KRATOS DEFENSE & SECURITY SOLUTIONS, INC. quarterly report, Q1 FY2013

Kratos Defense & Security Solutions, Inc. — Q1 2013 Form 10-Q Summary

Business context and reporting period

Kratos provides mission-critical defense, national security, cybersecurity, unmanned systems, electronic warfare, satellite communications, engineering, systems integration, and public safety solutions. Operations are reported through Kratos Government Solutions (KGS) and Public Safety & Security (PSS). The unaudited filing covers the 13 weeks ended March 31, 2013, compared with the 13 weeks ended March 25, 2012. The March 31, 2013 balance sheet is compared with December 30, 2012.

Key financial metrics

Metric	Q1 2013	Q1 2012	Change
Total revenue	$252.8 million	$209.5 million	20.7% increase
Service revenue	$115.5 million	$102.1 million	13.1% increase
Product sales	$137.3 million	$107.4 million	27.8% increase
Gross profit	$65.7 million	$57.8 million	13.7% increase
Gross margin	26.0%	27.6%	160 basis-point decline
Operating income	$11.5 million	$9.1 million	26.4% increase
Net loss	$10.3 million	$3.0 million	Loss increased
Loss from continuing operations	$8.2 million	$2.5 million	Loss increased
Basic and diluted loss per share	$0.18	$0.09	Loss per share increased
Operating cash flow from continuing operations	$5.1 million	$25.0 million	Decline of $19.9 million

Revenue growth included $25.9 million contributed by the Composite Engineering, Inc. acquisition, organic growth in satellite communications, specialized ground equipment, cybersecurity, and PSS transit programs. U.S. Government revenue was $160.7 million, or 64% of total revenue, compared with $140.9 million, or 67%, in the prior-year quarter.

Product margins declined to 28.0% from 33.1%, primarily because of a higher mix of lower-margin specialized ground equipment. Service margins improved to 23.6% from 21.8%. SG&A increased to $49.2 million from $44.2 million but declined as a percentage of revenue to 19.5% from 21.1%. Research and development expense increased to $4.9 million from $3.6 million.

Interest expense was $16.2 million. The company recorded a $2.8 million income tax provision despite a $5.4 million pretax loss, compared with a $4.1 million tax benefit in the prior-year quarter. Discontinued operations generated a $2.1 million loss, including a $1.2 million impairment charge related to businesses held for sale.

Balance sheet, debt, and liquidity

Cash and cash equivalents were $51.6 million at March 31, 2013, up from $49.0 million at December 30, 2012. Restricted cash was $5.3 million.
Accounts receivable increased to $281.8 million from $271.9 million; inventoried costs declined to $88.2 million from $94.3 million.
Total assets were $1.271 billion and stockholders’ equity was $315.6 million at quarter-end.
Total debt, including premiums and capital lease obligations as described by management, was approximately $648.9 million, compared with $650.3 million at December 30, 2012.
The company had $625.0 million principal amount of 10% Senior Secured Notes due 2017. The carrying amount of total long-term debt, including premium, was approximately $648.2 million at March 31, 2013.
The revolving credit facility had no outstanding borrowings, $14.1 million of outstanding letters of credit, and $91.7 million of net borrowing-base availability.
Cash flow from continuing operations was $5.1 million. Investing activities used $1.9 million, including $3.3 million of capital expenditures and $1.2 million of net acquisition-related cash proceeds. Financing activities used $0.5 million.
Management stated that cash on hand, operating cash flows, and available revolver capacity should be sufficient for at least the next 12 months.

Material changes versus the prior comparable period

Revenue increased 20.7%, led by KGS growth of $33.3 million and PSS growth of $10.0 million.
Gross margin contracted because of product mix, despite higher gross profit and improved service margins.
Operating income improved, but net loss worsened because interest expense, tax expense, other expense, and discontinued-operation losses offset operating gains.
Operating cash flow declined substantially, principally reflecting unfavorable working-capital changes, including accounts receivable and accounts payable movements.
CEI contributed $25.9 million of revenue and a $3.2 million operating loss in the quarter. Its acquisition increased reported revenue, expenses, amortization, and capital expenditures.
Backlog increased to approximately $1.2 billion from $1.1 billion. Approximately $604.0 million was funded in 2013 compared with $500.0 million in 2012.
The company paid the $2.1 million of DEI contingent acquisition consideration in April 2013.

Outlook, risks, contingencies, and unusual items

Management expected reduced fiscal 2013 defense budget levels and sequestration to result in lower awards on some programs, with potential subsequent effects on revenue, earnings, and cash flow. The filing does not provide formal quantitative revenue or earnings guidance. Management believes mission-critical modernization, maintenance, unmanned systems, cybersecurity, ballistic missile defense, satellite communications, and related national security priorities may support demand, but stated that the effects of sequestration and future federal budget decisions remain uncertain.

Approximately 64% of quarterly revenue came from the U.S. Government, creating exposure to appropriations, sequestration, continuing resolutions, contract delays, cancellations, and payment timing.
The $625.0 million senior secured notes carry a 10% stated interest rate and mature in 2017, creating significant leverage and recurring interest burden.
The company was in compliance with the senior notes, revolver, and Herley term-loan covenants at March 31, 2013. Management warned that adverse operating conditions could impair covenant compliance and liquidity.
DCAA audits are examining potential disallowed or disputed costs, and the Department of Justice is investigating a subsidiary under the False Claims Act regarding allegedly overstated labor and material costs on a pre-acquisition Department of Defense contract. The company has accrued an amount it considers immaterial, but unfavorable outcomes could exceed current accruals and materially affect results or cash flow.
The company continues to advance certain indemnifiable costs related to former Integral officers in an SEC-related matter. The filing states that the insurance policy limits were exhausted in December 2011.
CEI purchase-accounting valuations remained provisional, including certain assets, liabilities, contingent liabilities, and deferred taxes. Final adjustments could affect goodwill and reported results.
Goodwill totaled approximately $596.4 million, with accumulated impairment losses of $247.4 million. The KGS reporting unit exceeded carrying value by only 7.4% in the earlier impairment analysis, indicating sensitivity to defense-market valuations and operating assumptions.
Discontinued operations remain subject to sale-related valuation risk; the company recorded a $1.2 million impairment charge in Q1 2013.
The company adopted new comprehensive-income disclosure requirements without material impact. Disclosure requirements concerning offsetting arrangements were scheduled for adoption in fiscal 2014 and were not expected to have a material impact.

Important facts for investors to verify

Whether sequestration, federal appropriations, and continuing-resolution delays reduce funded backlog conversion, new awards, or operating cash flow.
Whether CEI and other acquired businesses achieve expected profitability and whether provisional purchase-accounting amounts change.
Whether product mix continues to pressure gross margin, particularly in specialized ground equipment and other lower-margin products.
Whether working-capital requirements, accounts receivable collection, and inventory levels constrain cash generation.
Debt maturity, 10% note interest requirements, revolver borrowing-base availability, and ongoing covenant compliance.
Potential exposure from DCAA audits, the False Claims Act investigation, Integral indemnification obligations, warranties, and other litigation.
The recoverability of significant goodwill and intangible assets if defense-market valuations or operating forecasts deteriorate.
The timing and proceeds from the remaining discontinued-business disposition and the effect of related impairment charges.