Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed this unaudited Form 10-Q for the 13-week quarter ended March 30, 2014, compared with the quarter ended March 31, 2013. Kratos provides specialized engineering, manufacturing, systems integration, test and evaluation, cybersecurity, unmanned systems, electronic warfare, satellite communications, missile defense, and public safety solutions. Its principal segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS), with substantial exposure to U.S. Government and Department of Defense spending.
Financial Performance and Position
| Metric | Q1 2013 | Q1 2014 | Change |
|---|---|---|---|
| Total revenue | $252.8 million | $200.1 million | Down $52.7 million, or 20.8% |
| Gross profit | $65.7 million | $52.6 million | Down $13.1 million |
| Gross margin | 26.0% | 26.3% | Up 0.3 percentage points |
| Operating income | $11.5 million | $3.3 million | Down $8.2 million |
| Loss from continuing operations | $(8.2) million | $(14.9) million | Loss increased |
| Net loss | $(10.3) million | $(15.0) million | Loss increased $4.7 million |
| Loss per diluted share | $(0.18) | $(0.26) | Loss increased |
| Operating cash flow from continuing operations | $5.1 million | $1.7 million | Down $3.4 million |
- KGS revenue declined 25.2% to $151.2 million, including a 27.5% decline in product sales and a 20.3% decline in service revenue. PSS revenue declined 3.4% to $48.9 million.
- Product sales represented 49.7% of revenue in Q1 2014 versus 54.3% in Q1 2013. Service margins improved from 23.6% to 26.3%, while product margins declined from 28.0% to 26.2%.
- SG&A declined to $43.4 million from $49.2 million, but increased to 21.7% of revenue from 19.5% because of lower revenue leverage. Research and development increased to $5.2 million from $4.9 million.
- Q1 2014 included $0.7 million of unused office space and restructuring expense, primarily for excess Sacramento facility space and employee termination costs.
- Cash and cash equivalents were $53.6 million at March 30, 2014, compared with $55.7 million at December 29, 2013. Accounts receivable declined to $248.0 million from $265.8 million, while inventoried costs increased to $81.1 million from $74.6 million.
- Total assets were $1.196 billion and stockholders’ equity was $284.1 million at March 30, 2014. Accumulated deficit was $574.5 million.
- Total debt, including the note premium, was reported at approximately $643.3 million, compared with $644.7 million at December 29, 2013. The company had $625.0 million principal amount of 10% Senior Secured Notes due 2017, $4.5 million of an Israeli term loan, and no borrowings under its $110.0 million revolving credit facility. Letters of credit outstanding were $9.2 million, with reported net borrowing-base availability of $65.8 million.
Material Changes Versus the Prior Comparable Period
- Revenue decreased primarily because defense product shipments declined by approximately $39.4 million, a satellite communications program completion was delayed by approximately $5.1 million, and legacy government services declined by approximately $6.5 million.
- Management attributed weaker activity to the continuing resolution, government personnel furloughs, the federal government shutdown, sequestration-related uncertainty, delayed awards, and lower Department of Defense budgets.
- Gross margin improved slightly because of favorable revenue mix and improved KGS service margins. Product margins were pressured by increased costs for retrofits and design changes addressing an issue on certain new aerial target platforms.
- Operating income fell sharply as the revenue decline outweighed cost reductions. SG&A declined in absolute dollars, but represented a larger percentage of sales.
- Discontinued operations generated no revenue and a $0.1 million loss in Q1 2014, compared with $3.6 million of revenue and a $2.1 million loss in Q1 2013.
- Backlog declined to approximately $1.1 billion from $1.2 billion. Funded backlog was $538.0 million in 2014 versus $604.0 million in 2013.
Guidance, Outlook, Risks and Unusual Items
The filing does not provide formal quantitative revenue or earnings guidance. Management stated that the Bipartisan Budget Act, the FY 2015 Department of Defense budget request, and the Quadrennial Defense Review provided a better defense-industry outlook than previously expected, particularly for cybersecurity, unmanned systems, satellite communications, missile defense, and electronic warfare. Nevertheless, management expected some lower or delayed awards, with potential negative effects on revenue, earnings, and cash flow.
- Management believed cash on hand, available revolver capacity, and expected operating cash flow would fund working capital and other needs for at least the next 12 months.
- Days sales outstanding increased from 103 days at year-end 2013 to 113 days at March 30, 2014, partly because delayed equipment deliveries, flight requirements, subcontractor issues, and funding delays postponed billable milestones.
- The company remains highly leveraged and exposed to interest expense, government funding changes, contract delays or cancellations, customer concentration, acquisition integration, competition, cybersecurity incidents, and covenant compliance.
- The Department of Defense may audit contract costs through the Defense Contract Audit Agency. The Department of Justice was investigating whether a subsidiary overstated labor and material costs on a pre-acquisition Department of Defense contract under the False Claims Act. Kratos had accrued an amount it considered immaterial, but stated that an unfavorable resolution could exceed current accruals and materially affect results or cash flows.
- Kratos maintained a full valuation allowance against most U.S. federal, state, and certain foreign deferred tax assets. Unrecognized tax benefits increased by $2.7 million during the quarter, offset by an equal increase in the valuation allowance.
- The company reported compliance with the Senior Secured Notes, revolver, and Israeli term-loan covenants as of March 30, 2014. The notes became redeemable on or after June 1, 2014, subject to specified premiums.
Important Facts for Investors to Verify
- Whether delayed government awards and satellite communications milestones recover, and whether the $1.1 billion backlog converts to revenue on the expected schedule.
- The liquidity impact of elevated receivable days, delayed billings, increased inventory, and only $1.7 million of quarterly operating cash flow.
- The company’s ability to service approximately $643 million of debt while continuing to report net losses.
- The financial exposure and potential penalties from the DOJ and DCAA contract-cost investigations.
- Whether aerial target retrofit and design costs are contained or lead to further margin reductions.
- The impact of defense-budget decisions, sequestration, continuing resolutions, procurement changes, and customer concentration on future revenue and cash flow.