized.
Non-operating expense was essentially flat for the quarter ended September 30, 2016 compared with the quarter ended September 30, 2015 .

The tax provision on continuing operations was a benefit of $1.9 million or 115.2% and an expense of $7.9 million or 1,054.4% for the three months ended September 30, 2016 and 2015 , respectively. The tax benefit recorded for the three months ended September 30, 2016 , was due to a reduction of the estimated annual effective tax rate. The tax expense recorded for the three months ended September 30, 2015 , was impacted by the valuation allowance that was established during the second quarter of 2015 due to the uncertainty of the utilization of deferred tax assets in future periods. The valuation allowance established in 2015 is still in effect as we currently believe it unlikely that we will realize a significant portion of our deferred tax asset.

Loss on discontinued operations increased by $0.2 million, or 18.9% for the three months ended September 30, 2016 , as compared to the three months ended September 30, 2015 . The largest driver of the increase was a decrease in the tax benefit on discontinued operations, partially offset by the sale of Hexis Cyber Solutions product lines in the second quarter of 2016.



27

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

COMPARISON OF NINE MONTHS ENDED SEPTEMBER 30, 2016 AND SEPTEMBER 30, 2015
The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements (and notes thereto) and other financial information of the Company appearing elsewhere in this report.

CONSOLIDATED OVERVIEW
(In thousands)
 
Nine months ended September 30, 2016
 
% of Revenue
 
Nine months ended September 30, 2015
 
% of Revenue
Revenue
 
$
219,099

 
100.0
 %
 
$
222,818

 
100.0
 %
Gross Profit
 
70,523

 
32.2
 %
 
68,344

 
30.7
 %
Operating Expenses
 
51,815

 
23.6
 %
 
50,521

 
22.7
 %
Intangible Amortization
 
4,463

 
2.0
 %
 
5,373

 
2.4
 %
Non-operating Expense, net
 
6,776

 
3.1
 %
 
7,655

 
3.4
 %
Income Tax Expense, net on Continuing Operations
 
2,491

 
1.1
 %
 
32,800

 
14.7
 %
Loss on Discontinued Operations
 
(27,496
)
 
(12.5
)%
 
(17,522
)
 
(7.9
)%
 
Revenue decreased by $3.7 million, or 1.7%, for the nine months ended September 30, 2016 , as compared to the nine months ended September 30, 2015 . The largest drivers of the decrease in revenue were related to the SETA divestiture, certain solutions contracts that ended in the second quarter of 2016 and delays in the follow-on efforts, partially offset by growth in our airborne ISR business, higher advanced geospatial intelligence products and solutions sales, increased government cyber training initiatives and increased revenue from other solutions contracts.
Gross profit increased by $2.2 million for the nine months ended September 30, 2016 , as compared to the period ended September 30, 2015 . Gross margin increased by 150 basis points for the nine months ended September 30, 2016 , as compared to the period ended September 30, 2015 . The increase in gross margin was predominately due to a change in our revenue mix towards our higher-margin airborne ISR business, higher advanced geospatial intelligence products and solutions sales.
Our operating expenses for the nine months ended September 30, 2016 , increased by $1.3 million and as a percentage of revenue compared to the same period ended September 30, 2015 . The increase is due primarily to costs associated with the newer Milestone facility, which we began occupying during the third quarter of 2015, increased business development costs and higher professional fees, partially offset by a reduction of indirect costs.
Intangible amortization expense decreased because certain intangibles from prior acquisitions became fully amortized during the period.
Non-operating expense decreased by $0.9 million for the nine months ended September 30, 2016 , compared with the nine months ended September 30, 2015 . The decrease in non-operating expense was driven by the pre-tax gain related to the sale of our SETA business of $3.0 million, which was partially offset by increased interest expense and certain operating lease disposal costs.

The effective tax rate on income from continuing operations was 33.4% and 684.0% for the nine months ended September 30, 2016 and 2015 , respectively. The effective tax rate for the nine months ended September 30, 2015 , was impacted by the valuation allowance that was established during the second quarter of 2015 due to the uncertainty of the utilization of deferred tax assets in future periods. The valuation allowance established in 2015 is still in effect as we currently believe it unlikely that we will realize a significant portion of our deferred tax asset.

