Kratos Defense & Security Solutions, Inc. — FY2022 Form 10-K
Reporting period: Fiscal year ended December 25, 2022. The filing is an annual Form 10-K, not a standalone fourth-quarter report. Comparisons are primarily with the fiscal year ended December 26, 2021.
Business context
Kratos is a defense, national security and technology company operating through two reportable segments: Kratos Government Solutions (KGS) and Unmanned Systems (US). Its focus areas include unmanned aircraft, space and satellite communications, microwave electronics, cybersecurity, rocket and hypersonic systems, propulsion, C5ISR and training solutions. Approximately 3,600 employees supported operations in approximately 13 countries.
U.S. Government-related contracts, including foreign military sales, represented approximately 69% of 2022 revenue. The U.S. Air Force accounted for 25.3% and the U.S. Navy for 14.2% of total revenue. No individual contract represented more than 6% of 2022 revenue.
Financial performance and key metrics
| Metric | FY2022 | FY2021 | Change |
|---|---|---|---|
| Total revenue | $898.3 million | $811.5 million | 10.7% increase |
| Service revenue | $325.2 million | $219.4 million | 48.2% increase |
| Product sales | $573.1 million | $592.1 million | 3.2% decrease |
| Gross profit | $226.0 million | $225.1 million | 0.4% increase |
| Gross margin | 25.2% | 27.7% | 250 basis-point decline |
| Operating income (loss) | $(2.6) million | $27.9 million | Decline |
| Net income (loss) attributable to Kratos | $(36.9) million | $(2.0) million | Greater loss |
| Diluted loss per share | $(0.29) | $(0.02) | Greater loss |
| Operating cash flow from continuing operations | $(25.6) million | $35.3 million | Decline |
| Capital expenditures | $45.4 million | $46.5 million | Decrease |
KGS revenue increased 16.7% to $676.6 million, primarily from acquisitions and growth in defense, rocket support, turbine technologies, C5ISR, and space, satellite and cyber activities. US revenue decreased 4.4% to $221.7 million, mainly because of the timing of program awards and lower tactical-drone revenue.
KGS operating income declined to $27.2 million from $42.3 million, while US reported an operating loss of $2.8 million versus operating income of $13.2 million. Consolidated results included $6.8 million of restructuring and other expenses, including a $5.5 million litigation settlement charge, and a $13.0 million loss on debt extinguishment.
Service gross margin declined to 26.5% from 28.8%; product gross margin declined to 24.4% from 27.3%. Management attributed margin pressure to unfavorable contract and program mix, lower-margin development work, inflation, supply-chain disruption, and approximately $4.5 million of nonrecoverable costs related to labor and subcontractor hiring difficulties.
Liquidity, debt and balance sheet
- Cash and cash equivalents declined to $81.3 million from $349.4 million.
- Total debt was $257.5 million at year-end, including $197.5 million under Term Loan A and $60.0 million under the revolving facility. Long-term debt, net of issuance costs, was $250.2 million.
- The company reported approximately $140 million of remaining revolver capacity, less approximately $10 million of outstanding letters of credit.
- Debt was refinanced in February 2022 through a five-year $200 million revolving facility and a five-year $200 million Term Loan A. The former $300 million 6.5% senior secured notes were redeemed in March 2022.
- Interest expense was $17.7 million, down from $23.4 million, but borrowings bear floating-rate interest tied to SOFR and remain exposed to rising rates.
- Operating cash flow was negative because of higher receivables and inventory, advance purchases to mitigate supply-chain disruptions, and approximately $16.7 million of internal investments in rocket motors and software.
- Total contractual cash obligations and commitments were $649.5 million, including $257.5 million of debt, $205.7 million of purchase orders, $58.1 million of operating leases and $80.1 million of finance leases.
Backlog, outlook and management commentary
Total backlog increased to approximately $1.112 billion from $953.9 million. Approximately 56% of remaining backlog was expected to be recognized as revenue in 2023, 13% in 2024 and the balance thereafter. Funded backlog was approximately $721.4 million at year-end.
