Kratos Defense & Security Solutions, Inc. — Q3 2021 Form 10-Q
Reporting period: Three and nine months ended September 26, 2021, compared with September 27, 2020. The interim financial statements are unaudited. Kratos operates in two reportable segments: Kratos Government Solutions (KGS) and Unmanned Systems (US).
Financial performance and position
| Metric | Q3 2021 | Q3 2020 | 9M 2021 | 9M 2020 |
|---|---|---|---|---|
| Total revenue | $200.6 million | $202.0 million | $599.9 million | $541.3 million |
| Gross profit | $60.6 million | $57.1 million | $163.6 million | $148.9 million |
| Gross margin | 30.2% | 28.3% | 27.3% | 27.5% |
| Operating income | $10.5 million | $12.7 million | $18.7 million | $20.3 million |
| Income from continuing operations | $(1.1) million | $2.6 million | $2.0 million | $2.2 million |
| Net income attributable to Kratos | $(2.4) million | $2.4 million | $0.6 million | $1.5 million |
| EPS attributable to Kratos | $(0.02) | $0.02 | $0.00 | $0.01 |
- Revenue mix: Q3 product sales increased 10.9% to $149.0 million, while service revenue declined 23.7% to $51.6 million. For the first nine months, product sales increased 24.7% to $433.0 million, while service revenue declined 14.0% to $166.9 million.
- Segment revenue: Q3 KGS revenue declined 6.2% to $139.3 million, while US revenue increased 14.6% to $61.3 million. Nine-month KGS revenue increased 4.6% to $422.4 million and US revenue increased 29.1% to $177.5 million.
- Profitability: Q3 gross margin improved due primarily to a more favorable mix, but operating income declined because SG&A increased 15.2% to $41.8 million. Nine-month gross margin decreased modestly because of lower product margins and a less favorable program mix.
- Taxes and unusual items: Q3 included $5.7 million of income tax expense despite pretax income of $4.6 million. Nine-month income taxes produced a $0.6 million benefit, including a $2.7 million benefit related to stock-based compensation tax effects.
- Cash flow: Nine-month operating cash flow from continuing operations was $34.6 million, compared with $19.1 million in the prior period. Capital expenditures were $33.4 million, and investing cash flow was $(35.1) million. Total cash, cash equivalents and restricted cash declined $11.6 million to $369.9 million.
- Balance sheet: Cash and cash equivalents were $369.9 million, accounts receivable were $85.4 million, unbilled receivables were $189.3 million, and inventoried costs were $90.9 million at September 26, 2021.
- Debt and liquidity: Long-term debt carrying value was $296.5 million, consisting primarily of $300.0 million of 6.5% senior secured notes due 2025. No revolver borrowings were outstanding; $6.6 million of letters of credit reduced net borrowing-base availability to $62.6 million. Management stated that available cash, credit capacity and expected operating cash flow should fund needs for at least the next 12 months.
- Backlog: Total backlog was approximately $839.1 million, including $618.0 million funded, versus $873.1 million total and $579.3 million funded at September 27, 2020. Management expects to recognize approximately 24% of remaining backlog in 2021 and 44% in 2022.
Material changes versus the prior comparable period
- Nine-month revenue increased $58.6 million, or 10.8%, primarily from higher US production activity, ASC Signal contributions, and growth in space and satellite businesses.
- Q3 revenue was essentially flat because increased product sales were offset by lower service revenue, including declines in legacy government services, training, and commercial turbine services.
- Nine-month operating income declined $1.6 million despite higher revenue, reflecting increased SG&A and R&D costs and lower product margins.
- Operating cash flow improved by $15.5 million, while 2020 financing cash flow benefited from $240.4 million of net equity-offering proceeds that were not repeated in 2021.
- Cash decreased modestly from $380.8 million at December 27, 2020, while net contract assets declined to $131.6 million because contract liabilities increased faster than contract assets.
- The company repaid approximately $5.1 million of Israel debt in August 2021, and the approximately $0.5 million 5-D Systems Paycheck Protection Program loan was forgiven in July 2021.
Guidance, outlook, risks and contingencies
- Management highlighted growth opportunities in unmanned systems, space and satellite communications, hypersonic and missile defense, cybersecurity, microwave electronics, and other national-security programs. The filing does not provide formal full-year revenue or earnings guidance.
- Expected 2021 capital expenditures were approximately $30 million to $33 million, including approximately $25 million for capital aerial targets and related support equipment.
- Defense-budget uncertainty, continuing resolutions, debt-ceiling issues and potential government shutdowns could delay, reduce or cancel programs, restrict new starts and affect customer payments.
- COVID-19 continued to affect supply chains, supplier deliveries, travel, customer access, demonstrations, exercises and certain commercial markets. The company stated that the ultimate financial impact could not be reasonably estimated.
- Approximately $8.2 million of unbilled receivables remained outstanding from a government training program terminated for convenience. Kratos also disputed approximately $10.0 million of unbilled receivables with an international US-segment customer; the customer asserted counterclaims. Management recorded no adjustment to previously recognized revenue.
- Kratos remains in a dispute with the buyer of its former Public Safety & Security Solutions business regarding an approximately $8 million closing working-capital adjustment. The resolution will be recorded in a future period.
- DCAA audits may result in claims concerning disallowed, overstated or disputed costs. The company has not recorded a liability for matters where the potential loss cannot be reasonably estimated.
- The company’s principal ongoing risks include dependence on U.S. government spending, contract cancellations or protests, performance and cost-estimation risk, subcontractor and supplier performance, leverage, cybersecurity, acquisitions and integration, competition, product defects, and pandemic-related disruptions.
Investor verification items
- Verify the sustainability of revenue growth in Unmanned Systems and product businesses, given the continuing decline in service revenue.
- Monitor product mix, developmental programs, SG&A and R&D spending for effects on operating margins and earnings conversion.
- Assess collectability and timing of the $189.3 million of unbilled receivables, including the $8.2 million terminated-program balance and $10.0 million customer dispute.
- Review funded backlog conversion, appropriations and the effect of continuing resolutions or government shutdowns on contract timing.
- Evaluate liquidity relative to the $300.0 million notes due 2025, planned capital expenditures and potential obligations related to the redeemable noncontrolling interest in FTT.
- Track the outcomes of the PSS working-capital dispute, DCAA audits and other legal or regulatory contingencies.