Loss on discontinued operations increased by $10.0 million, or 56.9% for the nine months ended September 30, 2016 , as compared to the nine months ended September 30, 2015 . The largest drivers of the increase were related to the additional goodwill impairment of $7.0 million and the $5.5 million pre-tax loss recognized on the sale of the Hexis Cyber Solutions product lines. These increases were partially offset by cost-saving measures put in place in January 2016 and the sale of Hexis Cyber Solutions product lines in the second quarter of 2016.

LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents totaled approximately $42.5 million at September 30, 2016 . Our working capital, defined as current assets minus current liabilities, was $73.0 million, which represents an increase of approximately $10.0 million from December 31, 2015. The increase in working capital is primarily due to the sale of our SETA business for approximately $11.2 million in cash. At September 30, 2016 , we were in compliance with all of our debt covenants under our senior credit agreement.
We believe that cash from operations, cash and cash equivalents on hand, and the $20.0 million of funds available under the 2014 Revolver (defined below) will be sufficient to fund our operations as we continue to grow. We may also use our 2014 Revolver

28

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

to fund acquisitions and to provide liquidity in the event of federal government budgetary issues, including the failure or delay by Congress and the President in approving federal budgets in the future. We may also raise additional capital through future debt or equity financing.
Convertible Notes
During the third quarter of 2014, we issued $149.5 million aggregate principal amount of the Company's 2.50% Convertible Senior Notes due July 15, 2019 (the "Notes") pursuant to an underwriting agreement, dated July 16, 2014. The Notes bear interest at a rate of 2.50% per annum on the principal amount, payable semi-annually in arrears on January 15 and July 15 of each year, beginning on January 15, 2015, to holders of record at the close of business on the preceding January 1 and July 1, respectively. The Notes mature on July 15, 2019, unless earlier repurchased or converted. The Company may not redeem the Notes prior to their stated maturity date.
The Notes are senior unsecured obligations of the Company and will rank equal in right of payment to all of the Company’s existing and future senior unsecured indebtedness. The Notes will be senior in right of payment to any existing or future indebtedness which is subordinated by its terms. The Notes are structurally subordinated to all liabilities of the Company’s subsidiaries and are effectively junior to the secured indebtedness of the Company to the extent of the value of the assets securing such indebtedness.
Holders may convert their Notes under the following conditions at any time prior to the close of business on the business day immediately preceding January 15, 2019, in multiples of $1,000 principal amount, under the following circumstances:

during any calendar quarter (and only during such calendar quarter) commencing after the calendar quarter ending September 30, 2014, if the last reported sale price of the Company’s common stock, for at least 20 trading days (whether or not consecutive) in the period of 30 consecutive trading days ending on the last trading day of the immediately preceding calendar quarter is greater than or equal to 130% of the conversion price for the Notes on each applicable trading day;
during the five business day period immediately after any five consecutive trading day period in which the trading price per $1,000 principal amount of Notes for each trading day of that period was less than 98% of the product of the last reported sale price of Company common stock and the conversion rate for the Notes for each such trading day; or
upon the occurrence of specified corporate events as described in the Indenture;

In addition, holders may convert their Notes at their option at any time on or after January 15, 2019 until the close of business on the second scheduled trading day immediately preceding the stated maturity date of the Notes, without regard to the foregoing circumstances.

Upon conversion, the Company will settle the Notes in cash, shares of Company common stock or a combination of cash and shares of Company common stock, at the Company’s election. The Notes have an initial conversion rate of 67.41 shares of common shares per $1,000 principal amount of the Convertible Notes, which is equal to an initial conversion price of approximately $14.83 per common share. The conversion price is subject to adjustments upon the occurrence of certain specified events as set forth in the Indenture.

In addition, upon the occurrence of a fundamental change (as defined in the Indenture), holders of the Notes may require the Company to repurchase the Notes at a purchase price of 100% of the principal amount of the Notes, plus accrued and unpaid interest, if any, to, but excluding, the fundamental change repurchase date.

