Business Context and Reporting Period
Kratos Defense & Security Solutions, Inc. filed an unaudited Form 10-Q for the quarter and six months ended June 24, 2012, with comparative periods ended June 26, 2011. Kratos provides national security technology, defense electronics, C5ISR, cybersecurity, satellite, unmanned systems, weapons, and public safety solutions through its Kratos Government Solutions (KGS) and Public Safety & Security (PSS) segments.
Key Financial Metrics
| Metric | Three Months Ended June 24, 2012 | Six Months Ended June 24, 2012 |
|---|---|---|
| Total revenue | $219.8 million | $429.3 million |
| Gross profit | $57.7 million | $115.1 million |
| Gross margin | 26.3% | 26.8% |
| Operating income | $7.4 million | $16.5 million |
| Loss from continuing operations | $14.9 million | $17.4 million |
| Net loss | $17.2 million | $20.2 million |
| Net loss per share | $0.41 | $0.54 |
- Six-month revenue consisted of $214.2 million of service revenue and $215.1 million of product sales. KGS revenue was $344.7 million and PSS revenue was $84.6 million.
- Six-month operating cash flow from continuing operations was $9.8 million, compared with cash used of $10.1 million in the prior-year period. Capital expenditures were $6.2 million.
- Cash and cash equivalents increased to $145.7 million at June 24, 2012, from $69.6 million at December 25, 2011. Total assets were $1.299 billion and stockholders’ equity was $391.5 million.
- Total debt, including the unamortized note premium and other debt, was approximately $653.1 million at quarter-end. The company had $625.0 million principal amount of 10% Senior Secured Notes due 2017 and $6.2 million outstanding under a Herley term loan.
- The $110.0 million revolving facility had no borrowings at quarter-end, $12.3 million of outstanding letters of credit, and approximately $85.0 million of net borrowing-base availability. Management stated that liquidity should be sufficient for at least the next 12 months.
- Backlog was approximately $1.1 billion, including $546.0 million of funded backlog, compared with approximately $932 million total backlog and $383 million funded backlog at June 26, 2011.
Material Changes Versus the Prior Comparable Period
- Second-quarter revenue increased 28.5% from $171.1 million to $219.8 million; six-month revenue increased 46.1% from $293.9 million to $429.3 million. Growth was driven principally by the acquisitions of Integral Systems, SecureInfo, Herley, and the Critical Infrastructure Business.
- Second-quarter operating income declined from $8.7 million to $7.4 million despite higher revenue, reflecting increased interest, research and development, and acquisition-related expenses, as well as pressure in legacy government services. Six-month operating income increased from $10.1 million to $16.5 million.
- Second-quarter gross margin decreased slightly from 26.5% to 26.3%. Six-month gross margin improved from 24.8% to 26.8%, primarily because acquired product businesses generated higher margins.
- Interest expense increased to $16.2 million in the second quarter and $32.3 million for the six months, primarily because of debt issued to finance the Herley and Integral acquisitions.
- SG&A increased to $42.6 million in the second quarter and $86.4 million for the six months. Research and development expense increased to $4.8 million and $8.4 million, respectively.
- The company sold 20.0 million common shares for $100.0 million gross proceeds, or approximately $97.0 million net proceeds. Shares outstanding increased from 32.4 million at December 25, 2011 to 52.5 million at June 24, 2012, creating substantial dilution.
Guidance, Outlook, Risks, and Unusual Items
- No formal revenue or earnings guidance is provided. Management expects cash on hand, operating cash flow, and revolver availability to fund anticipated needs for at least the next 12 months.
- On July 2, 2012, after quarter-end, Kratos completed the approximately $161.3 million acquisition of Composite Engineering, Inc. (CEI), funded with approximately $97.0 million of equity proceeds and $40.0 million of revolver borrowings. CEI results will be included beginning in the third quarter; acquisition accounting was incomplete at the filing date.
- Following the CEI acquisition, $25.0 million remained outstanding on the revolver as of August 1, 2012.
- Kratos classified certain non-core Integral businesses as held for sale in June 2012. Discontinued operations generated a $2.8 million six-month loss, including a $1.5 million goodwill impairment charge.
- The KGS reporting unit’s estimated fair value exceeded carrying value by only 7.4%. Management warned that further deterioration in defense spending or market conditions could result in additional goodwill impairment.
- U.S. Government revenue represented approximately 64% of second-quarter revenue and 65% of six-month revenue. The Budget Control Act and potential sequestration could reduce defense procurement, delay contracts, or increase cancellations.
- Potential future DEI contingent consideration was estimated at $2.0 million to $4.5 million, subject to reductions if anticipated cash receipts are not collected. The working-capital adjustment for the Critical Infrastructure Business remained unresolved.
- Other risks include high leverage, covenant compliance, contract timing and estimates, customer concentration, acquisitions and integration, cybersecurity incidents, competition, litigation and indemnification obligations related to former Integral officers.
- Management reported that the company was in compliance with its debt covenants at June 24, 2012, and that disclosure controls were effective at the reasonable-assurance level.
Investor Verification Points
- Verify the final accounting, goodwill, intangible assets, and tax treatment for the CEI acquisition and its effect on third-quarter leverage and results.
- Monitor revolver borrowings, liquidity, interest expense, and compliance with the 10% Senior Secured Notes and revolving-credit covenants.
- Assess the impact of sequestration, defense-budget reductions, contract delays, cancellations, and government insourcing on revenue and margins.
- Reconcile reported backlog with funded backlog and evaluate the timing, funding, and cancellation risk of unfunded awards.
- Track potential goodwill impairment in KGS and the outcome of the planned sale of the non-core Integral businesses.
- Evaluate dilution from the May equity offering, CEI shares issued, and other equity-linked awards.