Kratos Defense & Security Solutions, Inc. — Q2 2014 Form 10-Q Summary
Business context and reporting period
Kratos provides specialized defense and security technology, engineering, manufacturing, systems integration, testing, cybersecurity, unmanned systems, electronic warfare, satellite communications, missile defense, and public safety solutions. The company reports through Kratos Government Solutions (KGS) and Public Safety & Security (PSS), with substantial exposure to U.S. government and Department of Defense spending.
The filing covers the 13-week quarter and 26-week year-to-date period ended June 29, 2014, compared with the periods ended June 30, 2013. The financial statements are unaudited.
Key financial metrics
| Metric | Q2 2014 | Q2 2013 | Six months 2014 | Six months 2013 |
|---|---|---|---|---|
| Total revenue | $229.3 million | $235.2 million | $429.4 million | $488.5 million |
| Gross profit | $56.4 million | $60.4 million | $109.0 million | $126.2 million |
| Gross margin | 24.6% | 25.7% | 25.4% | 25.7% |
| Operating income | $4.7 million | $8.9 million | $8.0 million | $20.3 million |
| Net loss | $49.9 million | $9.6 million | $64.9 million | $19.9 million |
| Loss per share | $0.87 | $0.17 | $1.13 | $0.35 |
| Operating cash flow from continuing operations | Not separately provided | Not separately provided | $(10.3) million | $8.4 million |
Q2 revenue was 53.1% product sales and 44.4% service revenue. The company reported a $39.1 million loss on extinguishment of debt in Q2 and year-to-date 2014, materially increasing the net loss.
At June 29, 2014, cash and cash equivalents were $26.9 million, compared with $55.7 million at December 29, 2013. Accounts receivable were $265.9 million and inventoried costs were $78.5 million. Total assets were $1.172 billion and stockholders’ equity was $237.1 million.
Total debt, including capital lease obligations and other term debt, was approximately $664.2 million at June 29, 2014, up from $644.7 million at year-end 2013. The company had $41.0 million outstanding under its new revolving credit facility, $9.5 million of letters of credit outstanding, and reported $56.6 million of net borrowing-base availability.
Material changes versus the prior comparable period
- Q2 revenue declined 2.5%, while six-month revenue declined 12.1%.
- KGS revenue decreased 9.7% in Q2 and 17.9% year to date, primarily from delayed defense-product orders and awards, completion of a sizable satellite communications program, and weakness and increased competition in legacy government services.
- PSS revenue increased 23.0% in Q2 and 10.0% year to date, largely due to a $13.0 million communication-equipment sale. The sale carried a lower margin and reduced PSS profitability.
- Q2 gross margin fell to 24.6% from 25.7%; six-month gross margin declined modestly to 25.4% from 25.7%. Product margins were affected by contract costs for retrofits and design changes on certain aerial-target platforms, as well as unfavorable product mix.
- SG&A declined to $44.9 million in Q2 and $88.3 million year to date, mainly because of lower intangible-amortization expense and cost-reduction actions. Excluding amortization, SG&A as a percentage of revenue increased.
- Research and development expense increased to $5.9 million in Q2 and $11.1 million year to date as the company invested in electronic products, unmanned systems, and satellite communications programs.
- Operating cash flow from continuing operations changed from $8.4 million provided in the first six months of 2013 to $10.3 million used in the first six months of 2014, reflecting lower operating income and working-capital usage. Days sales outstanding increased from 103 to 106 days.
- Discontinued operations produced a $0.2 million loss year to date in 2014 versus a $4.4 million loss in 2013; no discontinued-operation revenue was reported in 2014.
Debt refinancing, liquidity, outlook, and risks
- In May 2014, Kratos refinanced its $625.0 million 10% senior secured notes due 2017 with $625.0 million of 7% senior secured notes due 2019. Net proceeds were $618.5 million after original-issue discount; debt issuance costs were approximately $8.4 million.
- The refinancing required a $31.2 million early termination fee and other write-offs and costs, resulting in the $39.1 million loss on extinguishment of debt. The lower coupon should reduce ongoing interest expense, although the company remains highly leveraged.
- The new five-year revolving credit facility has a maximum commitment of $110.0 million, potentially expandable to $135.0 million with lender approval. It includes a $50.0 million letter-of-credit subline and a $10.0 million swingline.
- Management stated that cash on hand, expected operating cash flow, and availability under the credit facility should fund anticipated working-capital and other cash needs for at least the next 12 months. This assessment is subject to operating performance, customer funding, covenant compliance, and access to borrowing capacity.
- Management described the defense-industry outlook as better than previously expected following legislation addressing the debt limit and sequestration-related spending. However, it continued to expect lower or delayed awards on some programs, with potential negative effects on revenue, earnings, and cash flow.
- Backlog was approximately $1.0 billion at both comparison dates, including approximately $557.0 million funded at June 29, 2014. Backlog timing is uncertain, and U.S. government contracts may generally be terminated for convenience.
- Key risks include federal budget reductions and delayed appropriations, contract cancellations or rescheduling, dependence on U.S. government customers, debt leverage and financial covenants, acquisition integration, cybersecurity threats, competition, contract-estimate changes, and DCAA audits or government cost claims.
- The Department of Justice was investigating whether a subsidiary overstated labor and material costs on a pre-acquisition Department of Defense contract. Kratos stated that it had accrued an amount considered immaterial, but unfavorable resolution could exceed current accruals and materially affect a future period.
- Management concluded that disclosure controls and procedures were effective as of June 29, 2014, and reported no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether delayed defense awards and lower KGS revenue persisted in subsequent quarters.
- Actual cash generation, receivables collections, inventory levels, and days sales outstanding relative to the company’s liquidity expectations.
- Revolving-credit availability, borrowing-base calculations, interest costs, and compliance with the 7% notes and credit-facility covenants.
- Whether aerial-target design and retrofit issues caused additional costs, margin pressure, or contract-estimate adjustments.
- Status and potential exposure of the DCAA and Department of Justice investigations and other government contract claims.
- Conversion of the approximately $1.0 billion backlog into funded orders and recognized revenue, including any cancellations or scope changes.
- Impact of the debt refinancing on recurring interest expense and the company’s ability to reduce leverage.