Capped Call Transactions
During the third quarter of 2014 in conjunction with the issuance of the Notes, the Company paid approximately $18.4 million to enter into capped call transactions with respect to its common shares, (the "Capped Call Transactions"), with certain financial institutions. The Capped Call Transactions generally are expected to reduce the potential dilution to the Company's common stock upon conversion of the Notes and/or offset any cash payments the Company is required to make in excess of the principal amount of any converted Notes, as the case may be, in the event that the market price of the common stock is greater than the strike price of the Capped Call Transactions, initially set at $14.83, with such reduction of potential dilution subject to a cap based on the cap price, which is initially set at $19.38. The strike price and cap price are subject to anti-dilution adjustments under the terms of the Capped Call Transactions.

The Capped Call Transactions are separate transactions entered into by and between the Company and the Counterparties and are not part of the terms of the Notes. Holders of the Notes will not have any rights with respect to Capped Call Transactions.

29

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

2014 Revolving Credit Facility
In July 2014, the Company, as guarantor and certain of the Company's subsidiaries, entered into a senior secured credit agreement, (the "2014 Credit Agreement") with certain financial institutions. The 2014 Credit Agreement provides the Company a $42.5 million revolving credit facility (the "2014 Revolver"). The 2014 Revolver includes a swing line loan commitment of up to $10 million and a letter of credit facility of up to $15 million.

Borrowings under the 2014 Credit Agreement bear interest at a rate equal to an applicable rate plus, at the Company’s option, either (a) adjusted LIBOR or (b) a base rate. The Company is required to pay a facility fee to the Lenders for any unused commitments and customary letter of credit fees.

The 2014 Revolver will mature on the earlier to occur of (i) the fifth anniversary of the closing of the 2014 Credit Agreement, and (ii) the date that is 180 days prior to the maturity date of the Notes unless the Notes are converted into equity, repaid, refinanced or otherwise satisfied on terms permitted under the 2014 Credit Agreement. The Company may voluntarily repay outstanding loans under the 2014 Revolver at any time without premium or penalty, subject to customary fees in the case of prepayment of LIBOR based loans.

The Credit Agreement contains a number of negative covenants that will, among other things, restrict, subject to certain exceptions, the Company and its subsidiaries’ ability to: incur additional indebtedness; incur additional liens; sell all or substantially all of the Company’s assets; consummate certain fundamental changes; change the Company’s lines of business or make certain restricted payments (including cash payments upon conversion of the Notes if a default or event of default exists under the facility or if, after giving effect to such payments and any debt incurred to make such payments, the Company is not in pro forma compliance with the financial covenants and other financial tests under the facility, or cash payments to pay the purchase price of the Notes). The Credit Agreement also contains certain customary affirmative covenants and events of default.

The Credit Agreement requires the Company to maintain a maximum consolidated senior secured leverage ratio and a minimum cash interest coverage ratio. The consolidated senior secured leverage ratio test measures the ratio of the Company’s consolidated funded indebtedness (other than consolidated funded indebtedness that is unsecured) to trailing four quarter Consolidated EBITDA (as defined in the Credit Agreement). This ratio is permitted to be no greater than 2.25 to 1.00 as of the end of any fiscal quarter during the applicable period. The cash interest coverage ratio test measures the ratio of trailing four quarter Consolidated EBITDA minus taxes paid in such period to consolidated interest expense paid in such period in cash. This ratio is permitted to be no less than 3.50 to 1.00.

The 2014 Revolver is secured by a security interest and lien on substantially all of the Company’s, the Borrower’s and the Subsidiary Guarantors’ assets including a pledge of one hundred percent of the equity securities of the Borrower and the Subsidiary Guarantors.

In February 2016, the Company amended the Credit Agreement by adjusting the minimum cash interest coverage ratio covenant effective for the quarters ended December 31, 2015, and March 31, 2016 to 2.25:1.00 and 3.25:1.00, respectively, and increasing the applicable interest rates with respect to the Credit Agreement’s consolidated senior secured leverage ratio pricing tiers. The amendment permanently decreases the amount available under the revolver to $20.0 million . At September 30, 2016 , we were in compliance with all of our debt covenants under the Credit Agreement.

