Kratos Defense & Security Solutions, Inc. — Q2 2011 Form 10-Q Summary
Business context and reporting period
Kratos is a national security technology company providing engineering, manufacturing, systems integration, cybersecurity, weapons systems support, missile testing and launch services, modeling and simulation, unmanned systems, and public safety and security solutions. The filing covers the unaudited three and six months ended June 26, 2011, compared with the periods ended June 27, 2010. The company operates through Kratos Government Solutions (KGS) and Public Safety & Security (PSS).
Financial performance and position
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Total revenue | $171.1 million | $99.1 million | $293.9 million | $167.8 million |
| Gross profit | $45.4 million | $19.9 million | $72.8 million | $35.2 million |
| Gross margin | 26.5% | 20.1% | 24.8% | 21.0% |
| Operating income | $8.7 million | $4.5 million | $10.1 million | $8.1 million |
| Net income (loss) | $(5.2) million | $10.7 million | $(8.7) million | $10.9 million |
| Diluted EPS | $(0.22) | $0.65 | $(0.38) | $0.66 |
| Interest expense, net | $13.1 million | $5.5 million | $19.8 million | $9.4 million |
- Revenue increased 73% in the quarter and 75% for the six-month period, driven primarily by acquisitions. Product sales rose to 56% of quarterly revenue from 28% in the prior-year quarter; service revenue increased more modestly.
- Six-month operating cash flow from continuing operations was negative $10.1 million versus positive $6.6 million in the prior-year period. Excluding cash-paid merger and acquisition costs of $13.9 million, management reported $3.8 million of operating cash generation.
- Investing cash use was $250.7 million for the six months, including $249.2 million for acquisitions. Financing provided $350.3 million, including $305.0 million of debt issuance and $61.1 million of equity proceeds.
- Cash and cash equivalents were $100.4 million at June 26, 2011, compared with $10.8 million at December 26, 2010. Working capital was $224.1 million versus $66.0 million at year-end.
- Total debt was approximately $518.7 million, including $510.0 million principal amount of 10% senior secured notes due 2017 and $7.2 million of assumed Herley term debt. Long-term debt carried on the balance sheet was $516.3 million, with an estimated fair value of $545.5 million.
- The existing revolving facility had no borrowings and $8.6 million of outstanding letters of credit, leaving $26.4 million of net availability at June 26, 2011. The company reported compliance with its debt covenants.
Material changes versus the prior comparable period
- Herley Industries was acquired in March 2011 for total aggregate consideration of $272.6 million. Herley contributed $51.8 million of second-quarter revenue and $6.5 million of operating income.
- The company’s 2011 results also included contributions from HBE, SCT and DEI, while Gichner contributed a full six months in 2011 compared with only part of the prior-year period.
- KGS revenue increased 59% in both the quarter and six-month period; PSS revenue increased 244% in the quarter and 248% for the six-month period. Segment operating income increased to $9.7 million for KGS and $1.7 million for PSS in the quarter.
- Higher gross margins reflected the acquired businesses and product mix, but SG&A, amortization, acquisition expenses and interest expense increased substantially. Interest expense more than doubled for the six-month period, contributing to the net loss.
- The federal government accounted for 71% of quarterly revenue and 74% of six-month revenue, down from 87% and 86%, respectively, in the comparable 2010 periods.
- Backlog increased to approximately $932 million at June 26, 2011 from $680 million at June 27, 2010. Funded backlog was $383 million versus $252 million.
Guidance, outlook, risks and unusual items
- No formal revenue or earnings guidance is provided. Management stated that cash on hand, operating cash flow and available revolving capacity should fund anticipated needs for at least the next 12 months.
- The prolonged federal continuing resolution delayed contract awards and funding, increased work performed before funding, pressured operating cash flow and increased days sales outstanding from 75 days at year-end, excluding HBE, to 87 days at June 26, 2011.
- On July 27, 2011, after the reporting date, Kratos completed its acquisition of Integral Systems for an estimated $240.1 million, including $37.2 million of assumed debt. The acquisition accounting was incomplete at filing.
- To finance Integral Systems, the company issued $115.0 million of additional 10% senior secured notes and amended its revolving credit facility to $65.0 million, with a maturity date of July 27, 2016 and potential expansion to $100.0 million.
- Acquisition purchase-price allocations for Herley, HBE, SCT and DEI remained provisional and could change, including goodwill, intangible assets, inventory, property and equipment, deferred taxes and potentially reported earnings.
- Future contingent acquisition consideration included potential payments of up to $8.0 million for DEI and $3.5 million for SCT, plus other contractual and indemnification obligations.
- Key risks include substantial leverage, increased interest obligations, covenant compliance, dependence on U.S. government spending and appropriations, contract delays or cancellations, customer concentration, acquisition integration, competition, working-capital requirements and the use of estimates in percentage-of-completion accounting.
- The company maintained a full valuation allowance against most deferred tax assets. Federal NOL utilization is limited under Section 382 following a March 2010 ownership change.
- Management reported effective disclosure controls and no material change in internal control over financial reporting. No material legal proceeding developments were reported.
Important facts for investors to verify
- Whether acquired businesses generate sufficient recurring cash flow to support approximately $519 million of debt and the related interest burden.
- The conversion of the $932 million backlog into funded revenue, including exposure to federal appropriations, contract timing, cancellations and scope changes.
- The final purchase accounting for Herley and Integral Systems, including goodwill, intangible assets, debt, contingent consideration and any resulting earnings adjustments.
- Operating cash flow, accounts receivable collection trends and days sales outstanding after the federal continuing-resolution disruption.
- Compliance with senior-note and revolving-credit covenants following the Integral Systems acquisition and additional debt issuance.
- The extent to which reported margin improvement is sustainable after acquisition integration, product-mix changes and increased corporate expenses.