Management expects 2023 capital expenditures to remain significant, including approximately $22 million to $26 million, of which approximately $10 million to $15 million relates to capital aerial targets and support equipment. The filing does not provide formal revenue or earnings guidance.
Management continues to emphasize internally funded research and development, first-to-market technology, unmanned systems, space and satellite communications, propulsion, hypersonics and production programs. The company believes margins may improve as development programs transition to production programs and corporate infrastructure is leveraged across higher revenue.
The filing cites increased U.S. defense spending under the fiscal 2023 appropriations law and strong customer interest in autonomous systems, space, missile defense and other national-security priorities. However, continuing resolutions, appropriations delays, debt-ceiling uncertainty, potential government shutdowns, program cancellations and changing defense priorities could delay or reduce awards.
Material changes and unusual items
- Revenue growth was driven substantially by the acquisitions of Cosmic, CTT and Southern Research Institute’s Engineering Division; 2022 acquisition-related cash payments totaled approximately $132.2 million.
- The Southern Research Engineering Division acquisition was completed in May 2022 for approximately $79.4 million, including $74.4 million in cash and $5.0 million in stock.
- Goodwill increased to $558.2 million from $493.9 million; goodwill represented approximately 36% of total assets. Future impairment remains sensitive to forecasts for unmanned systems, government funding, discount rates and market conditions.
- The company recorded a $5.6 million net increase in its tax valuation allowance and a $1.4 million income-tax provision despite a pretax loss from continuing operations.
- A $5.5 million settlement charge was recorded for a dispute with an international customer in the US segment. Approximately $5.6 million of related assets remained in inventory at year-end.
- Approximately $4.8 million of unbilled receivables remained subject to negotiation following termination for convenience of a large training-solutions program.
- The company had no material weakness in internal control over financial reporting, and the independent auditor issued unqualified opinions. Controls for Cosmic and SRE were excluded from management’s assessment.
Principal risks and contingencies
- High dependence on U.S. Government spending, annual appropriations, foreign military sales and a limited number of major programs and customers.
- Fixed-price contracts represented approximately 71% of revenue, exposing margins to inflation, labor shortages, technical problems, supplier delays and cost overruns.
- Supply-chain constraints, semiconductor shortages, higher material and labor costs, and difficulty recruiting personnel with engineering skills and security clearances adversely affected execution and margins.
- Floating-rate debt, substantial contractual obligations and restrictive credit-agreement covenants create liquidity and refinancing risk.
- Backlog includes funded and unfunded amounts and may be affected by cancellations, protests, scope changes, appropriations delays or government termination-for-convenience rights.
- Goodwill and intangible assets are material and could require impairment if expected growth, program awards or cash flows do not materialize.
- Cybersecurity incidents, classified-program restrictions, CMMC compliance requirements, government audits, procurement investigations, environmental liabilities and product defects could result in penalties, claims or loss of contracts.
Investor verification checklist
- Reconcile the $898.3 million revenue increase with acquisition contributions, organic growth and the decline in US segment revenue.
- Assess whether the margin decline is temporary or reflects a sustained shift toward lower-margin development, fixed-price or services work.
- Monitor operating cash conversion, receivables, inventory and days sales outstanding, which increased to 134 days from 128 days.
- Verify backlog quality, funding status, expected conversion timing and exposure to program cancellations or appropriations delays.
- Review debt maturities, SOFR sensitivity, covenant compliance and the approximately $222.5 million principal payment scheduled for 2027.
- Evaluate acquisition integration, goodwill impairment sensitivity and the performance of Cosmic, SRE and other acquired businesses.
- Track resolution of the $4.8 million training-program receivable, government cost audits and remaining litigation or regulatory contingencies.
- Confirm the company’s ability to recruit cleared technical personnel and satisfy evolving cybersecurity and CMMC requirements.