Kratos Defense & Security Solutions, Inc. — Q3 2022 Form 10-Q
Reporting period: Three and nine months ended September 25, 2022, compared with September 26, 2021. Fiscal periods were 13 and 39 weeks, respectively. The financial statements are unaudited.
Business context
Kratos is a government contractor focused on unmanned systems, space and satellite communications, microwave electronics, cybersecurity, rocket and hypersonic systems, missile defense, turbine technologies, C5ISR, and training solutions. Operations are reported through Kratos Government Solutions (KGS) and Unmanned Systems (US). U.S. Government revenue represented 69% of third-quarter revenue and 70% of nine-month revenue.
Key financial metrics
| Metric | Q3 2022 | Q3 2021 | 9M 2022 | 9M 2021 |
|---|---|---|---|---|
| Total revenue | $228.6 million | $200.6 million | $649.0 million | $599.9 million |
| Gross profit | $54.9 million | $60.6 million | $164.6 million | $163.6 million |
| Gross margin | 24.0% | 30.2% | 25.4% | 27.3% |
| Operating income (loss) | $(3.6) million | $10.5 million | $(6.7) million | $18.7 million |
| Net income (loss) attributable to Kratos | $(8.0) million | $(2.4) million | $(28.6) million | $0.6 million |
| Loss per diluted share | $(0.06) | $(0.02) | $(0.23) | — |
| Operating cash flow from continuing operations | Not separately provided | Not separately provided | $(32.3) million | $34.6 million |
- Service revenue increased 71.7% in Q3 and 41.0% for the nine-month period, while product sales declined 6.0% and 4.5%, respectively.
- SG&A was $48.5 million in Q3 and $136.3 million for nine months, representing 21.2% and 21.0% of revenue, respectively.
- Research and development expense was $9.6 million in Q3 and $28.0 million for nine months.
- Cash and cash equivalents were $125.2 million at September 25, 2022, down from $349.4 million at December 26, 2021.
- Total debt principal was $298.7 million, consisting of $198.7 million under Term Loan A and $100.0 million under the revolving facility. The company had $100.0 million of revolver capacity remaining, less $8.0 million of outstanding letters of credit.
- The company was in compliance with its credit facility covenants at September 25, 2022.
- Total backlog was approximately $1.0689 billion, including $696.1 million of funded backlog, compared with $839.1 million and $618.0 million, respectively, at September 26, 2021.
Material changes versus the prior comparable period
- Revenue increased 14.0% in Q3 and 8.2% for the nine-month period, primarily from KGS growth and contributions from the Cosmic, CTT, and Southern Research Engineering acquisitions.
- KGS revenue increased 28.2% in Q3 and 16.0% for nine months. US revenue declined 18.4% and 10.4%, respectively, mainly because of tactical drone program timing and lower production activity.
- Gross margin contracted because of unfavorable revenue mix, inflation and supply-chain effects, and labor shortages. KGS also recorded approximately $4.5 million of third-quarter cost impacts from non-recoverable labor and indirect-rate costs.
- Operating results included $6.4 million of nine-month restructuring and other expenses, primarily a $5.5 million litigation settlement charge related to an international customer dispute.
- The company refinanced its prior $300 million, 6.5% senior secured notes with a new five-year $200 million Term Loan A and $200 million revolving facility. The refinancing generated a $13.0 million loss on extinguishment of debt but reduced interest expense.
- Acquisition spending totaled $132.2 million in the first nine months, while capital expenditures totaled $34.8 million. Operating cash flow was negatively affected by higher unbilled receivables, inventory purchases, prepaid expenses, and other working-capital needs.
Outlook, risks, contingencies, and unusual items
- Management expects to recognize approximately 20% of remaining performance obligations in fiscal 2022, 39% in fiscal 2023, and the balance thereafter. The filing does not provide formal revenue or earnings guidance.
- Management expects fiscal 2022 capital expenditures to remain significant, including approximately $25 million to $28 million in the US business and approximately $18 million to $20 million for capital aerial targets and related support equipment.
- Management states that cash on hand, available credit, and expected operating cash flow should fund anticipated needs for at least the next 12 months, but warns that deteriorating industry conditions, customer cancellations or delays, insufficient revenue growth, or covenant issues could reduce liquidity.
- Key operating pressures include supply-chain disruptions, inflation, higher labor costs, difficulty hiring and retaining cleared technical personnel, rising interest rates, and continuing COVID-19 effects.
- Defense budget uncertainty, continuing resolutions, potential government shutdowns, debt-ceiling issues, changes in Ukraine-related funding, contract delays or cancellations, bid protests, subcontractor performance, cybersecurity incidents, and regulatory or litigation outcomes could materially affect results.
- Approximately $4.8 million of unbilled receivables remains subject to negotiation following termination for convenience of a large training solutions program. A $6.0 million partial settlement was collected in July 2022.
- A remaining $5.6 million inventory carrying value related to a settled international customer dispute was expected to be settled by year-end 2022. The company paid approximately $3.7 million under the settlement during Q3.
- Government contract audits by the Defense Contract Audit Agency may result in disputed or disallowed costs; the company has not recorded a liability because potential losses cannot reasonably be estimated.
Investor verification points
- Verify whether backlog conversion, program awards, and funded backlog support management’s expected revenue recognition schedule.
- Assess whether labor shortages, supplier delays, inflation, and indirect-rate growth continue to pressure gross margins, particularly in KGS.
- Monitor operating cash flow, inventory growth, unbilled receivables, and cash conversion following the nine-month $32.3 million operating cash outflow.
- Review leverage, floating-rate exposure, required Term Loan A amortization, revolver availability, and compliance with credit facility covenants.
- Track integration and profitability of the Cosmic, CTT, and SRE acquisitions and the related goodwill and intangible-asset balances.
- Follow resolution of the remaining training-program receivable, DCAA audits, legal contingencies, and the remaining minority-interest purchase obligations.