KRATOS DEFENSE & SECURITY SOLUTIONS, INC. quarterly report, Q2 FY2018

Kratos Defense & Security Solutions, Inc. — 2Q18 Form 10-Q Summary

Reporting period: Quarterly and year-to-date periods ended July 1, 2018; comparable periods ended June 25, 2017. Results are unaudited and reflect the sale of the Public Safety & Security business as discontinued operations. Kratos operates through Kratos Government Solutions and Unmanned Systems, serving primarily U.S. and allied national-security customers.

Financial performance and position

Metric	Three months ended July 1, 2018	Three months ended June 25, 2017	Six months ended July 1, 2018	Six months ended June 25, 2017
Total revenue	$151.2 million	$147.9 million	$294.2 million	$279.9 million
Gross profit	$39.3 million	$37.5 million	$80.1 million	$73.6 million
Gross margin	26.0%	25.4%	27.2%	26.3%
Operating income from continuing operations	$2.6 million	$1.5 million	$9.6 million	$2.9 million
Loss from continuing operations	$3.8 million	$6.9 million	$2.5 million	$17.0 million
Net loss	$7.7 million	$6.2 million	$9.9 million	$16.2 million
Net loss per share	$0.07	$0.07	$0.10	$0.20

Second-quarter revenue increased 2.2%; six-month revenue increased 5.1%.
Product sales increased 10.7% in the quarter and 13.7% year to date, while service revenue declined 12.6% and 9.7%, respectively.
Unmanned Systems revenue increased 60.4% in the quarter and 67.7% year to date, partially offsetting declines in Kratos Government Solutions.
SG&A declined to $30.1 million in the quarter and $59.9 million year to date, compared with $31.9 million and $61.9 million, respectively, in the prior-year periods. R&D also declined.
Operating results included $3.0 million of second-quarter restructuring and other expense, primarily a $2.3 million pending legal settlement, approximately $0.5 million of related legal fees, and $0.2 million of employee termination costs.

Cash flow, liquidity and debt

Cash and cash equivalents were $182.8 million at July 1, 2018, versus $130.5 million at December 31, 2017. Including restricted cash, ending cash was $183.1 million.
Continuing-operations operating cash flow was $1.4 million for the six months, compared with an operating cash outflow of $16.3 million in the prior-year period.
Continuing-operations investing cash flow was $56.9 million, including approximately $67.9 million of net proceeds from the Public Safety & Security divestiture, partially offset by $11.0 million of capital expenditures.
Capital expenditures are expected to be approximately $23 million to $26 million for fiscal 2018, including $14 million to $17 million for unmanned aerial systems. The company also expects $7 million to $10 million of remaining non-capital internal product-development spending related to the LCASD program.
Total debt carrying value was $294.1 million, consisting primarily of $300.0 million of 6.5% senior secured notes due 2025 and a $0.3 million Israeli term loan. The former 7% notes due 2019 were fully extinguished in 2017.
No borrowings were outstanding under the $90 million revolving credit facility; $9.3 million of letters of credit were outstanding, leaving reported net borrowing-base availability of $57.1 million. The company reported compliance with its debt covenants.
Management stated that cash on hand, available credit and expected operating cash flow should be sufficient for anticipated needs for at least the next 12 months.

Material changes versus the prior comparable period

ASC 606 revenue guidance was adopted on January 1, 2018 using the modified-retrospective method. The adoption reduced opening equity by $0.2 million and increased reported revenue by $3.6 million in the quarter and $11.2 million year to date, with corresponding cost-of-revenue effects.
The company completed the sale of Public Safety & Security on June 11, 2018 for a stated purchase price of $69 million in cash. Expected net cash proceeds were approximately $70 million, including approximately $7 million of net working capital expected to be collected by year-end. The business is presented as discontinued operations for all periods.
Discontinued operations generated a loss of $3.9 million in the quarter and $7.4 million year to date, compared with income of $0.7 million and $0.8 million in the prior-year periods. The 2018 losses included transaction expenses of $1.9 million and $2.7 million, respectively, and project cost adjustments.
Backlog or remaining performance obligations were approximately $501.9 million at July 1, 2018, including $451.9 million funded. Management expects to recognize approximately 44% in 2018, an additional 34% by 2020, and the remainder thereafter. ASC 606 reduced reported backlog by approximately $200.2 million; the comparable prior-year backlog under ASC 606 was approximately $542.6 million.
Days sales outstanding increased to 137 days from 116 days at December 31, 2017, primarily because certain billing milestones had not yet been achieved.

Outlook, commentary and risks

Management cited increased defense appropriations under the Bipartisan Budget Act and the FY2018 Omnibus Appropriations Act as supportive of national-security demand, while noting continuing uncertainty regarding federal budgets, appropriations and the debt ceiling.
Growth is focused on proprietary technology, unmanned systems, aerial targets, missile-defense products, space communications, microwave electronics and other designed-in national-security programs.
Key risks include U.S. government spending reductions or delays, continuing resolutions or shutdowns, contract cancellations and bid protests, LPTA-driven pricing pressure, schedule and cost-estimate changes, customer concentration, debt leverage, cybersecurity events, competition, litigation and regulatory or Defense Contract Audit Agency cost claims.
Approximately 70% of second-quarter revenue and 71% of year-to-date revenue came from the U.S. Government, including foreign military sales contracted through the U.S. Government.
The company disclosed a pending $2.3 million legal settlement and approximately $0.5 million of related legal fees concerning a former employee from an acquired business. It also remains subject to DCAA audits and potential claims for disputed or disallowed costs; the filing states that a loss range cannot currently be reasonably estimated for certain matters.
The company maintained a full valuation allowance against most U.S. federal, state and certain foreign deferred tax assets. Tax accounting for the 2017 Tax Cuts and Jobs Act remained incomplete, although no material change to prior provisional amounts was reported.

Investor verification points

Reconcile reported 2018 revenue, backlog and margins with the effects of ASC 606 and distinguish accounting acceleration from underlying demand.
Track execution of the Unmanned Systems growth programs and whether KGS legacy-service declines continue.
Verify collection of the approximately $7 million of retained divestiture working capital and compliance with the debt-indenture requirement to reinvest or otherwise apply asset-sale proceeds within 360 days.
Monitor accounts receivable, unbilled receivables, days sales outstanding and operating cash conversion.
Assess the impact of planned 2018 capital expenditures and LCASD development spending on liquidity.
Review the pending legal settlement, DCAA audits, tax indemnities related to the divestiture and other contingencies.
Confirm continued compliance with the revolving-credit and senior-note covenants, particularly if operating performance or government funding deteriorates.