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THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
In addition to the risks inherent in our operations, we are exposed to financial, market, political and economic risks. The following discussion provides additional detail regarding our exposure to interest rates and foreign exchange rate risks.
 
Interest Rate Risk
At September 30, 2016 , we had $149.5 million aggregate principal amount of 2.5% convertible senior notes due 2019 (the "Notes"). As the Notes are fixed rate instruments, as of September 30, 2016 , our results of operations are not subject to fluctuations in interest rates.
 
Foreign Exchange Risk
We currently do not have any material foreign currency risk, and accordingly estimate that an immediate 10 percent change in foreign exchange rates would not have a material impact on our reported net income. We do not currently utilize any derivative financial instruments to hedge foreign currency risks.

Equity Price Risk
We do not currently own nor have we ever owned any marketable equity investments to include marketable equity securities and equity derivative instruments such as warrants and options. Therefore, since we do not currently own investments that are subject to market price volatility, our equity price risk is very low.


ITEM    4.    CONTROLS AND PROCEDURES
 
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our filings and submissions to the Securities and Exchange Commission (the “SEC”) under the Exchange Act is recorded, processed, and reported within the time periods specified in the SEC’s rules and forms. Such controls include those designed to ensure that information is accumulated and communicated to management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), as appropriate, to allow timely decisions regarding required disclosures.

An evaluation was conducted under the supervision and with the participation of management, including the CEO and CFO, on the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, the CEO and CFO concluded that as of December 31, 2015, our disclosure controls and procedures were not effective because of the material weaknesses described in Management's Annual Report on Internal Control Over Financial Reporting contained in our Annual Report on Form 10-K for the year ended December 31, 2015, filed with the Securities and Exchange Commission on March 15, 2016 . In light of the material weaknesses identified at December 31, 2015, management has implemented processes and procedures to begin to remediate the identified material weaknesses.

We have also conducted an evaluation, under the supervision and with the participation of our management, including our CEO and CFO, pursuant to Rule 13a-15 of the Exchange Act, of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2016 . Based on that evaluation, our CEO and CFO concluded that, because the material weakness in our internal control over financial reporting described above had not been fully remediated as of September 30, 2016 , our disclosure controls and procedures were not effective as of September 30, 2016 .
Notwithstanding the existence of this material weakness, our management has concluded that our condensed consolidated financial statements in this Quarterly Report on Form 10-Q fairly present, in all material respects, our financial position, results of operations and cash flows for all periods and dates presented.

Management’s Plan for Remediation
Our management and Board of Directors are committed to the remediation of the identified material weaknesses, as well as the continued improvement of our overall system of internal control over financial reporting. We are currently working to remediate the underlying causes of the control deficiencies that gave rise to the material weaknesses as follows:

We are enhancing our procedures to better formalize our process over the creation of long term forecasts, and to improve the level of documentation that exists with respect to the development of our annual long-term forecast. Specific enhancements will include procedures to improve our process of retaining documentation throughout forecast creation, along with the documentation of management's review .

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THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

We are augmenting our internal controls over financial reporting related to inventory to include controls designed specifically to assess costs capitalized into inventory at a higher level of precision. Management has completed a change in its internal processes and has enhanced monitoring activities designed to review and conclude proper accounting treatment for inventory and related period costs is applied consistently.
We are enhancing our internal controls over financial reporting to properly assess the revenue recognition of individual multiple element sales, which may include software, hardware, training and professional services to ensure they are properly recognizing revenue in accordance with US GAAP. Controls will be enhanced to capture and document the impact of complex transactions that are unique in nature and require additional consideration prior to concluding on the proper revenue recognition.
With respect to our overall global approach to addressing these material weaknesses, management will enhance their approach to evaluating complex transactions at a level of precision that minimizes the risk of material misstatement to an acceptable level and document these conclusions.

