Kratos Defense & Security Solutions, Inc. — Q3 2013 Form 10-Q Summary
Business context and reporting period
Kratos is a security technology and defense contractor serving primarily U.S. national-security agencies. Its two operating segments are Kratos Government Solutions (KGS) and Public Safety & Security (PSS), providing engineering, manufacturing, systems integration, unmanned systems, electronic warfare, cybersecurity, missile defense, communications, and infrastructure-security solutions.
The filing covers the three and nine months ended September 29, 2013, compared with September 30, 2012. The 2013 nine-month period contained 39 weeks versus 40 weeks in the comparable 2012 period. The interim financial statements are unaudited.
Financial performance and position
| Metric | Q3 2013 | Q3 2012 | 9M 2013 | 9M 2012 |
|---|---|---|---|---|
| Total revenue | $226.4 million | $276.3 million | $714.9 million | $705.6 million |
| Gross profit | $52.3 million | $74.1 million | $178.5 million | $189.2 million |
| Gross margin | 23.1% | 26.8% | 25.0% | 26.8% |
| Operating income | $6.1 million | $14.1 million | $26.4 million | $30.6 million |
| Operating margin | 2.7% | 5.1% | 3.7% | 4.3% |
| Net loss | $(9.9) million | $(4.2) million | $(29.8) million | $(24.4) million |
| Net loss per share | $(0.17) | $(0.07) | $(0.52) | $(0.56) |
| Operating cash flow from continuing operations | Not separately provided for the quarter | Not separately provided for the quarter | $11.0 million | $35.1 million |
- Third-quarter revenue declined 18.1%, while nine-month revenue increased 1.3%.
- Service revenue declined 13.4% in Q3 and 1.4% year to date. Product sales declined 22.0% in Q3 but increased 3.9% for the nine months.
- Interest expense was $16.2 million in Q3 and $48.7 million for the nine months. Loss from continuing operations was $9.5 million in Q3 and $25.0 million year to date.
- Discontinued operations generated a $0.4 million loss in Q3 and a $4.8 million loss for the nine months, including a $1.2 million impairment charge recorded in the first quarter.
- At September 29, 2013, cash and cash equivalents were $49.8 million, restricted cash was $5.0 million, and total assets were $1.225 billion. Stockholders’ equity was $301.7 million.
- Total debt, including debt premium and capital lease obligations, was approximately $646.1 million, compared with $650.3 million at December 30, 2012. The company had $625.0 million of 10% Senior Secured Notes due 2017 and $5.0 million outstanding under a term loan acquired with Herley.
- The $110.0 million revolving credit facility had no outstanding borrowings, $15.1 million of letters of credit, and $74.6 million of net borrowing-base availability. Kratos reported compliance with its debt covenants.
- Backlog was approximately $1.1 billion at September 29, 2013, down from $1.3 billion at September 30, 2012. Funded backlog was $543.0 million versus $692.0 million in the prior-year period.
Material changes versus the prior comparable period
- Q3 KGS revenue fell $48.9 million, or 21.9%, to $174.6 million. PSS revenue declined $1.0 million, or 1.9%, to $51.8 million.
- For the nine months, KGS revenue declined 1.3% to $560.8 million, while PSS revenue increased 12.2% to $154.1 million.
- Product gross margin fell to 22.0% in Q3 from 31.1% and to 25.7% for the nine months from 31.2%. The decline primarily reflected increased costs on certain aerial-target contracts, including retrofits related to a design issue, and product mix.
- Service gross margin improved to 24.3% in Q3 from 21.7% and to 24.1% for the nine months from 22.1%.
- SG&A decreased $6.7 million in Q3 but increased as a percentage of revenue to 21.1%. Year-to-date SG&A increased $4.0 million to $144.9 million, partly because of the CEi acquisition and higher information-technology, network-security, and audit costs.
- A $6.8 million reduction in the excess-facility accrual benefited Q3 operating results; the comparable 2012 quarter included a $0.7 million expense. The nine-month 2013 restructuring line was a $5.0 million benefit versus a $2.1 million expense in 2012.
- Operating cash flow declined to $11.0 million from $35.1 million, primarily reflecting lower earnings and working-capital movements. Days sales outstanding increased from 94 days at December 30, 2012 to 108 days at September 29, 2013.
- Investing cash use improved substantially to $9.1 million from $160.9 million because the prior-year period included the $149.4 million cash acquisition outlay for Composite Engineering, Inc. Capital expenditures were $12.2 million versus $12.0 million.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide formal financial guidance. Management expects reduced or delayed fiscal 2013 and 2014 defense funding to result in lower or delayed awards on some programs, with potential adverse effects on revenue, earnings, and cash flow. Management nevertheless believes modernization and maintenance of foundational defense and national-security assets remain priorities and that Kratos is aligned with areas such as unmanned systems, cybersecurity, electronic warfare, missile defense, satellite communications, and space programs.
- Approximately 64% of nine-month 2013 revenue and 63% of Q3 2013 revenue came from the U.S. Government, creating significant exposure to sequestration, continuing resolutions, appropriations delays, contract cancellations, and changes in defense spending.
- Management believes cash on hand, revolver availability, and operating cash flow will fund working-capital and other needs for at least the next 12 months, but warns that weaker operating conditions or customer delays could pressure liquidity and covenant compliance.
- The company remains highly leveraged, with substantial interest obligations and secured debt. The Senior Secured Notes have a 10% stated rate and mature in 2017.
- Government contract costs are subject to Defense Contract Audit Agency review. The Department of Justice is investigating potential False Claims Act issues involving a subsidiary and pre-acquisition contract costs. Kratos has recorded an accrual it considers immaterial, but states that ultimate losses could exceed current accruals and could materially affect results or cash flow.
- Contract accounting depends on estimates of costs, revenue, incentives, penalties, and completion schedules. Changes in estimates can cause cumulative catch-up adjustments to earnings.
- Goodwill was $596.4 million, and accumulated goodwill impairment losses were $247.4 million. The KGS reporting unit had previously experienced significant valuation pressure and an $82.0 million impairment charge in the fourth quarter of 2012.
- The company completed the sale of certain non-core Integral businesses classified as discontinued operations. The SEC-related indemnification matter involving former Integral personnel was described as concluded, while other ordinary-course litigation remained outstanding but was not considered material by management.
- Management concluded that disclosure controls and procedures were effective as of September 29, 2013, with no material change in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether defense appropriations, sequestration, and continuing-resolution effects continue to delay or reduce KGS awards, shipments, and service work.
- Whether the aerial-target design retrofit issue has been fully addressed and whether additional contract-cost overruns or margin charges are possible.
- Whether the $1.1 billion backlog, particularly the $543.0 million funded portion, converts to revenue on the expected schedule and remains commercially executable.
- Whether operating cash flow improves from the $11.0 million year-to-date level and whether DSO remains elevated at 108 days.
- Whether cash, revolver availability, and operating performance remain sufficient to service approximately $646.1 million of debt and maintain covenant compliance.
- The potential exposure from DCAA audits and the Department of Justice False Claims Act investigation, including any required accrual increases or settlements.
- The sustainability of reported results excluding the $6.8 million facility-accrual benefit and other unusual restructuring or acquisition-related items.