KRATOS DEFENSE & SECURITY SOLUTIONS, INC. annual report, FY2023

Kratos Defense & Security Solutions, Inc. — FY2023 Form 10-K Summary

Business context and reporting period

Kratos is a defense, national security and technology company focused on unmanned systems, space and satellite communications, microwave electronics, C5ISR, hypersonic and rocket systems, propulsion, cybersecurity and training solutions. The filing covers the 53-week fiscal year ended December 31, 2023, compared primarily with the 52-week year ended December 25, 2022. Operations are reported through Kratos Government Solutions (KGS) and Unmanned Systems (US).

Approximately 3,900 employees operated across approximately 13 countries.
U.S. Government contracts, including foreign military sales, represented $712.7 million, or 69% of revenue, compared with 69% in 2022.
No individual contract represented more than 6% of 2023 revenue, although the U.S. Air Force represented 22.6% and the U.S. Navy 13.0% of revenue.

Financial performance and liquidity

Metric	FY2023	FY2022	Change
Total revenue	$1,037.1 million	$898.3 million	15.5% increase
Gross profit	$268.6 million	$226.0 million	18.8% increase
Gross margin	25.9%	25.2%	70 basis-point increase
Operating income	$31.1 million	$(2.6) million	Improved by $33.7 million
Income from continuing operations	$2.2 million	$(34.1) million	Improved by $36.3 million
Net income	$2.4 million	$(33.2) million	Improved by $35.6 million
Net loss attributable to Kratos	$(8.9) million	$(36.9) million	Loss narrowed by $28.0 million
Diluted loss per share	$(0.07)	$(0.29)	Improved

KGS revenue increased 21.9% to $824.9 million, driven by the full-year contribution of SRE and growth in space, satellite, training, cyber, C5ISR, turbine technologies and microwave electronics.
US revenue decreased 4.3% to $212.2 million, primarily because of lower tactical-drone revenue, partly offset by $6.4 million from Sierra Technical Services.
Service revenue increased 23.8% to $402.6 million; product sales increased 10.7% to $634.5 million.
KGS operating income rose to $52.7 million from $27.2 million. US operating income improved to $4.2 million from a $2.8 million loss, partly reflecting the absence of the $5.5 million 2022 litigation settlement charge.
SG&A increased to $197.8 million but declined to 19.1% of revenue from 20.3%. R&D was $38.4 million, or 3.7% of revenue, versus $38.6 million, or 4.3%, in 2022.
Net interest expense increased to $20.5 million from $17.7 million because of higher interest rates. The 2022 results included a $13.0 million loss on extinguishment of debt that did not recur in 2023.
Cash provided by operating activities from continuing operations was $65.2 million, compared with $25.6 million used in 2022. Capital expenditures were $52.4 million, producing cash used in investing activities of $43.8 million.
Cash and cash equivalents were $72.8 million at year-end, down from $81.3 million. Approximately $44.1 million was held by foreign subsidiaries and was considered permanently invested.
Total debt was $227.5 million, including $192.5 million under Term Loan A and $35.0 million under the revolving facility. The company reported $165.0 million of remaining revolver capacity, before approximately $10.2 million of outstanding letters of credit.
The company was in compliance with its credit agreement covenants at December 31, 2023. A SOFR interest-rate swap with an initial notional amount of $195.0 million was entered into in 2023 and runs through May 2026.

Material changes versus the prior comparable period

Revenue growth and improved mix drove a return to operating profitability and positive continuing-operations income.
Gross margin improved because of a more favorable mix, including stronger product margins; service margins declined to 24.7% from 26.5%.
Operating cash flow improved by $90.8 million, supported partly by a $28.4 million increase in billings in excess of costs and earnings.
Inventory increased to $156.2 million from $125.5 million, reflecting supply-chain mitigation and production requirements. Unbilled receivables declined to $200.4 million from $222.8 million.
Debt declined by $30.0 million, although interest expense increased because the debt carries floating-rate exposure.
The company acquired Sierra Technical Services in October 2023, issuing 866,026 shares valued at $12.8 million and recording $10.9 million of goodwill. Up to an additional 979,038 shares may be issued under holdback and earn-out provisions.
Backlog increased to approximately $1.244 billion from $1.112 billion. Management expects to recognize approximately 65% in 2024 and an additional 14% in 2025.

Guidance, outlook, commentary, risks and unusual items

The filing does not provide formal revenue or earnings guidance. Management expects 2024 capital expenditures of approximately $28 million to $32 million, including approximately $18 million to $22 million for capital aerial targets and related support equipment.
Management believes the business is aligned with defense priorities including unmanned systems, space, hypersonics, missile defense, propulsion, electronic warfare and C5ISR, and expects margin opportunities as development programs transition to production programs.
Defense spending remains exposed to continuing resolutions, delayed appropriations, potential government shutdowns, debt-ceiling and budget debates, changing priorities, and funding related to conflicts in Israel and Ukraine.
Inflation, supply-chain disruption, shortages of qualified labor and employees holding security clearances have increased costs and pressured execution, margins and forecasts. Higher interest rates also increased borrowing costs.
Approximately 70% of revenue came from fixed-price contracts. These contracts offer margin upside but expose Kratos to cost overruns, inflation, technical problems and supplier delays.
At December 31, 2023, the company had $4.8 million of unbilled receivables related to a 2019 customer termination-for-convenience matter that remains subject to negotiation and settlement.
Government audits of incurred costs and accounting practices remain a contingency. The company has submitted incurred-cost claims through fiscal 2022, but certain audits remain in process and potential adjustments cannot be clearly estimated.
Goodwill was $569.1 million, approximately 35% of total assets. Future impairment risk depends on forecasts for revenue, cash flow, government funding, unmanned-system awards and market valuation assumptions.
The company reported no known cybersecurity incident that materially affected its business, but identified cybersecurity, classified-information protection and future DoD CMMC compliance as significant risks.
The company does not expect to pay cash dividends or repurchase shares in the foreseeable future, and its credit agreement restricts dividends and buybacks.
Internal control over financial reporting was assessed as effective, and Deloitte & Touche issued an unqualified opinion. Critical audit matters included fixed-price contract cost estimates and goodwill impairment analysis.

Important facts for investors to verify

Whether backlog converts into revenue as projected, particularly the expected 65% recognition in 2024, and whether cancellations, funding delays or scope changes reduce realization.
The sustainability of KGS growth and whether US segment growth accelerates through tactical-drone, target-drone and other unmanned-system awards.
Future gross and operating margins as development programs transition to production and as labor, materials and subcontractor costs evolve.
Cash conversion, inventory growth, unbilled receivables, customer advances and the $4.8 million termination-for-convenience receivable.
Debt-service requirements, floating-rate exposure, covenant compliance and the $200.0 million Term Loan A maturity balance scheduled for 2027.
Results of DCAA and other government audits, including potential cost disallowances, refunds or billing-rate adjustments.
Goodwill impairment sensitivity, particularly for the US reporting unit and assumptions regarding future unmanned-aircraft awards.
Implementation costs and contract eligibility implications of final DoD CMMC requirements.
Potential additional share issuance related to the STS earn-out and the redeemable noncontrolling interest in KTT Core, estimated at $22.5 million at year-end.