KRATOS DEFENSE & SECURITY SOLUTIONS, INC. annual report, FY2019

Kratos Defense & Security Solutions, Inc. — FY2019 Form 10-K Summary

Reporting period: Fiscal year ended December 29, 2019, with 52 weeks. The filing is an annual report rather than a quarterly filing; fourth-quarter 2019 results are included in the annual and quarterly disclosures.

Business context

Kratos is a government contractor focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity and warfare, missile defense, turbine technologies, training systems, C5ISR and related national-security products and services. It operates through two reportable segments: Kratos Government Solutions (KGS) and Unmanned Systems (US).

U.S. Government revenue, including foreign military sales, was $507.4 million, or 71% of total revenue, compared with 72% in 2018.
International revenue was $132.5 million, or 18% of total revenue.
No individual contract represented more than 8% of 2019 revenue.
The Company had approximately 3,000 employees and approximately 1.7 million square feet of facilities at year-end.

Financial performance and liquidity

Metric	FY2019	FY2018	Change
Revenue	$717.5 million	$618.0 million	+16.1%
Gross profit	$190.0 million	$169.7 million	+12.0%
Gross margin	26.5%	27.5%	Down 100 bps
Operating income	$38.0 million	$30.5 million	+24.6%
Operating margin	5.3%	4.9%	Up approximately 40 bps
Income from continuing operations	$10.9 million	$4.1 million	Improved
Net income attributable to Kratos	$12.5 million	$(3.5) million	Returned to profit
Diluted earnings per share	$0.11	$(0.03)	Improved
Operating cash flow from continuing operations	$28.9 million	$18.1 million	+59.7%
Cash and equivalents	$172.6 million	$182.7 million	Down $10.1 million
Long-term debt, net	$295.1 million	$294.2 million	Up $0.9 million

Service revenue increased 35.8% to $272.6 million, while product sales increased 6.6% to $444.9 million. KGS revenue rose 14.6% to $556.1 million, and US revenue rose 21.4% to $161.4 million. Segment operating income was $45.2 million for KGS and $6.1 million for US, partly offset by $13.3 million of corporate activities.

Gross margin declined because of product mix and lower margins in both service and product sales. SG&A increased to $130.8 million but declined to 18.2% of revenue from 19.4%, reflecting operating leverage and cost-reduction actions. Research and development expense increased to $18.0 million, or 2.5% of revenue.

Capital expenditures were $26.3 million, including approximately $13.9 million for the US business. Investing cash flow was $(43.7) million, including $17.7 million of net cash paid for acquisitions. Financing cash flow was $3.5 million. Days sales outstanding improved to 134 days from 140 days.

Material changes versus the prior comparable period

Revenue increased $99.5 million, driven by the FTT acquisition, growth in satellite communications, modular systems, training, microwave products, ballistic missile targets and unmanned aerial targets.
On February 27, 2019, Kratos acquired an 80.1% interest in Florida Turbine Technologies for approximately $60.0 million, consisting of cash, deferred consideration and 1.825 million shares of common stock. FTT contributed $52.5 million of revenue and a $0.7 million operating loss in 2019.
The FTT acquisition added $15.0 million of redeemable noncontrolling interest and created additional goodwill and intangible assets.
The Company completed the divestiture of its Public Safety & Security business in June 2018. Discontinued operations produced $1.7 million of income in 2019 versus a $7.6 million loss in 2018, including a $3.6 million gain from release of an indemnification liability.
Total backlog declined to $601.2 million from $620.7 million; funded backlog declined to $501.3 million from $537.2 million. Management expects approximately 62% of remaining backlog to be recognized as revenue in 2020 and 21% in 2021.
Gross margin decreased to 26.5% from 27.5%, while operating margin improved because of revenue growth and SG&A leverage.
No goodwill impairment was recorded in 2019 or 2018; a $24.2 million impairment had been recorded in 2017.
The Company adopted the lease standard ASC 842, resulting in recognition of operating and finance lease assets and liabilities. The adoption did not materially affect earnings or cash flow.

