Kratos Defense & Security Solutions, Inc. — Q2 2017 Form 10-Q Summary
Business context and reporting period
Kratos is a technology and intellectual-property-focused government contractor serving U.S. and allied national-security markets, including unmanned systems, satellite communications, microwave electronics, cyber security, missile defense, training systems, and public safety and security. The filing covers the unaudited three and six months ended June 25, 2017, compared with the corresponding periods ended June 26, 2016.
The company operates through Kratos Government Solutions (KGS), Public Safety & Security (PSS), and Unmanned Systems (US). Approximately 60% of second-quarter revenue and 59% of year-to-date revenue came from the U.S. Government.
Financial performance and key metrics
| Metric | Three months ended June 25, 2017 | Three months ended June 26, 2016 | Six months ended June 25, 2017 | Six months ended June 26, 2016 |
|---|---|---|---|---|
| Total revenue | $185.7 million | $168.2 million | $353.5 million | $321.2 million |
| Gross profit | $47.4 million | $45.2 million | $92.5 million | $81.1 million |
| Gross margin | 25.5% | 26.9% | 26.2% | 25.2% |
| Operating income (loss) | $2.6 million | Break-even | $4.3 million | $(10.2) million |
| Net loss | $(6.2) million | $(10.4) million | $(16.2) million | $(32.6) million |
| Net loss per share | $(0.07) | $(0.17) | $(0.20) | $(0.55) |
- Second-quarter revenue increased 10.4%; year-to-date revenue increased 10.1%. Product sales grew 17.6% in both comparisons, while service revenue grew 3.9% in the quarter and 3.4% year to date.
- Second-quarter gross margin declined because of less favorable product and service mix. Year-to-date gross margin improved, primarily from a more favorable product mix.
- SG&A was $40.6 million in the quarter and $79.3 million year to date. R&D was $4.1 million and $8.5 million, respectively.
- Interest expense was $7.2 million in the quarter and $15.4 million year to date. Year-to-date results included a $2.1 million loss on extinguishment of debt.
- Segment revenue for the quarter was $125.6 million for KGS, $37.9 million for PSS, and $22.2 million for US. Segment operating income was $5.7 million, $0.5 million, and $(1.8) million, respectively.
Liquidity, cash flow, debt, and balance sheet
- Cash and cash equivalents were $63.3 million at June 25, 2017, down from $69.1 million at December 25, 2016. Current assets were $373.8 million and current liabilities were $187.1 million.
- Operating cash flow from continuing operations was $(11.3) million for the first six months, compared with $(12.4) million in the prior-year period. Investing cash flow was $(11.9) million, including $12.7 million of capital expenditures.
- Financing activities generated $17.8 million, primarily reflecting $81.7 million of common-stock issuance proceeds, partly offset by $64.0 million used to retire debt.
- Total debt carrying value was $370.5 million, down from $432.0 million at year-end 2016. The company had $372.8 million of 7.00% Senior Secured Notes outstanding and $1.3 million under an Israeli term loan.
- The $110.0 million revolving credit facility had no borrowings, $10.1 million of outstanding letters of credit, and reported net borrowing-base availability of $72.4 million. The company reported compliance with its debt covenants and no event of default.
- Stockholders’ equity increased to $347.0 million from $276.4 million, primarily because of the equity offering, despite the year-to-date net loss.
Material changes versus the prior comparable period
- Revenue growth was driven by increased KGS work in training solutions, cyber security, satellite communications, and modular systems; a large PSS transportation-security deployment; and higher US unmanned-aerial-system shipments and development work.
- Operating results improved substantially year to date, benefiting from higher revenue and the absence of the prior-year $7.7 million modular-systems restructuring charge and $1.9 million PSS litigation-settlement charge.
- Second-quarter product margin fell to 24.2% from 26.8%, primarily because of product mix; service margin was broadly stable at 26.9%.
- Backlog declined to approximately $766.5 million from $874.6 million at June 26, 2016. Funded backlog was $543.8 million, compared with $542.3 million in the prior-year period.
- The company issued approximately 11.9 million common shares for $81.9 million of cash during the first six months, increasing shares outstanding to 86.6 million from 73.9 million and creating dilution.
Guidance, outlook, commentary, risks, and unusual items
- Management expects fiscal 2017 capital expenditures of approximately $18.0 million to $23.0 million, primarily for company-owned aerial targets, support equipment, and tooling related to the Valkyrie and Mako platforms.
- Management expects $7.0 million to $10.0 million of fiscal 2017 non-capital internal product-development spending related to the Valkyrie program; approximately $4.9 million had been incurred through June 25, 2017.
- Management stated that cash on hand, expected operating cash flow, and available revolver capacity should fund anticipated working-capital and other cash needs for at least the next 12 months.
- The company entered into long-term leases for a new San Diego headquarters and Colorado Springs facilities. The San Diego lease has a 10-year initial term and initial annual base rent of approximately $0.8 million. Colorado Springs base rent was approximately $1.0 million annually for the existing building and was expected not to exceed approximately $1.9 million annually for the new building, before additional operating costs.
- Key risks include U.S. Government and DoD budget reductions, continuing resolutions or debt-ceiling disruptions, contract cancellations or delays, bid protests, customer concentration, backlog timing and funding, debt leverage and refinancing, cybersecurity incidents, competition, litigation, regulatory audits, and execution of cost-reduction and product-development initiatives.
- DCAA audits may result in disputed or disallowed costs; the filing states that the potential loss range for certain ongoing audits cannot reasonably be estimated and no related liability was recorded.
- The company maintains a full valuation allowance against most U.S. federal, state, and certain foreign deferred tax assets. Prior ownership changes limit use of tax attributes, and future equity offerings or acquisitions could impose additional limitations.
- The company plans to adopt the new revenue-recognition standard on January 1, 2018, using the cumulative-effect method. Management did not expect a material impact on results or cash flows, although revenue timing may accelerate for certain contracts.
Most important facts for investors to verify
- Whether revenue growth and backlog conversion offset the decline in total backlog and the company’s continuing net losses.
- Whether US segment losses improve as Valkyrie, Mako, and other unmanned-systems investments mature.
- Product and segment margins, particularly after the second-quarter mix-driven decline in product margin.
- Cash usage, inventory growth, capital expenditures, and the company’s ability to generate positive operating cash flow without additional equity financing.
- Debt maturity and refinancing plans for the $372.8 million of 7.00% Senior Secured Notes due 2019.
- Compliance with debt covenants and available revolver capacity, including the effect of letters of credit and working-capital needs.
- Potential impacts from U.S. Government appropriations, continuing resolutions, debt-ceiling negotiations, contract audits, litigation, and cybersecurity events.
- The dilution and capital-allocation implications of the 2017 equity offering and the company’s planned facility commitments.