As we perform our interim testing, we may take additional measures or modify the remediation plan. We believe these measures will remediate the control deficiencies; however, the material weakness will not be considered remediated until management has concluded, through required testing, that these controls are operating effectively. 

Changes in Internal Control over Financial Reporting
Except for the implementation of the remediation measures described above, there have not been any changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


PART II - OTHER INFORMATION

ITEM 1.     LEGAL PROCEEDINGS

As of September 30, 2016 , and the date of this filing, the Company is not party to any material on-going legal proceedings.

ITEM 1A .     RISK FACTORS

Part I, Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2015 and Part II, Item 1A, Risk Factors in our Quarterly Reports on Form 10-Q for the periods ended March 31, 2016 and June 30, 2016, include certain risk factors that could materially affect our business, financial condition, or future results. Except for the risk factors set forth below, which are clarified and updated in their entirety, the risk factors stated in our periodic reports remain applicable.

The risk factor entitled “ Acquisitions have formed a significant part of our growth strategy in the past and we expect to continue this strategy in the future. If we are unable to identify suitable acquisition candidates, integrate the businesses we acquire or realize the intended benefits, this aspect of our growth strategy may not succeed. Acquisitions involve numerous risks, including risks related to integration and undisclosed or underestimated liabilities ” in our Annual Report on Form 10-K for the year ended December 31, 2015 is revised in its entirety as follows:

We have made and may continue to make acquisitions and divestitures that involve numerous risks and uncertainties.

Historically, part of our growth strategy has relied on acquisitions. We expect to selectively pursue acquisitions and upon completion to integrate those businesses into our existing operations. We intend to seek acquisition opportunities both to expand into new markets and to enhance our position in our existing markets. However, our ability to make acquisitions will depend on a number of steps, including our ability to:
  
identify suitable acquisition candidates;

negotiate appropriate acquisition terms;

obtain debt or equity financing that we may need to complete proposed acquisitions;

complete the proposed acquisitions; and

integrate the acquired business into our existing operations.

In addition, acquisitions involve numerous risks, including difficulties in the assimilation of the operations accounting systems, technologies, services and products of the acquired company, the potential loss of key employees of the acquired company and the diversion of our management’s attention from other business concerns. This is the case particularly in the fiscal quarters immediately following the completion of an acquisition to the extent the operations of the acquired business are integrated into the acquiring businesses’ operations during this period. We cannot be sure that we will accurately anticipate all of the changing demands that any future acquisition may impose on our management, our operational and management information systems, and our financial systems.

We may underestimate or fail to discover liabilities relating to a future acquisition during due diligence and we, as the successor owner, might be responsible for any such liabilities. Although we seek to minimize the impact of underestimated or potential undiscovered liabilities by structuring acquisitions to minimize liabilities and obtaining indemnities and warranties from the selling party, these methods may not fully protect us from the impact of undiscovered liabilities. Indemnities or warranties are often limited in scope, amount or duration, and may not fully cover the liabilities for which they were intended. The liabilities that are not covered by the limited indemnities or warranties could have a material adverse effect on our business and financial condition. In addition, acquisitions can raise potential Organizational Conflict of Interest (OCI) issues that can impact the nature and timing of the acquisition or the acquiring entity’s ability to compete for future contracts where the acquired entity may have been involved.

In addition, we have divested, and may in the future divest, businesses that are no longer a part of our ongoing strategic plan. These divestitures similarly require significant investment of time and resources, may disrupt our business, distract management from other responsibilities and may result in losses on disposal or continued financial involvement in the divested business, including through indemnification, guarantee or other financial arrangements, for a period of time following the transaction, which could adversely affect our financial results.

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THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

The risk factor entitled “ Business disruptions could reduce our expected revenue, increase our expenses, and damage our reputation ” in our Annual Report on Form 10-K for the year ended December 31, 2015 is revised in its entirety as follows:

System failures or security threats, including those resulting from cybersecurity threats, could cause business disruptions, which could have a material adverse effect on our business and damage our reputation.

