Kratos Defense & Security Solutions, Inc. — Q3 2015 Form 10-Q Summary
Business context and reporting period
Kratos is a national security technology company serving primarily U.S. Government and Department of Defense customers through Kratos Government Solutions, Public Safety & Security, and Unmanned Systems. This unaudited report covers the 13 weeks and 39 weeks ended September 27, 2015, compared with the periods ended September 28, 2014. Results have been recast to classify the divested Herley Entities as discontinued operations.
Key financial metrics
| Metric | Q3 2015 | Q3 2014 | 9M 2015 | 9M 2014 |
|---|---|---|---|---|
| Total revenue | $161.7 million | $190.8 million | $479.6 million | $570.9 million |
| Gross profit | $40.4 million | $42.4 million | $119.6 million | $134.3 million |
| Gross margin | 25.0% | 22.2% | 24.9% | 23.5% |
| Operating income (loss), continuing operations | $1.6 million | $(3.0) million | $(6.0) million | $(0.3) million |
| Income (loss) from continuing operations | $4.3 million | $(11.3) million | $(26.2) million | $(72.9) million |
| Net income (loss) | $55.1 million | $(10.9) million | $23.8 million | $(75.8) million |
| Diluted EPS | $0.92 | $(0.19) | $0.40 | $(1.32) |
- Q3 SG&A was $34.9 million and R&D was $3.5 million. Nine-month SG&A was $112.6 million and R&D was $11.7 million.
- Continuing operations generated $23.4 million of operating cash outflow during the first nine months, compared with $14.9 million of outflow in the prior-year period. Capital expenditures were $8.1 million.
- Cash and cash equivalents were $35.8 million at September 27, 2015, versus $33.5 million at December 28, 2014. Accounts receivable were $194.7 million, inventoried costs were $54.6 million, and reported DSOs increased to 110 days from 104 days.
- Debt carrying value was approximately $449.5 million, including $450.0 million of 7% Senior Secured Notes outstanding and a $3.0 million Israeli term loan, net of discounts. The $41.0 million Credit Agreement balance was repaid, and no borrowings remained outstanding under that facility.
- The revolving facility had $8.5 million of letters of credit outstanding and reported net borrowing-base availability of $62.4 million. The borrowing base was temporarily reduced to $72.1 million by a $37.9 million Herley disposition reinvestment reserve.
Material changes versus the prior comparable period
- Q3 revenue declined 15.3%; nine-month revenue declined 16.0%. Product sales fell 20.7% in Q3 and 20.4% for the nine-month period, while service revenue declined 10.0% and 12.0%, respectively.
- KGS Q3 revenue declined 13.1%, primarily because anticipated hardened critical-infrastructure shelter awards were delayed and legacy government services contracted. Nine-month KGS revenue declined 9.0%.
- PSS Q3 revenue declined 22.7% and nine-month revenue declined 31.7% due to project completions and the strategic shift away from lower-margin security integration work. PSS margins improved materially to 26.0% in Q3 and 25.9% for nine months.
- Unmanned Systems revenue declined 13.1% in Q3 and 16.7% for nine months because of delayed follow-on and international aerial-target awards.
- Gross margin improved despite lower revenue, reflecting more favorable product and service mix, completion of lower-margin PSS projects, cost reductions, and improved Q3 Unmanned Systems margins.
- Q3 operating results benefited from lower SG&A and restructuring costs, while nine-month operating performance remained negative because of lower volumes, unabsorbed overhead, and continuing corporate costs.
- Net income primarily reflects the $80.3 million pretax gain from selling the Herley Entities, partly offset by $26.2 million of related Q3 income tax expense. Continuing operations remained loss-making for the nine-month period.
Guidance, outlook, commentary, risks and unusual items
- The Company did not provide explicit quantitative revenue or earnings guidance in the filing. Management stated that cash on hand, available credit, and expected operating cash generation should fund anticipated needs for at least the next 12 months.
- Backlog increased to approximately $960.7 million at September 27, 2015, from $922.3 million a year earlier; funded backlog increased to $551.5 million from $459.3 million. Backlog remains subject to funding, timing changes, cancellation, scope adjustments, and government termination rights.
- The August 21, 2015 sale of Herley generated $260.0 million of cash consideration, subject to escrow, taxes, indemnities, and an estimated $8.3 million working-capital adjustment expected to be finalized in Q4 2015. The gain remains subject to working-capital and indemnification adjustments.
- The Company repaid the $41.0 million revolving balance and repurchased $175.0 million of Notes at par. The repurchase produced a $3.4 million loss on extinguishment of debt.
- Key risks include U.S. Government and DoD budget reductions or delays, delayed contract awards, bid protests, customer cancellations, contract-performance and estimate risk, debt leverage and covenant compliance, cybersecurity incidents, competition, litigation, and DCAA or DCMA scrutiny of government-contract costs.
- On July 28, 2015, DCMA issued a determination regarding potentially unallowable costs at a subsidiary for fiscal 2007. Kratos is evaluating the matter, believes it has a defensible position, and has not accrued a liability because the potential loss cannot reasonably be estimated.
- Management represented that the Company was in compliance with its debt and credit-facility covenants at September 27, 2015. Disclosure controls were deemed effective at a reasonable assurance level.
Facts investors should verify
- Whether the Herley working-capital adjustment, tax costs, escrow release, and indemnification exposures ultimately differ from current estimates.
- Whether contract-award delays in KGS and Unmanned Systems reverse and whether PSS margin improvements are sustainable at lower revenue levels.
- Progress in reinvesting approximately $10 million to $12 million of remaining disposition proceeds and restoring the revolving borrowing base toward $110.0 million.
- Ability to convert the $960.7 million backlog into revenue and cash flow, including the unfunded portion and government funding dependencies.
- Trend in operating cash flow, accounts receivable, DSOs, inventory, and unabsorbed overhead.
- Future DCAA/DCMA findings, litigation, environmental indemnification claims, tax examinations, and potential effects on liquidity or earnings.