Kratos Defense & Security Solutions, Inc. — 2016 Second-Quarter Form 10-Q
Reporting period: Three and six months ended June 26, 2016; comparative periods ended June 28, 2015. The interim financial statements are unaudited. Kratos is a mid-tier defense contractor focused on unmanned systems, satellite communications, microwave electronics, missile defense, cyber and security solutions. Its reportable segments are Kratos Government Solutions, Unmanned Systems, and Public Safety & Security.
Key Financial Metrics
| Metric | Three months ended June 26, 2016 | Three months ended June 28, 2015 | Six months ended June 26, 2016 | Six months ended June 28, 2015 |
|---|---|---|---|---|
| Total revenue | $168.2 million | $160.5 million | $321.2 million | $317.4 million |
| Gross profit | $45.2 million | $40.9 million | $81.1 million | $79.2 million |
| Gross margin | 26.9% | 25.5% | 25.2% | 25.0% |
| Operating loss from continuing operations | $0.0 million | $3.7 million loss | $10.2 million loss | $7.6 million loss |
| Loss from continuing operations | $10.3 million | $15.9 million | $32.5 million | $30.4 million |
| Net loss | $10.4 million | $15.0 million | $32.6 million | $31.3 million |
| Net loss per share | $0.17 | $0.25 | $0.55 | $0.54 |
| Operating cash flow from continuing operations | Not separately provided | Not separately provided | $12.4 million used | $15.1 million used |
- Quarterly revenue increased 4.8%, while six-month revenue increased 1.2%.
- Product sales increased 11.6% in the quarter and 6.4% year to date; service revenue declined 0.7% in the quarter and 3.0% year to date.
- Quarterly SG&A declined to $36.4 million from $40.3 million, and six-month SG&A declined to $74.1 million from $77.7 million.
- Interest expense was $8.7 million in the quarter and $17.4 million year to date.
- Cash and cash equivalents were $17.6 million at June 26, 2016, down from $28.5 million at December 27, 2015. Total assets were $874.2 million and stockholders’ equity was $225.6 million.
- Accounts receivable were $211.0 million, and days sales outstanding increased to 114 days from 106 days at year-end.
Segment and Operational Trends
- Kratos Government Solutions: Second-quarter revenue increased 12.0% to $120.0 million; six-month revenue increased 6.8% to $228.6 million. Growth was attributed to satellite communications, ballistic missile targets, training and microwave products. Quarterly segment operating income increased to $4.5 million from $0.2 million.
- Public Safety & Security: Second-quarter revenue declined 14.4% to $30.4 million; six-month revenue declined 17.0% to $60.6 million, reflecting the wind-down of security installation projects and a shift toward smaller, higher-margin work. Six-month segment operating results included a $1.9 million litigation settlement charge.
- Unmanned Systems: Second-quarter revenue was $17.8 million, essentially unchanged; six-month revenue increased 5.6% to $32.0 million. The segment remained loss-making, with operating losses of $3.0 million in the quarter and $7.2 million year to date.
- Backlog was approximately $874.6 million at June 26, 2016, including $542.3 million funded, compared with total backlog of $953.5 million and funded backlog of $554.2 million a year earlier.
- U.S. Government revenue represented approximately 61% of second-quarter revenue and 62% of six-month revenue.
Material Changes and Unusual Items
- Second-quarter operating results included $4.8 million of unused office space, restructuring and other expense, primarily a $4.7 million charge related to closing a manufacturing facility and exiting lower-margin product lines.
- Six-month unusual expenses totaled $10.3 million, including $7.7 million of restructuring charges, the $1.9 million PSS litigation settlement, and employee termination costs.
- The restructuring charge included $3.4 million for fixed and intangible asset impairments, $3.0 million for exited product lines, and $1.3 million for excess facility costs.
- Herley Industries and related entities were sold in August 2015 and are presented as discontinued operations. The 2015 comparative periods therefore include Herley results; 2016 discontinued-operations results were a $0.1 million loss for both the quarter and six-month period.
- Subsequent to quarter-end, Kratos received a $40.8 million Air Force Research Laboratory cost-share award for an unmanned aerial system demonstration. The Company expects $7.3 million of government funding but may invest up to $33.5 million over approximately 30 months and expects to record a loss accrual in the third quarter; the amount was not yet determined.
Debt, Liquidity and Cash Flow
- Long-term debt carrying value was $445.7 million at June 26, 2016, including $450.0 million principal outstanding on the 7.00% Senior Secured Notes due 2019 and a $2.2 million Israeli term loan.
- The $110.0 million revolving credit facility had no borrowings, $13.0 million of letters of credit outstanding, and reported net borrowing-base availability of $48.4 million.
- Kratos reported compliance with the Notes, revolving credit facility and Israeli term-loan covenants, with no event of default.
- Six-month cash used in continuing operations was $12.4 million; capital expenditures were $3.5 million. Cash decreased $10.9 million during the six months to $17.6 million.
- Management stated that cash on hand, expected operating cash flow and available credit were sufficient for anticipated working-capital and other cash needs for at least the next 12 months.
Outlook, Risks and Contingencies
- Management cited the improved defense funding environment under the Bipartisan Budget Act of 2015, but noted that government spending changes, funding delays, contract cancellations, bid protests and changes in project scope could affect results.
- Key risks include high debt leverage, covenant compliance, declining backlog, customer concentration, cybersecurity and information-system disruptions, competition, litigation, regulatory actions and execution of restructuring and divestiture strategies.
- Higher receivables and DSOs reflect delayed billing milestones, including equipment deliveries and flight requirements, as well as the timing of advanced billings. Management expects DSOs to decline as work is performed and revenue is recognized.
- DCAA audits may result in disputed or disallowed costs. A $0.2 million settlement was reached for certain fiscal 2007 and 2008 costs, but potential outcomes of other audits could not be reasonably estimated.
- The Company maintains a full valuation allowance against most U.S. federal, state and certain foreign deferred tax assets. Six-month income-tax expense included a $1.7 million discrete increase in uncertain tax positions.
- Kratos does not expect payment under a $34.0 million environmental indemnification related to the Herley sale, although the indemnification remains a contingency.
Investor Verification Checklist
- Verify whether the expected third-quarter loss accrual on the $40.8 million LCASD cost-share contract is recorded and its eventual amount.
- Monitor cash burn, receivables, DSO trends and conversion of backlog into funded revenue.
- Assess the Company’s ability to service approximately $450 million of Notes while continuing investment in unmanned systems and other product programs.
- Track restructuring benefits, the performance of the Unmanned Systems segment and the effect of the PSS strategic shift on margins and revenue.
- Review DCAA audit developments, litigation matters, tax indemnities and other contingencies for potential cash or covenant impacts.
- Reconcile reported credit availability, letter-of-credit exposure and financial-covenant compliance in subsequent filings.