We rely upon sophisticated technology systems and infrastructure. We take reasonable steps to protect them, including the implementation and use of industry standard security precautions. However, such systems are potentially vulnerable to breakdown, malicious intrusion, natural disaster, and random attack. A disruption to our systems or infrastructure could damage our reputation and cause us to lose customers and revenue. This could require us to expend significant efforts and resources or incur significant expense to eliminate these problems and address related security concerns.

In addition, as a defense contractor, we face various security threats, including cybersecurity threats, to gain unauthorized access to sensitive information; threats to the safety of our directors, officers, and employees; threats to the security of our facilities and infrastructure; and threats from terrorist acts. Although we utilize various procedures and controls to monitor and mitigate these threats, there can be no assurance that these procedures and controls will be sufficient to prevent security threats from materializing. If any of these events were to materialize, they could lead to losses of sensitive information or capabilities, harm to personnel or infrastructure, or damage to our reputation, and could have a material adverse effect on our financial position, results of operations, or cash flows.

We face a heightened risk of a security breach or disruption because of our possession of classified and other sensitive information. Many government contractors have already been targeted and these types of attacks are likely to occur in the future. Attacks of any kind on our network or other systems could result in the loss of customer or proprietary data, interruptions or delays in our customers' business and damage to our reputation, which could have a material adverse effect on our business operations and reputation. In addition, the failure or disruption of our systems, communications or utilities could result in the interruption or suspension of our operations, which could have a material adverse effect on our business operations and reputation.

If our systems, services or other applications have significant defects or errors, if we are successfully attacked by cyber or other security threats, or if we suffer delivery delays or otherwise fail to meet our customers' expectations, we may:

lose revenue due to adverse customer reaction;

incur additional costs related to monitoring and increasing our cyber security;

incur additional costs related to remediation;

be sued by customers and other who were harmed;

reduce or negate the value of our proprietary information;

receive negative publicity, which could damage our reputation and adversely affect our ability to attract or retain customers;

be unable to successfully market services that rely on the creation and maintenance of secure IT systems:

damage the confidence of our employees in the management and systems of the company;

suffer claims for substantial damages, particularly as a result of any successful network or systems breach and exfiltration of customer information; or

incur significant costs complying with applicable federal or state laws, including laws governing protection of personal information.




ITEM 2.    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

During the nine months ended September 30, 2016 , 505,000 long-term incentive shares were granted to new hires outside of the 2013 Plan, in accordance with Section 4(2) of the Securities Act of 1933.

34

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


ITEM 6.    EXHIBITS

Exhibits – See Exhibit Index 

35

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES



SIGNATURES
 
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
THE KEYW HOLDING CORPORATION
 
 
 
 
Date:
November 2, 2016
By:
/s/ William J. Weber
 
 
William J. Weber
 
 
President and Chief Executive Officer
 
 
 
 
Date:
November 2, 2016
By:
/s/ Michael J. Alber
 
 
Michael J. Alber
 
 
Executive Vice President and Chief Financial Officer

 

36

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES


Exhibit No.
 
Exhibit Description
 
 
 
 
 
3.1
 
Amended and Restated Articles of Incorporation of the Company, as filed on October 6, 2010
(1)  
 
 
 
   
3.2
 
Certificate of Correction of Articles of Amendment and Restatement
(2)  
 
 
 
 
3.3
 
Amended and Restated Bylaws of the Company, effective as of August 13, 2014
(3)  
 
 
 
   
4.1
 
Specimen of Common Stock Certificate
(4)  
 
 
 
   
4.2
 
Indenture, dated July 21, 2014, between the Company and Wilmington Trust, National Association, as trustee.
(5)  
 
 
 
 
4.3
 
First Supplemental Indenture, dated July 21, 2014, between the Company and Wilmington Trust, National Association, as trustee.
(5)  
 
 
 
 
4.4
 
Form of 2.50% Convertible Senior Note due 2019 (incorporated by reference to Exhibit 4.2 hereto).
(5)  
 
 
 
 
31.1
 
Certification of the Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a)
x
 
 
 
 
31.2
 
Certification of the Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a)
x
 
 
 