Debt, liquidity and commitments

Kratos had $300.0 million principal amount of 6.5% senior secured notes due November 2025, carried at $295.1 million net of unamortized issuance costs.
The $90.0 million revolving credit facility had no borrowings outstanding, $5.4 million of letters of credit outstanding and $69.3 million of net borrowing-base availability at year-end.
The Company was in compliance with its debt covenants and stated that available cash, operating cash flow and credit availability should fund expected needs for at least the next 12 months.
Contractual commitments totaled $717.0 million, including $300.0 million of debt principal, $136.5 million of estimated debt interest, $153.1 million of purchase orders and $127.4 million of operating and finance lease payments.
Management does not expect to pay cash dividends or repurchase shares in the foreseeable future.

Guidance, outlook, commentary and risks

The filing does not provide specific consolidated revenue, earnings or cash-flow guidance. Management expects continued investment in unmanned systems, space and satellite communications, cybersecurity, microwave electronics, missile defense, training, turbine technologies and C5ISR, with a stated objective of improving operating margins as revenue and production increase.

Management views the 2020 defense budget and longer-term defense priorities as supportive of areas such as unmanned systems, space, missile defense, hypersonics and strategic weapon-system recapitalization.
During 2019, the Company advanced the XQ-58A Valkyrie program, continued production of BQM-177A and BQM-167A aerial targets, and pursued tactical unmanned aircraft opportunities. A fourth Valkyrie demonstration flight was completed in January 2020.
A large training-solutions program was terminated for convenience in November 2019. Approximately $11.5 million of related unbilled receivables remained outstanding pending settlement.
Kratos was in dispute with an international customer over approximately $10.0 million of unbilled receivables related to system requirements and contractual milestones. Management recorded no revenue or receivable adjustment at year-end.
The Company was also disputing an approximately $8.0 million closing working-capital adjustment related to the 2018 PSS divestiture.
Government funding, continuing resolutions, potential shutdowns, debt-ceiling debates, bid protests and program cancellations could delay awards, payments and new starts.
Fixed-price contracts represented approximately 83% of 2019 revenue, increasing exposure to cost overruns, technical performance, schedule and supplier risks.
Goodwill and long-lived asset valuations depend on future contract awards, government funding, successful development of tactical unmanned systems and international market expansion. Goodwill was $455.6 million, approximately 38% of total assets.
DCAA audits and other government reviews could result in cost disallowances, refunds, penalties, payment delays or restrictions on future contracting. The filing states that incurred-cost claims were submitted through fiscal 2018 and audits were completed through fiscal 2017.
The Company identified cybersecurity, classified-information, export-control, environmental, supply-chain, labor and national-security-clearance risks. The new DoD Cybersecurity Maturity Model Certification requirements could increase costs and affect eligibility for future contracts.
The Company’s internal controls over financial reporting were deemed effective, although the assessment excluded FTT, which represented approximately 4.2% of consolidated assets and 7.3% of consolidated revenue.

Most important facts for investors to verify

Whether backlog converts into revenue and cash at the expected pace, particularly the 62% expected in 2020.
Collection and settlement outcomes for the $11.5 million training-program receivable, the $10.0 million international receivable dispute and the $8.0 million PSS working-capital dispute.
Progress, contract awards and profitability of the Valkyrie, SSAT, AFSAT and other tactical unmanned-system programs.
FTT integration, profitability, deferred purchase consideration and the future put or purchase rights covering the 19.9% minority interest.
Gross-margin recovery, especially in fixed-price production and government-services contracts.
Compliance with the 6.5% notes and revolving-credit covenants, refinancing or repayment capacity for the $300.0 million notes due in 2025, and access to additional working capital if unmanned-system production expands.
Results of DCAA audits, uncertain tax positions of approximately $24.0 million and the potential release or continued maintenance of the deferred-tax valuation allowance.
Potential goodwill impairment if projected growth, government funding, contract awards or market conditions weaken.