Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed its Form 10-K for the 52-week fiscal year ended December 27, 2015. Kratos is a mid-tier government contractor focused on unmanned systems, satellite communications, microwave electronics, cyber security and warfare, missile defense, combat systems, and public safety and security. Its reportable segments are Kratos Government Solutions, Unmanned Systems, and Public Safety & Security.
The consolidated financial statements were recast to present the U.S. and U.K. operations of the Electronic Products Division, including Herley Industries and certain subsidiaries, as discontinued operations following their sale on August 21, 2015.
Financial Performance and Position
| Metric | 2015 | 2014 | Change |
|---|---|---|---|
| Revenue | $657.1 million | $763.0 million | Down 13.9% |
| Gross profit | $161.8 million | $179.4 million | Down $17.6 million |
| Gross margin | 24.6% | 23.5% | Up 110 basis points |
| Operating income from continuing operations | $(4.5) million | $5.3 million | Declined $9.8 million |
| Loss from continuing operations | $(33.2) million | $(75.7) million | Improved $42.5 million |
| Net income | $19.8 million | $(78.0) million | Improved $97.8 million |
| Net income per diluted share | $0.34 | $(1.35) | Improved |
| Cash from continuing operating activities | $(29.7) million | $2.5 million | Down $32.2 million |
| Cash and equivalents | $28.5 million | $33.5 million | Down $5.0 million |
| Total debt, including discounts and issuance costs | $445.1 million | $656.5 million | Down $211.4 million |
Service revenue was $354.2 million, down 9.4%, while product sales were $302.9 million, down 18.6%. SG&A declined to $150.7 million, but increased to 22.9% of revenue because of lower volume and unabsorbed overhead. Internal research and development expense was $16.2 million, or 2.5% of revenue.
Working capital was $148.0 million at year-end, compared with $147.1 million in 2014. Total assets declined to $903.3 million, primarily reflecting the disposal of the Herley-related assets. Goodwill remained $483.4 million, representing approximately 54% of total assets; management concluded that goodwill was not impaired at year-end.
Material Changes Versus the Prior Comparable Period
- Revenue declined by $105.9 million, driven by lower Public Safety & Security revenue, reduced KGS product shipments and legacy services, delayed government awards, and lower Unmanned Systems shipments.
- Public Safety & Security revenue fell 26.3% to $144.7 million, but segment margin improved from 19.3% to 26.0% following a shift toward smaller, higher-margin projects and cost reductions.
- KGS revenue declined 8.0% to $446.1 million. KGS operating income declined to $16.1 million from $24.4 million.
- Unmanned Systems revenue declined 18.7% to $66.3 million, and the segment recorded a $16.2 million operating loss. Margin fell to 16.3%, partly because of product mix and retrofit costs related to design changes on aerial target projects.
- Overall gross margin improved despite lower revenue, primarily because of a more favorable service mix and improved PSS performance.
- Continuing operations remained unprofitable, but the loss narrowed substantially because 2014 included a $39.1 million loss on extinguishment of debt and 2015 benefited from an $11.4 million income-tax benefit.
- Net income was largely driven by the $80.8 million pretax gain on the sale of the Herley Entities. Discontinued operations contributed $53.0 million after tax in 2015, compared with a $2.3 million loss in 2014.
- Following the disposition, Kratos repaid $41.0 million outstanding under its revolving credit facility and repurchased $175.0 million of its 7.00% Senior Secured Notes at par. The remaining principal amount of the Notes was $450.0 million.
Cash Flow, Debt and Liquidity
- Continuing operations used $29.7 million of operating cash in 2015, compared with $2.5 million provided in 2014. Management cited lower operating income, strategic investments, SG&A spending, and working-capital changes.
- Capital expenditures were $11.3 million, and continuing investing activities used $5.7 million.
- Financing activities used $214.7 million, principally for the $175.0 million Note repurchase and $42.0 million of credit-facility repayments, partially offset by $3.4 million from employee equity programs.
- The revolving credit facility had no borrowings, $11.1 million of outstanding letters of credit, and reported net borrowing-base availability of $60.1 million at year-end. The facility’s maximum capacity was temporarily reduced to $105.1 million by a disposition-related reserve.
- The 7.00% Senior Secured Notes mature May 15, 2019. Contractual commitments totaled $728.5 million, including $452.7 million of debt principal net of interest, $106.5 million of estimated interest, $95.8 million of purchase orders, and $73.5 million of operating leases.
- Management stated that cash, operating cash flow, and availability under the credit facility should be sufficient for expected needs for at least the next 12 months, while warning that weaker industry conditions, customer delays or cancellations, or insufficient revenue growth could pressure liquidity and covenant compliance.
Guidance, Outlook, Commentary and Risks
The filing does not provide formal revenue or earnings guidance. Management’s strategy is to pursue internally generated growth in proprietary technology and intellectual property, particularly unmanned tactical systems, satellite communications, microwave electronics, and other national-security applications. Management also expects to improve margins through cost reductions, higher-value contracts, operating efficiencies, and greater utilization of existing corporate infrastructure.
The 2015 Bipartisan Budget Act increased defense spending caps for fiscal 2016 and 2017 and established a fiscal 2016 DoD base budget of approximately $548.0 billion, which management viewed as a more favorable funding backdrop. However, the filing continues to identify significant uncertainty from government budget decisions, contract delays, bid protests, sequestration-related constraints, and changing procurement priorities.
- U.S. Government contracts represented approximately 61% of 2015 revenue, creating material exposure to defense budgets, appropriations, contract cancellations, options not being exercised, and government termination rights.
- Approximately 80% of 2015 revenue came from fixed-price contracts, increasing exposure to cost overruns, design changes, schedule delays, supplier performance, and contract losses.
- DCAA and other government audits may result in disallowed costs, billing-rate reductions, customer refunds, penalties, or restrictions on bidding for future contracts. The company had received a July 2015 DCMA determination regarding potentially unallowable costs for a subsidiary’s fiscal 2007 activity, but had not recorded a liability because the outcome could not be reasonably estimated.
- The company carries substantial goodwill and intangible assets. Future impairment could result if projected cash flows, government funding, unmanned-system awards, international expansion, or market valuations do not meet assumptions.
- The Herley sale included indemnification obligations, including up to $34.0 million for pre-existing environmental conditions over five years and indemnification for pre-acquisition tax liabilities. Management did not believe material environmental payments were likely, but the gain on sale remained subject to changes in indemnification obligations.
- Cybersecurity incidents, classified-program requirements, technology obsolescence, product defects, environmental liabilities, international trade restrictions, employee retention, and dependence on specialized cleared personnel remain material operating risks.
Important Facts for Investors to Verify
- Whether continuing operations can return to positive operating cash flow after using $29.7 million in 2015.
- The company’s ability to refinance or repay the $450.0 million of Notes due in 2019.
- Progress in converting approximately $0.9 billion of backlog, including $528.7 million of funded backlog, into revenue and cash flow; backlog remains subject to funding, cancellation, scope, and timing risks.
- Whether Unmanned Systems investments produce expected contract awards and whether retrofit and product-development costs decline.
- The outcome of pending DCAA and DCMA reviews and any resulting cost disallowances, refunds, penalties, or covenant effects.
- The sustainability of improved PSS margins and the effect of lower revenue on fixed corporate and overhead costs.
- Potential future impairment of the $483.4 million goodwill balance and $36.5 million of intangible assets.
- Final settlement of remaining Herley transaction obligations, including the $5.0 million tax reimbursement received in January 2016 and the remaining $4.0 million to $6.0 million of disposition proceeds intended for replacement collateral.