 
32.1*
 
Certification of the Chief Executive Officer and the Chief Financial Officer and Principal Accounting Officer pursuant to Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002
x
 
 
 
 
101.INS**
 
XBRL Instance Document
x
 
 
 
 
101.SCH**
 
XBRL Taxonomy Extension Schema Document
x
 
 
 
 
101.CAL**
 
XBRL Taxonomy Extension Calculation Linkbase Document
x
 
 
 
 
101.LAB**
 
XBRL Taxonomy Extension Label Linkbase Document
x
 
 
 
 
101.PRE**
 
XBRL Taxonomy Extension Presentation Linkbase Document
x
 
 
 
 
101.DEF**
 
XBRL Taxonomy Extension Definition Linkbase Document
x
 

37

THE KEYW HOLDING CORPORATION AND SUBSIDIARIES

x
Filed herewith.

(1)
Filed as Exhibit 3.1 to the Registrant's Form 10-K filed March 29, 2011, File No. 001-34891.
(2)
Filed as Exhibit 3.1 to the Registrant's Form 8-K filed July 15, 2014, File No. 001-34891.
(3)
Filed as Exhibit 3.1 to the Registrant's Form 8-K reporting under Items 5.02, 5.03, 5.07, filed August 15, 2014, File No. 001-34891.
(4)
Filed as Exhibit 4.3 to the Registrant's Registration Statement on Form S-1, as amended, File No. 333-167608.
(5)
Filed as Exhibits 4.1, 4.2, and 4.3, respectively to the Registrant’s Current Report on Form 8-K filed July 21, 2014, File No. 001-38491.

*
This exhibit is being “furnished” with this periodic report and are not deemed “filed” with the Securities and Exchange Commission and are not incorporated by reference in any filing of the Company under the Securities Act of 1933 or the Securities Exchange Act of 1934, whether made before or after the date hereof and irrespective of any general incorporation by reference language in any such filing.

**
Pursuant to Regulation S-T, this interactive data file is deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, and otherwise is not subject to liability under these sections.



38


Exhibit 31.1
 
The KEYW Holding Corporation
 
CERTIFICATION
 
I, William J. Weber, certify that:
1.
 I have reviewed this quarterly report on Form 10-Q of The KEYW Holding Corporation;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (e) and 15d-15 (e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15-d-15(f)) for the registrant and have:
a.
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b.
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c.
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d.
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5.
The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a.
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b.
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:
November 2, 2016
/s/ William J. Weber
 
 
William J. Weber
 
 
President and Chief Executive Officer
  




Exhibit 31.2
 
The KEYW Holding Corporation
 
CERTIFICATION
 
I, Michael J. Alber, certify that:
1.
 I have reviewed this quarterly report on Form 10-Q of The KEYW Holding Corporation;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (e) and 15d-15 (e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15-d-15(f)) for the registrant and have:
a.
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b.
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c.
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d.
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and
5.
The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a.
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b.
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date:
November 2, 2016
/s/ Michael J. Alber
 
 
Michael J. Alber
 
 
Executive Vice President and Chief Financial Officer
 




Exhibit 32.1
 
CERTIFICATION
 
Each of the undersigned hereby certifies, for the purposes of Section 1350 of Chapter 63 of Title 18 of the United States Code, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, in his capacity as an officer of The KEYW Holding Corporation (“KEYW”), that, to the best of his knowledge and belief, the Quarterly Report of KEYW on Form 10-Q for the period ended September 30, 2016 , fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that the information contained in such report fairly presents, in all material respects, the financial condition and results of operations of KEYW.
 
Date:
November 2, 2016
By:  
/s/ William J. Weber
 
 
 
William J. Weber
 
 
 
President and Chief Executive Officer
 
Date:
November 2, 2016
By:  
/s/ Michael J. Alber
 
 
 
Michael J. Alber
 
 
 
Executive Vice President and Chief Financial Officer
 
This written statement is being furnished to the Securities and Exchange Commission as an exhibit to such Form 10-Q. A signed original of this statement has been provided to KEYW and will be retained by KEYW and furnished to the Securities and Exchange Commission or its staff upon request.